Audiences today are eager to understand what is really happening in our financial system, and for a way out of the false alternative: (a) Keynes / Friedman / Modern Monetary Theory / Econometrics /obsession with consumer prices vs. (b) a “pure, 100% backed” (so called) gold standard without banking or lending

I recently presented my thoughts on the ongoing collapse of paper currencies–that debt is accumulating which cannot possible be paid back. Based on my study of the ideas of Professor Antal Fekete, I gave a pretty comprehensive survey of monetary science: the origin of money, irredeemable debt based money, interest rates, fractional reserve banking, arbitrage, and gold backwardation.

http://keithweiner.posterous.com/

The common definition of inflation is “an increase in consumer prices”, and deflation is “a decrease in consumer prices.” A corollary is the old myth: “a fine suit costs the same in gold as it did in 1912, one ounce.” Why should that be? It takes less land today to raise enough sheep to produce the wool, and less labor to shear them.

Consumer prices are affected by many factors. Increasing production efficiency tends to lower prices. But today, fewer people wear a suit than in 1912, and so the suit market has shrunk. This would tend to be a force for higher prices.

I don’t know if a suit cost $20 (i.e. one ounce of gold) in 1912. Today, one can certainly get a good suit for far less than $1600 (i.e. one ounce).

Consumer prices are a red herring. If certain prices don’t change in any given year, the government claims that there is no inflation. This is a lie.

One can’t understand much about the monetary system from inside this box. I offer a different definition.

Inflation is an expansion of counterfeit credit.

Inflation is a monetary phenomenon, but it is not simply about the money supply. In a gold standard, does gold mining create inflation? How about private lending? Bank lending? What about Real Bills of Exchange?

These processes do not create inflation under gold. We must focus on counterfeiting. Gold production is never counterfeit. Nor is lending. If Joe works hard, saves his money, and gives a loan of 100 ounces to John, this is an expansion of credit, but it is not counterfeit.

It does not matter whether there are market makers or other intermediaries in between the saver and the borrower. This is because such middlemen have no power to expand credit beyond what the saver provides. Bank lending is not inflation.

At least two factors distinguish legitimate from counterfeit credit. First, someone produces more than he consumes. Second, he knowingly and willingly extends credit. He understands the terms and the risks and when he will be repaid. In the meantime, he does not have the use of his money.

Let’s look at fractional reserve banking. I have written on this topic before (Fractional Reserve Banking). To summarize: if a bank takes in a deposit and lends for a longer duration than the deposit that is duration mismatch and fraud (and the source of banking system crashes). If a bank lends deposits only for the same or shorter duration, then the bank is perfectly stable and perfectly honest. An honest bank can expand credit by lending, but it is good credit.

The saver chooses how long he is willing to lock up his money, based on the bank’s offer of different interest rates for different durations. He lends to the bank under a contract of that duration. The bank then lends it out for that same duration (or less).

Now let’s look at Real Bills of Exchange. Under the gold standard of the 19th century, a business bought merchandise from its supplier and agreed to pay on Net 90 terms. For merchandise in urgent consumer demand the signed invoice, or Bill of Exchange, circulated as a kind of money. It was accepted at a discount from the face value based on the time to maturity and the prevailing discount rate.

This is a kind of credit that isn’t debt. The Real Bill market is a clearing mechanism. The end consumer will buy the final goods with gold. In the meantime, every business in the entire supply chain does not necessarily have the gold to pay at time of delivery. This problem would become worse as business and technology improved to allow additional specialization and thus extend the supply chain with more value-adding steps. And it would become worse as certain goods went into high demand seasonally (e.g. at Christmas).

The Real Bill is self-liquidating credit that arises from consumption, and it is legitimate.

Now let’s look at counterfeit credit. Per above, it is counterfeit because there is no saver, or he does not knowingly or willing forego the use of his savings.

First, is the example where there is no surplus. A good example is when the Federal Reserve creates currency to buy a Treasury bond. On their books, they create a liability for the currency issued and an asset for the corresponding bond purchase. Fed monetization of bonds is counterfeit credit, by its very nature. When the Fed expands its balance sheet, it is inflation.

Their very purpose is to create inflation. When real capital becomes more scarce, and thus its owners become more reluctant to lend it (especially at low interest rates), the Fed’s official role is to be the “lender of last resort”. Their goal is to continue to expand credit against the increasing market forces for credit contraction.

All counterfeit credit would go to default. Thus the Fed must do more and more to avoid ending up where it’s “pay or else”. Debts must be “rolled”. Debtors must be able to borrow anew to repay the old debts forever. The job of the Fed is to enable this.

Next, let’s look at duration mismatch. It begins the same way as good credit. The counterfeiting occurs when the bank lends a demand deposit or lends money in a 1-year time account for 5 years. Both cases are the same. The saver is not knowingly foregoing the use of his money, nor lending it out on such terms and length. The saver thinks he has his money, but yet there is another party who actually has it.

Sometimes the saver does not willingly extending credit. The worker who foregoes 16% of his wage to Social Security knows that he loses his money. He is extending credit, by force. The government promises him a monthly stipend someday plus some medical coverage. It’s a bad deal, which is why they need to use force.

Social Security is counterfeit credit.

Unlike in legitimate credit, counterfeit credit is mathematically certain not to be repaid. This is because the borrower is without the intent or means to repay. It is a matter of time before it defaults (or the borrower forfeits his collateral).

Above, I offered two factors distinguishing legitimate credit:
1. The creditor has produced more than he has consumed
2. He knowingly and willingly extends credit

Now, let’s complete this definition with the third factor:
3. The borrower has the means and the intent to repay

A corollary to this is that dealers in counterfeit credit, by nature and design, must work constantly to keep “rolling” it, and to maintain the confidence game. It cannot be repaid normally. Sooner, or later, it inevitably becomes a crisis that either hurts the creditor by default or the debtor by threatening or seizing his collateral.

I repeat my definition of inflation and add my definition of deflation:

Inflation is an expansion of counterfeit credit.
Deflation is a forcible contraction of counterfeit credit.

Inflation is only possible by the use of force by governments and central banks. Whenever credit is extended with no means or ability to repay, that credit is certain to eventually become a crisis. Either the creditor will be harmed, or if he has good collateral then the debtor must take the pain.

Here’s to hoping that in 2012, the discussion of a more sound monetary and banking system begins in earnest.

http://keithweiner.posterous.com/

It seems self-evident.  The government can debase the currency and thereby be able to pay off its astronomical debt in cheaper dollars.  But as I will explain below, things don’t work that way.  In order to use the debasement of paper currencies to repay the debt more easily, governments will need to issue and use the gold bond[1].

I give credit for the basic idea of using gold bonds to solve the debt problem to Professor Antal Fekete, as proposed in his paper: “Cut the Gordian Knot: Resurrect the Latin Monetary Union” (http://www.professorfekete.com/articles/AEFCutTheGordianKnot.pdf).  My paper covers different ground than Fekete’s, and my proposal is different as well.  I encourage readers to read both papers.

The paper currencies will not survive too much longer.  Most governments now owe as much or more than the annual GDPs of their nations (typically far more, under GAAP accounting).  But the total liabilities in the system are much larger.

Even worse, in the formal and shadow banking system, derivative exposure is estimated to be more than 700 trillion dollars.  Many are quick to insist that this is the “gross” exposure, and the “net” is much smaller as these positions are typically hedged.  But the real exposure is close to the “gross” exposure in a crisis.  While each party may be “hedged” by having a long leg and a balancing short leg, these will not “net out”.  This is because in times of stress the bid (but not the offer) is withdrawn.  To close the long leg of an arbitrage, one must sell on the bid (which could be zero).  To close the short leg, one must buy at the offer (which will still be high).  When the bid-ask spread widens that way, it will be for good reason and it does not do to be an armchair philosopher and argue that it “should not” occur.  Lots of things will occur that should not occur.

For example, gold should not go into backwardation.  This is another big (if not widely appreciated) piece of evidence that confidence in the ability of debtors to pay is waning.  Gold and silver went into backwardation in 2008 and have been flitting in and out of backwardation since then.  Backwardation develops when traders refuse to take a “risk free” profit.  That is, the trade is free from all risks except the risk of default and losing one’s metal in exchange for a defaulted futures contract.  See my paper (http://keithweiner.posterous.com/61392399) for a full treatment of this topic.

The root cause of our monetary disease has its origins in the creation of the Fed and other central banks prior to World War I, and in the insane treaty signed in 1944 at Bretton Woods in which many nations agreed for their central banks to use the US dollar as if it were gold, and this paved the way for President Nixon to pound in the final nail in the coffin.  He repudiated the gold obligations of the US government in 1971, thereby plunging the whole world into the regime of irredeemable paper.

The US dollar game is a check-kiting scheme.  The Fed issues the dollar, which is its liability.  The Fed buys the US Treasury bond, which is the asset to balance the liability.  The only problem is that the bonds are payable only in the central bank’s paper scrip!  Meanwhile, per Bretton Woods, the rest of the world’s central banks use the dollar as if it were gold.  It is their reserve asset, and they pyramid credit in their local currencies on top of it.

It is not a bug, but a feature, that debt in this system must grow exponentially.  There is no ultimate extinguisher of debt.  In my paper on Inflation (http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit), I define inflation as an expansion of counterfeit credit.  I define deflation as a forcible contraction of counterfeit credit, and the inevitable consequence of inflation.  Well, we have had many decades of rampant expansion of counterfeit credit.  Now we will have deflation, and the harder the central banks try to fight it by forcing yet more expansion of counterfeit credit, the worse the problem becomes.  With leverage everywhere in the system, it would not take many defaults to wipe out every financial institution.  And there will be many defaults.   One default will beget another and once it really begins in earnest there will be no stopping the cascade.

Another key problem is duration mismatch.  Today, every bank and financial institution borrows short to lend long, many corporations borrow short to finance long-term projects, and every government is borrowing short to fund perpetual debts.  Duration mismatch can cause runs on the banks and market crashes, because when depositors demand their money, banks must desperately sell any asset they can into a market that is suddenly “no bid”.  In two papers (http://keithweiner.posterous.com/fractional-reserve-is-not-the-problem and  http://keithweiner.posterous.com/falling-interest-rates-and-duration-mismatch), I cover duration mismatch in banks and corporations in more depth.

Most banks and economists have supported a policy of falling interest rates since they began to fall in 1981.  But falling interest rates destroy capital, as I explain in that last paper, linked above.  As the rate of interest falls, the real burden of the debt, incurred at higher rates, increases.

Related to this phenomenon is the fact that the average duration of bonds at every level has been falling for a long time (US Treasury duration began increasing post 2008, but I think this is an artifact of the Fed’s purchases in their so-called “Quantitative Easing”).  Declining duration is an inevitable consequence of the need to constantly “roll” debts.  Debts are never repaid, the debtor merely pays the interest and rolls the principal when due.  As the duration gets shorter and shorter, the noose gets tighter and tighter.  If there is to be a real payback of debt, even in nominal terms, we need to buy more time.  At the US Treasury level, average duration is about 5 years.  I doubt that’s long enough.

And of course the motivation for building this broken system in the first place is the desire by nearly everyone to have a welfare state, without the corresponding crippling taxation.  It has been long believed by most people a central bank is just the right kind of magic to let one have this cake and eat it too, without consequences.  Well, the consequences are now becoming visible.  See my papers (http://keithweiner.posterous.com/the-laffer-curve-and-austrian-economics and http://keithweiner.posterous.com/a-politically-incorrect-look-at-marginal-tax) discussing what raising taxes will do, especially in the bust phase like we have now.

In reality, stripped of the fancy nomenclature and the abstraction of a monetary system, the picture is as simple as it is bleak.  Normally, people produce more than they consume.  They save.  A frontier farmer in the 19^th century, for example, would dedicate some work to clearing a new field, or building a smokehouse, or putting a wall around a pasture so he could add to his herd.  But for the past several decades, people have been tricked by distorted price signals (including bond prices, i.e. interest rates) into consuming more than they produce.

In any case, it is not possible to save in an irredeemable paper currency.  Depositing money in a bank will just result in more buying of government bonds.  Capital accumulation has long since turned to capital decumulation.

This would be bad enough, as capital is the leverage on human effort that allows us to have the present standard of living.  We don’t work any harder than early people did 10,000 years ago, and yet we are vastly more productive due to our accumulated capital.

Now much of the capital is gone, and it cannot be brought back.  It will soon be impossible to continue to paper over the losses.  The purpose of this piece is not to propose how to save the dollar or the other paper currencies.  They are past the point where saving them is possible.  This paper is directed to avoiding the collapse of our civilization.

If we stay on the present course, I think the outcome will look more like 472 AD than 1929.  We must solve three problems to avoid that kind of collapse:

1. Repayment of all debts in nominal terms
2. Keep bank accounts, pensions, annuities, corporate payrolls, annuities, etc. solvent, in nominal terms
3. Begin circulation of a proper currency before the collapse of the paper currencies, so that people have something they can use when paper no longer works

I propose a few simple steps first, and then a simple solution.  All of this is designed to get gold to circulate once again as money.  Today, we have gold “souvenir coins”.  They are readily available, and have been for many years, but they do not circulate.

A gold standard is like a living organism.  While having the right elements present and arranged in the right way is necessary, it is not sufficient.  It must also be in constant motion.  Gold, under the gold standard, was always flowing.  Once the motion is stopped, restarting it is not easy.  This applies to a corpse of a man as well as of a gold standard.

The first steps are:

1. Eliminate all capital “gains” taxes on gold and silver
2. Repeal all legal tender laws that force creditors to accept paper
3. Also repeal laws that nullify gold clauses in contracts
4. Open the mint to the (seigniorage) free coinage of gold and silver; let people bring in their metal and receive back an equal amount in coin form.  These coins should not be denominated in paper currency units, but merely ounces or grams

Each of these items removes one obstacle for gold to circulate as money, along side the paper currencies.  The capital “gains” tax will do its worst damage precisely when people need gold the most.  At that point, the nominal price of gold in the paper currencies will be rising very rapidly.  Any sale of bullion will result in a tax of virtually the entire amount, as the cost basis from even a few weeks prior will be much lower than the current price.  This amounts, in the US, to a 28% confiscation of gold.  This tax will force people to keep gold underground and not bring it to market.  It will contribute to the acceleration of permanent backwardation.

It is important to realize that gold is not “going up”.  Paper is going down.  There is no gain for the holder of gold; he has simply not lost wealth due to the debasement of paper.

Current law forces creditors to accept paper as payment in full for all debts, and there are also laws that nullify gold clauses in contracts.  Repeal them, and let creditors and borrowers negotiate something mutually agreeable.

Finally, the bid-ask spread on gold bullion coins such as the US gold eagle or the South African krugerrand is too wide.  If the mint provided seigniorage-free coinage service, then people would bring in gold bars and other forms of bullion until the bid-ask spread narrowed appropriately.  One of the attributes that gives gold its “moneyness” is its tight spread (even today, it is 10 to 30 cents per $1600 ounce!)  But currently, this tight spread only applies to large bullion bars traded by the bullion banks and other sophisticated traders.  This spread must be available to the average person.

As I said earlier, these steps are necessary.  Gold certainly will not circulate under the current leftover regime from Roosevelt and Nixon.  But it is not sufficient to address the debt problem.

Accordingly, I propose a simple additional step.  The government should sell gold bonds.  By this, I do not mean gold “backed” paper bonds.  I mean bonds denominated in ounces of gold, which pay their coupon in ounces of gold and pay the principal amount in ounces of gold.  Below, I explain how this will solve the three problems I described above.

Mechanically, it is straightforward.  The government should set a rule that, to buy a gold bond, one does not bid dollars.  One bids paper bonds!  So to buy a 100-ounce gold bond, then one could bid for example $160,000 worth of paper bonds (assuming the price of gold is $1600 per ounce).  The government retires the paper bond and in exchange replaces it with a newly-issued gold bond.

The government should start with a small tender, to ensure a high bid to cover ratio.  And a series of small auctions will give the market time to accept the idea.  It will also allow the development of gold bond market makers.

With gold bonds, it would be possible to sell long durations.  With paper, there is no good reason to buy a 30-year bond (except to speculate on the next move by the central bank).  The dollar is expected to fall considerably over a 30-year period.  But with gold, there is no such debasement.  The government could therefore exchange short-duration debt for long-duration debt.

At first, the price of the gold bonds would likely be set as a straight conversion of the gold price, perhaps adjusted for differing durations.  For example, a 100 ounce gold bond of 30 years duration might be bid at $160,000 worth of 30-year paper bond.

But I think that the bid on gold bonds will rise far above “par”, for several reasons I will discuss below.

The nature of the dynamic will become clear to more and more people in due course.  In the present regime, there is a common misconception that the yield on a bond is set by the market’s expectation of how much consumer prices will rise (the crude proxy for the loss of value for the dollar).  But this is not true.  Unlike in a gold standard, in an irredeemable paper standard, people are disenfranchised.  They have no say over the rate of interest.  The dollar system is a closed loop, and if you sell a bond then you either hold cash in a bank, which means the bank will buy a bond.  Or you buy another asset.  In which case the seller of that asset holds cash in a bank or buys a bond.  This is one of the reasons why the rate of interest has been falling for 30 years despite huge debasement.  All dollars eventually go into the Treasury bond.

The price of the paper bond today is set by a combination of central bank buying, and structural distortions in the system.  But it is a self-referential price, in a game between the Treasury and the Fed.  The price of the bond does not really come from the market.  And this impacts every other bond in the universe, which all trade at varying spreads to the Treasury.

An alternative to paper bonds would be very attractive to those who want to save and earn income for the long term, pension funds, annuities, etc.  Not only will the price of gold continue to rise (i.e. the value of the paper currency will continue to fall towards zero), but also a premium for gold bonds would develop and grow.  The quality asset will be recognized to be worth more, and at the least people would price in whatever rate of the price of gold they expect to occur over the duration of the bond.

This dynamic—a rising price of gold, and a rising exchange value of gold bonds for paper bonds—will allow governments and other debtors to use the devaluation of paper as a means to repay their debts in nominal terms, but affordably in real terms.

This is impossible under paper bonds!  This is because the process of debasement is a process of the Treasury borrowing more money.  Debt goes up to debase the dollar.  This path leads not to repayment of the debt cheaply, but to exponentially growing debt until a total default.

So we have solved problem number one.  With a rising gold price, and a rising exchange rate of gold bonds for paper bonds, we have set up a dynamic whereby every paper obligation can be met in nominal terms.  Of course, the value of that paper will be vastly lower than it is today.  This is the only way that the immense amounts of debt outstanding can possibly be honored.

This also solves problem number two.  If every financial institution is repaid every nominal dollar it is owed, then they will remain solvent.  To be sure, pension payments, bank accounts, corporate payroll, and annuities etc. will be of much lower real value.  But there is a critical difference between smoothly losing value vs. abruptly losing everything, along with catastrophic failure of the financial system.

I want to address what could be a misconception at this point.  Does this work only for governments that have gold reserves in the vaults?  No, this is not about gold reserves.  While that may help accelerate a gold bond program, the essential is not gold stocks but gold flows.  The government issuer of gold bonds must have a gold income (or a credible plan to develop one quickly).

And this leads to problem number three.  Gold does not circulate today.  Who has a gold income?  That is where we must look to begin the loop.  There is one kind of participant today who has a gold income: the gold miner.  Beset by environmentalist lawsuits, regulations, permits, impact studies, fees, labor law, confiscatory taxes, and other obstacles created by government, these companies still manage to extract gold out of the ground.

The gold miners are the group to which we must turn to help solve the catch-22 of getting gold to circulate from the current state where it does not.  I think there is a simple win-win proposition to offer them.  In exchange for exemptions from the various taxes, regulations, environmentalism, etc. they have a choice to pay a tax in gold bullion.

There are other kinds of entities to consider taxing, but the problem is that they all would need to buy gold in the open market in order to pay the tax.  As the price begins to rise exponentially, this will be certain bankruptcy for anyone but a gold miner.

And now, look at the progress we’ve made on the problem of getting gold to circulate.  We have gold miners paying tax in gold to governments who are making bond coupon payments in gold to investors who now have a gold income.  We can see how gold bond market makers will enter the scene, and earn a gold income to provide liquidity for bonds that are not “on the run”.  These bond market makers could pay a tax in gold also.

And we have released other creditors from any restriction in lending and demanding repayment in gold.  And anyone else in a position to sign a long-term agreement involving a stream of payments over a long period of time, such as landlords, can incorporate gold clauses in their contracts.  And if the tenant has a gold income, perhaps from owning a gold bond, he can manage his cash flows and confidently sign such a lease.

Note that the lender, unlike the employee, the restaurant, or most other economic actors, is in a position to demand gold.  While everyone else would like to be paid in gold, they haven’t got the pricing power to demand it.  The lender can say: “if you want my capital, you must repay it in gold!”

If enough gold bonds are issued soon enough, we may reverse the one-way flow of gold from the markets into private hiding, that is inexorably leading to inevitable permanent backwardation and the withdrawal of all gold from the system.

One of the key points in my backwardation paper is that the value of the dollar collapses to zero not as a consequence of the quantity of dollars rising to infinity, but because of the desire of some dollar holders to get gold.  If they cannot trade paper for gold, then they will trade paper for commodities without regard to price and trade those commodities for gold.  This will cause the price of the commodities in dollar terms to rise to levels that make the dollar useless in trade (and collapse the price of commodities in gold terms).

If we reverse the flow of gold out of the markets, we may be able to prevent this disaster from occurring.  The dollar will then continue to lose value in a continuous (if accelerating) manner, as people migrate to gold.

This is the best outcome that could possibly be hoped for.  If it occurs along with a reduction in spending so that spending does not exceed (tax) revenues, we will avert Armageddon and be on the path to a proper and real recovery.  To be clear, times will be hard and the average standard of living will decline precipitously.

But this is infinitely preferable to total collapse.

It is now up to farsighted leaders, especially in government, to take the first concrete steps towards saving Western Civilization.

http://keithweiner.posterous.com

Professor Antal Fekete has written several pieces discussing gold backwardation, and arguing that this is the red alert signal for the coming financial Armageddon, when the tower of unpayable debts collapses. In this paper, I delve deeper into this topic. My goal is to make this topic approachable by the layman and describe what I think will happen when backwardation in gold futures becomes permanent.

Most people define “backwardation” for a commodity as when the price of a future contract is lower than the price in the spot market. But since there are two prices for everything, we must look at the bid and the offer. They are more meaningful than the last cleared price (which is what people think of as “the price”). So we must refine the concept of backwardation slightly, as I will show below.

In backwardation, one can sell a physical good for cash and simultaneously buy a future to make a profit. Note that in doing this trade, one’s position does not change in the end. One begins with a certain amount of the good and ends (upon maturity of the contract) with that amount of the good.

So let us examine the actual trade that any arbitrager in the market could do. To sell the physical commodity, one must take the bid. And likewise, to buy the future one must pay the offer. With this arbitrage in mind, we define the term:

Backwardation is when the bid in the spot market > offer on a future

Why is this important? What does it mean?

Many commodities, like wheat, are produced seasonally. But consumption is much more evenly spread around the year. Immediately prior to the harvest, the spot price of wheat is normally at its highest. This is because wheat stocks in the warehouses are very low. People will have to pay a higher price for immediate delivery. At the same time, everyone in the market knows that the harvest will be in one month. So the price, if a buyer can wait one month for delivery, is lower. This is a case of backwardation.

Normally, backwardation is a signal that a commodity is scarce. This is because if anyone had a quantity of it, they could make a risk-free profit by delivering it and getting it back later. Markets do not normally offer risk-free profits, and in the case of backwardation there is not normally a real opportunity to make a risk-free profit because the good really is scarce—no one actually has a lot of it to sell at that time.

It is worth delving into arbitrage briefly to complete the point about backwardation. Arbitrage is, in essence, an attempt to make a profit on a spread (usually by buying one thing and selling another). The important thing to note is that the arbitrager pays the offer on what he buys, thus lifting said offer, and takes the bid on what he sells, thus depressing said bid. The arbitrager, alone or with many others doing the same trade, will usually force the spread to narrow to the point where further arbitrage is no longer profitable. If it is possible to make a risk-free profit someone will do it, and another, and so on until it is no longer to make a risk-free profit.

I said “usually” because in the case of a shortage of wheat it is not possible to make a risk-free profit unless one has physical wheat in one’s warehouse. In the case when there is not enough grain remaining in stock to compress this spread, backwardation persists (or grows) until the harvest.

Earlier, I said backwardation “normally” means there is a shortage. But what if backwardation happens to gold? There is more gold in human possession than any other commodity by a factor of 100 or more (abundance or scarcity must be measured as a ratio of stocks or inventories to flows or annual production—the absolute amount is not important). Given gold’s massive accumulated inventories, a “shortage” of gold is impossible.

So what does gold backwardation really mean?

For ordinary commodities, the lower price on the future contract vs. spot signals the relative scarcity available for delivery today vs. delivery in the future. But what would a lower price on gold for future delivery mean compared to a higher price on gold to be had in one’s hand today? Well, mechanically, it means that gold delivered to the market is in short supply.

The meaning of gold backwardation is that trust in future delivery scarce, vs. trust in the gold in one’s hands today.

In an ordinary commodity, scarcity of the physical good available for delivery today is resolved by higher prices. At a high enough price, demand for wheat falls until existing stocks are sufficient to meet the reduced demand.

But how is scarcity of trust resolved?

Thus far, the answer has been via higher prices. However, when backwardation becomes permanent, then trust in the gold futures market will have collapsed. Unlike with wheat, millions of people and some large institutions have plenty of gold they can sell in the physical market and buy back via futures contracts. When they choose not to, that is the beginning of the end of the current financial system.

Why?

Think about the similarities between the following three statements:

• “My paper gold future contract will be honored by delivery of gold.”
• “If I trade my gold for paper now, I will be able to get gold back in the future.”
• “I will be able to exchange paper money for gold in the future.”

I submit that it will not take gold holders a long time to arrive at the inevitable conclusion. If some holders of gold do not agree, then they will sell (at higher prices, probably) to those who do. Soon enough, there will not be sellers of gold in the physical market.

With an ordinary commodity, there is a limit to what buyers are willing to pay based on the need satisfied by that commodity, the availability of substitutes, and the buyers’ other needs that also must be satisfied within the same budget. The higher the price, the more that holders are motivated to sell and the less that consumers are motivated (or able) to buy. The cure for high prices is high prices.

But gold is different. Unlike wheat, it is not bought for consumption. While some people hold it to speculate on increases in its paper price, by the logic above, they will be replaced by people who are holding it because they do not trust paper and want to hold gold because gold is money.

Gold does not have a “high enough” price that will discourage buying or encourage selling. No amount of price change will bring back trust in paper currencies once said currencies decline past the threshold where it is obvious to a critical mass of people. Thus gold backwardation will not only recur, but at some (hard to predict) point, it will not leave its backwardated state.

In looking at the bid and offer, one other fact is germane to this discussion. In times of crisis, it is always the big that is withdrawn; there is never a lack of offers. Another way of looking at permanent gold backwardation is as the withdrawal of gold’s (i.e. money’s) bid on irredeemable government debt paper (e.g. dollar bills). But paper’s bid on gold is unlimited.

The remainder of this essay address what will happen to non-monetary goods when gold goes into permanent backwardation. Note that it is possible that silver will go into backwardardation prior to, concurrently with, or following gold. I make no prediction about the sequence. In the following discussion, everything should be interpreted to apply to silver as well as gold.

Many people who hold paper but who desire to hold gold will buy (e.g.) crude oil for paper, and then sell it for gold (I will call buying a commodity for paper to sell it for gold “gold arbitrage”). This will drive up the price of crude in terms of paper, and drive down the price of crude in terms of gold. Even if this “window” were to remain open indefinitely, it is obvious that larger and larger amounts of paper will buy dwindling amounts of gold. This is because of the twin rising prices of crude-in-paper and gold-in-crude.

For example, if today the price of a barrel of crude in terms of paper is $100 and gold priced in crude is 15 barrels, then $1500 can be traded for one ounce of gold this way. But if the price of crude in paper rises to $2000 and the price of gold in crude rises to 150 barrels, then one would need $300,000 to trade for one ounce of gold this way. There will always be a gold bid on crude, but it need not necessarily be high.

Of course, this window will shut sooner or later (I suspect sooner), as I show below.

To summarize, what I have outlined above is the logical outcome of permanent gold backwardation. With an understanding of Austrian economics, particularly the ideas of Carl Menger and Antal Fekete, one can see that in permanent gold backwardation the following steps are inevitable:

• Withdrawal of offers to sell physical gold for paper money
• Skyrocketing price of liquid commodities in terms of paper
• Falling price of commodities in terms of gold

Gold is not officially recognized as the foundation of the financial system. Yet it is still a necessary component, without which the system will collapse. As I will show, it is impossible to divorce gold and paper without also divorcing commodities and paper.

Earlier, I gave three equivalent statements:

• “My paper gold future contract will be honored by delivery of gold.”
• “If I trade my gold for paper now, I will be able to get gold back in the future.”
• “I will be able to exchange paper money for gold in the future.”

My point was to show that these statements are all false. They are false for the same reason. This is what is discovered by the market, when it goes into permanent backwardation. Paper currencies are backed by debt, and the debt has grown far past the point where it could possibly be repaid. It is rapidly approaching the point where the interest cannot be kept current. So governments and other borrowers seek to borrow ever more money to pay the interest on their debt and to cover their permanent deficits. This cannot continue forever, or indeed much longer.

There is a fourth statement that is equivalent to the other three above:

“My paper money will be accepted in trade for the goods I need in the future”

If the first three are false, this one is also necessarily false.

The commodity producers will eventually be forced to do business by buying their inputs for gold and selling their outputs for gold. To validate this, let us use the technique of assuming the opposite is true, and see if that leads to a contradiction. Let us assume that commodity producers will continue to operate by buying their inputs for paper and selling their outputs for paper. As discussed above, paper prices for their output products will be skyrocketing. At first, this would seem to be good for them.

However, we must consider that each business needs to keep the appropriate balance of its capital in cash, ready to pay for inputs, wages, etc. Under conditions of rapidly rising prices for inputs, cash is rapidly losing purchasing power. One cannot keep cash for more than a day (if that), without losing precious capital. Every business will spend its cash as quickly as possible. Now someone has to hold it, as the cash does not go out of existence when one spends it—it just goes into someone else’s hands. So this will be a period of rapidly accelerating capital decumulation. Second, most businesses will have a suboptimal allocation of cash which is determined, not by rational analysis, but by this game of “hot potato”. This leads to another consequence: shortages.

Ordinarily, the businessman does not want to keep excess inventory of his output product. This is because the marginal utility of oil or tires or whatever declines rapidly, but the marginal utility of money (even paper money) does not. But in the condition of gold backwardation, the marginal utility of paper is declining faster than any real product.

So the commodity producer would be wise to keep its output in inventory, and only sell his products as he needs the cash to buy another input. This is inefficient, and tantamount to losing the benefit of indirect trade. It will cause supply disruptions to businesses that use this commodity as their input. It will also cause much wider spreads, as the market becomes less liquid, and rapidly changing prices add the risk that a normally profitable spread could become unprofitable. Narrow spreads are a sign of increasing economic coordination; widening spreads are a sign of collapsing coordination.

In gold backwardation, the next problem for commodity producers to (somehow) address is: how can a business use a rapidly diminishing currency as its unit of account? How is one to even determine whether production is profitable or unprofitable? Hint: if a business is decumulating capital, it is making losses.

One must also consider real demand (as opposed to the demand for a medium for the gold arbitragers). As the paper price rises, most buyers don’t have unlimited amounts of paper to pay. How many people can fill their car with gasoline every week at $100 per gallon? How about $1000? Real demand for commodities is collapsing in this environment (going back to the analysis above, recall that the prices of commodities in gold are falling). But the prices are rising in paper terms. Regardless of the value of paper money, in real terms: most businesses that produce a good with rapidly falling demand do not make a profit.

Another challenge comes from the fact that not all prices rise equally. As discussed above, the primary driver for liquid commodity prices is the arbitrage to get into gold, because there will always be a gold bid for food and energy. But what about specialty manufactured products?

Machine parts and truck tires do not make a suitable vehicle for the gold arbitrage, and so their prices may not rise to the extent of oil and wheat. The spread (i.e. profit margin) for manufacturers of these items, who need to buy oil as their inputs, may very well become permanently negative. While there will be some demand from commodity producers to provide a bid, such thinly traded markets could see enormous volatility. The nature of a business who makes a specialty product for a thinly traded market, especially a business which is thinly capitalized, is that it must make a profit every month or at least every quarter or else close its doors. Even if the spread reverts to the mean, an inversion lasting one or two months could be enough to destroy such a company.

And even if the spread does not collapse, think of the behavior of their customers. Unlike oil drillers whose output product is in constant demand (especially by the gold arbitragers), who can choose exactly when they sell their products, specialty manufacturers are not sovereign. They must sell when buyers want to buy. But their buyers, the commodity producers, are going to be controlling their buying and selling in larger batches rather than the steady buying of “just in time” that was operative when the currency was stable.

So a summary of (some) consequences suffered by all commodity producers who try to do business in terms of paper money after permanent gold backwardation:

• Capital decumulation due to the necessity of holding some cash at some times while said cash is rapidly falling in value
• Supply shortages, including failure of critical vendors, causing production disruptions and lost time/money
• Hoarding of produced goods
• Collapsing real demand
• Skyrocketing prices do not perfectly compensate for skyrocketing costs
• Rising volatility and widening spreads across the board
• No usable unit of account for one’s books, so losses will (temporarily) look like gains
• As currency devolves, efficiency of transactions devolves also to become more like direct (barter) trade, requiring coincidence of wants or at least timing

Without even addressing strikes by workers, failure of critical infrastructure like the electrical grid, or the breakdown of law and order (how will the government collect and use taxes to employ police and firefighters?), it should be clear that businesses who use paper money will not be able to operate profitably for long.

Thus it is safe to conclude that the gold miners will not continue to provide gold to the paper market. The same holds true for all other commodities. By temporarily assuming that commodity producers could continue to supply goods to sell for paper, the opposite has been proven.

While no one can predict the timing, and I think that it will be years away, my conclusion is that Von Mises’ “Crack Up Boom” is an inevitable consequence of permanent gold backwardation.

© Keith Weiner May 10, 2011