And Its Implications for the International Monetary System

http://professorfekete.com/articles/AEFTheVanishingOfTheGoldBasis.pdf

The gold basis is defined as the difference between the nearby futures price and the cash price of gold in the same location. A positive basis is called contango; a negative one, backwardation. Since there were no organized futures markets in gold prior to 1971, the history of gold basis is confined to the last 35 or so years.

Gold futures trading started on the Winnipeg Commodity Exchange in Canada in 1971 at a time when ownership and trading of gold was still illegal in the United States. Upon becoming legal the bulk of gold futures trading moved to New York and Chicago.

For all these 35 years the gold markets have been in contango (with minor exceptions due to temporary friction in the delivery mechanism). The basis cannot theoretically exceed the carrying charge (the lion’s share of which is interest, usually calculated on the basis of LIBOR). If it did, speculators would be able to pocket risk-free profits in buying the cash gold and selling the futures contract against it. This arbitrage would quickly push the basis back to the level of carrying charge. By contrast, should the market ever go to backwardation, there is no theoretical limit below which a negative basis could not fall. One should see clearly the economic significance of gold backwardation. It is an unmistakable indication of shortages of deliverable supplies.

On the face of it, backwardation in gold would be a rank aberration of the world economy as most of the gold produced throughout the ages is still in existence in marketable form. For this reason profit is to be made by selling cash gold while replacing it through buying the much cheaper futures contract. If people hesitate to do it, there must be a reason. Indeed, the reason is the lack of confidence that paper gold can be exchanged for physical gold at maturity as specified by the futures contract.

The basis for agricultural commodities shows a clear annual cyclical pattern that closely follows the crop year. It starts with contango just after harvest, and ends with backwardation when supplies are drawn down just before the new crop is brought in.

The behavior of the gold basis lacks this cyclical pattern characteristic of the markets for agricultural goods. Contango obviously follows the fluctuations of the interest rate up or down, the adjustment being practically instantaneous. But, in addition, there is a rather curious phenomenon that can be described as the secular vanishing of the gold basis. This means that, as a percentage of the carrying charge (interest) the gold basis has been steadily eroding and by now has all but reached zero. Reversals in the trend, if any, are minor and temporary. It is difficult to imagine any combination of circumstances in which there could be a major reversal in the trend of the gold basis, unless there was an explosion of interest rates.

It is incumbent upon economic theorists to explain the peculiarity of the secular vanishing of the gold basis, which is not observed in the case of the basis of other non-agricultural commodities such as the base metals, for example.

The overwhelming fundamental fact about gold during the past half a century is the steady and relentless absorption of new supplies from the mines through individual hoarding demand. Half a century of gold production at peak rates of output has disappeared without a trace and is by and large unaccounted for. This is more gold than had ever been produced previously. At the same time also absorbed was whatever monetary gold governments and central banks have in their wisdom dishoarded. It can hardly be doubted that if further supplies of monetary gold were dishoarded, it would be easily absorbed as well, and any setback in the price of gold on that account would be temporary. One should also remember that net dishoarding of gold by governments and central banks is a thing of the past. Countries such as China, Russia, Brazil, to mention but a few, are on record as wanting to buy all the gold they can without unduly disturbing the price. This means that the combined net private and official demand for gold will be insatiable for the foreseeable future. This is in full agreement with the secular vanishing of the gold basis.

The burning question is what happens when gold markets go to permanent backwardation, as is likely if present trends continue. Clearly, the gold futures markets will be no longer viable as they are presently constituted. The main source of gold for investment purposes will be permanently shut, as a negative gold basis means that all offers to sell cash gold have been withdrawn. To see this we have only to remember that paper gold promising future delivery can no longer be trusted under the regime of a negative basis, as explained above.

The huge volume of trade in paper gold would disappear with the advent of permanent backwardation. The demise of the paper market means that governments and central banks have abruptly lost their power to control the price of gold. They would no longer be able to sell unlimited amounts of futures contracts. Paul Volcker has admitted in public that he made a mistake as Chairman of the Federal Reserve in allowing the dollar price of gold to rise as far and as fast as it did in 1979-1980. By implication, he and his successors have learned from his “mistake” and succeeded in subsequently driving down the dollar price of gold during the period 1981-2001, or to contain increases during the period from 2001 onwards. They did it through offering unlimited amounts of paper gold in the futures markets. As we approach the landmark of permanent backwardation, the question arises how will the Federal Reserve control the gold price once the facility of gold futures trading is gone.

Another question is how the gold mining industry will react to the disappearance of the futures market. There is a possibility that they will stop selling gold against dollars altogether until normalcy returns to the market. However, an announcement to withdraw the offer to sell newly mined gold would make the upheaval in the gold market even worse.

The implications for the international monetary system, in which the U.S. dollar is supposed to play the role of ultimate means of payment and extinguisher of debt, are devastating. The international monetary system is facing its greatest crisis for the past forty years as it confronts the threat of permanent backwardation in gold. Yet there is no sign that the financial press, or academia, let alone the U.S. Treasury and the Federal Reserve, take notice. They appear to think that the futures price of gold has no more relevance to the international monetary system than that of frozen pork bellies. They are under the illusion that gold has been demonetized. It has not. Not by the people anyhow, who had monetized it in the first place.

This crisis is a gold crisis, just as the last one in 1968 was. If anything, this one is the more serious of the two. In 1968 the crisis could be “papered over”, literally, by making the dollar irredeemable. Debt could still be liquidated in paper dollars because paper gold was still available. Presently this availability is the residual extinguisher of debt. Without it the debt markets could not function because bonds would, in effect, become irredeemable.

In 1968 policy-makers at the Treasury and the Federal Reserve were granted a “breathing space” during which they could devise a new international monetary system that would provide for orderly liquidation of debt. One hopes that they have used this breathing space fruitfully, and they have by now contingency plans ready for implementation when permanent gold backwardation engulfs the system and paper gold is no longer available, effectively removing the last “pacifier” from the debt markets.

It is not an encouraging sign that the planning, if any, has been done behind closed doors. There should have been an open debate on the debt crisis that threatens the world as gold markets go to backwardation. A blueprint for a new international monetary system should be drawn up publicly, with the participation of economists of all stripes and persuasion. Monetary reform should not be the exclusive turf of Keynesians and Friedmanites, according to whom there are compelling reasons to dismiss the gold standard out of hand as unfit, both conceptually and in practice, to play any role in a future international monetary system. They argue that its “disciplines” would be politically unacceptable in today’s world.

However, there is no way of telling what is politically acceptable and what is not in the throes of a great depression, with double digit unemployment, past the teens, when law and order is about to break down. Our debt crisis and the threat of gold backwardation are not unrelated . Aggregate debt as it exists in the world today is comparable to a runaway train on a down-sloping track. The train started picking up speed back in 1971 when the golden brakes were disabled. By now it is accelerating beyond any safe speed limit, and a crash appears inevitable. In order to slow the train down one needs an ultimate extinguisher of debt that is universally acceptable as a means of payment. The dollar no longer answers this description. Gold does. Everything else has been tried “to paper over” debt, all in vain. Already, the debt crisis wiped out an enormous amount of wealth indiscriminately, causing great economic pain. We ought to remember that if all the remaining paper wealth is wiped out, gold will still survive intact. It is the only financial asset that has no counterpart as a liability in the balance sheet of someone else. That is its main excellence, a property lacking in all other financial assets.

The hour is late. It calls for statesmanship. This is no time for finger-pointing and rancor. Having recognized the threat of gold backwardation for what it is: the greatest financial crisis in all history, we should act responsibly. If we do, it will be our “finest hour”.

aefekete@hotmail.com

June 23, 2009.

The Obama Administration is Looking at the Wrong Ratio

The Obama Administration has raised the ante in combatting the recession by increasing the debt of the government to levels that were previously considered unthinkable. It is explaining away the weakening financial structure of the country by saying that aggregate debt has not increased much relative to GDP and is therefore not excessive.

This argument is false to the core. One cannot take comfort in past increases of GDP to justify future increases of debt. The fact is that the increase in debt has been the major motive power behind the increase in GDP and prices. It cannot, therefore, be tested by its own results. The real test is the burden of debt. The economic advisers of president Obama forget that the GDP and prices may well decline, but the debt remains fixed. This means that, given the decline, even without further increases in aggregate debt the financial structure will deteriorate. How much more must it then deteriorate when all caution concerning the threat from excessive debt is thrown to the winds!

The argument about stimulating the economy with the proceeds of selling more government debt is equally false. It misrepresents the long-run economic effect of debt on the capacity to produce. If we stimulate the economy beyond its natural level by increasing debt, then we create a capacity that will not be required, and we induce a price and wage level that will not be possible to maintain when the debt spiral ceases. In this way government stimuli create latent pressures for future price, wage, and output declines, increasing the debt burden to a much greater extent than was originally envisaged.

Some people say it does not make any difference whether the money spent has come from debt or equity. This is fallacious because debt creates rigidities that are hard to adapt to declining prices and output. There will be some very unsettling effects. When people are scrambling for liquidity in self-defense, as they do now, debt will make them extra cautious about increasing their spending. This, in turn, makes conditions worse which will then make the debt more burdensome still, etc., creating a snowball effect. In adapting to adverse conditions the greatest enemies are fixed costs, such as interest, depreciation and, above all, debt which is not only hard to refinance but it also limits flexibility. If equity was used instead of excessive debt, then the snowball effect of adjusting to adverse conditions would be far less.

By virtue of pricing power the granting of “cost-of-living adjustments” to labor is easy and logical, provided that the cycle is in its upswing, so things are kept in fair balance. By contrast, reverse adjustments are very hard to make on the downswing. Therefore rigidities and maladjustments accumulate much faster, and they result in a much more precipitate decline as compared to the preceding rise in output.

The Obama administration is looking at the wrong ratio. Instead of the ratio of total GDP to total debt it should watch the ratio of additional GDP to additional debt, that is, the amount of GDP contributed by the creation of $1 in new debt. This ratio shows how effective debt is to make the economy grow at the margin, and for this reason it may be called the marginal productivity of debt. As long as it is well above 1, the creation of new debt has an economic justification. It shows that the economy can have a healthy growth. But a falling marginal productivity is a danger sign. It shows that the quality of debt is deteriorating. Should the ratio fall below 1, it is “red alert”. The volume of debt is rising faster than the national income. The country is living beyond its means and is consuming capital.

In the worst-case scenario the marginal productivity of debt may fall into negative territory. This means that the economy is on a collision course with the iceberg of debt. Not only does more debt add nothing to GDP, in fact it causes contraction and greater unemployment. Debt creation must cease at once as a matter of utmost urgency. The condition of the economy can be compared to that of a patient suffering from internal hemorrhaging that must be stopped immediately.

Several observers calculated the marginal productivity of debt tracing it back for the past fifty or sixty years. One of them, Barry B. Bannister of Baltimore published his results on his website bbbannister@stifel.com. While the calculations of various observers have yielded various results, they all agree that the marginal productivity of debt has been falling and will reach 0 if it has not already done so. The discrepancy is due to the difference in defining net financial debt to avoid double counting. For example, Bannister is netting out all except the first round debt in the derivatives tower and, as a consequence, his calculations predict a further decline in the ratio but it will not become negative before 2015. Others argue that the layers of the derivatives tower are essentially higher levels of debt re-insurance which cannot be netted out because every higher level means the introduction of new risks. Accordingly, their calculations show that zero marginal productivity of debt was reached back in 2007 and since then the ratio has been negative and falling further.

In spite of disagreements and discrepancies, these studies agree that the present crisis is a debt crisis, and any further addition to aggregate debt runs the risk of making the economy contract further. Under these circumstances the Obama administration’s economic policy is self-defeating. More debt is poison to the economy. The internal hemorrhage will continue, nay, it will get worse.

The correct policy should allow insolvent firms and banks to be liquidated without interference from the government. There should be a resolute policy to strengthen the capital structure of the remaining firms and banks. It is imperative that the level of aggregate debt be progressively reduced until a marginal productivity of 1 or higher is restored. It follows that the balance sheet of the Federal Reserve banks should be contracted rather than expanded.

Why is a negative marginal productivity of debt a sign of an imminent economic catastrophe? Because it indicates that the economy is literally devouring itself through the consumption of capital. Production is no longer supported by the prerequisite quantity and quality of capital goods. The responsibility for this belongs to the fast-breeder of debt. It may give the economy a sense of euphoria during the upswing of the cycle, but is devastating in a downswing.

In March, while he was the president of the European Union, the Czech prime minister Mirek Topolanek publicly characterized president Obama’s plan to spend nearly $2 trillion to ease the U.S. economy out of its recessionary hole, as “a highway to hell”, and he predicted that “it will undermine the stability of the global financial market”. While undoubtedly it was an undiplomatic gaffe and a display of extreme impoliteness, the caretaker prime minister did nothing but blurted out unpleasant truths.

It would have been more polite and diplomatic if Mr. Topolanek had couched his comments in the following tenor: “the stimulus plan was made in blissful ignorance of the marginal productivity of debt which is negative and falling. In this situation more debt will only stimulate deflation, economic contraction, unemployment, and it will lead to further weakening of the global financial structure.”

June 24, 2009.

Twenty-five years ago I visited Comex at the World Trade Center, watching the feverish activity in the gold pit from behind the glass wall in the gallery. A gentleman standing next, unknown to me, remarked: “One day this make-believe charade will come to a bad end. All that these guys are doing down there is creating ever more claims to the same lump of gold – just as governments have been doing before they met their ignominious fate.”

Later that day I went to see the Director of Research of Comex. During our chat that lasted about an hour he intimated that he was greatly disturbed by the mystery that the gold basis has been steadily declining year in and year out. Perhaps it was the fact that he could not solve the puzzle that bothered him so much that he quit his job a few months later.

I must confess that I could not solve that puzzle myself until the Twin Towers of the World Trade Center came tumbling down many years later. For me it was a symbolic event, conjuring up the unknown gentleman and bringing back his cryptic remark. We are watching a game of musical chairs. When the music stops, paper claims to gold will be dishonored, and the gold futures markets will tumble down just like the Twin Towers.

In my earlier article The Dress Rehearsal for the Last Contango I observed that “a very strange phenomenon has been manifesting itself during the past thirty-five years, since the inception of gold futures trading. The basis as a percentage of the rate of interest, rather than remaining constant, has been vanishing and, by now, it has dropped to zero.” In the rest of that article I drew attention to the apocalyptic consequences of the prospect of permanent backwardation in gold threatening the world, which is completely ignored by the makers of monetary policy, as I had opportunity to convince myself during my recent encounter with Paul Volcker, the Chairman of President Obama’s Economic Recovery Advisory Board. As I see it, the Debt Tower will topple, just as the Twin Towers of the World Trade center have, when hit by permanent gold backwardation. The reason is that the availability of gold is absolutely indispensable for maintaining our system of irredeemable debt. Only then will bondholders, like the participants of the game of musical chairs, be satisfied that there is a goodly number of vacant chairs available, so let’s get on with bond trading, gold futures trading, and let the music roar on.

But once permanent backwardation in gold establishes itself, gold is no longer available at any price. Bondholders will scramble to sell their irredeemable bonds before they lose all their remaining value. There is no other way to pacify bondholders than letting the game of musical chairs go on, that is, continue the charade of gold futures trading putting ever more claims on the same lump of gold.

The response to my article was overwhelming. I have never realized how many people out there are following my writings on the internet so closely. I want to thank every one of you and assure you that I take this responsibility most seriously. Even if I cannot answer every message I get from you individually, I will continue to do my best to explain the results of my research in simple, understandable terms.

Let me spell out for my readers what the vanishing of the gold basis means from the point of view of the puppet-masters of the gold futures markets. It means that they are fighting a losing battle. They are desperately trying to coax gold out of hiding by offering ever higher bribes – not in terms of the price but in terms of the basis. A low basis means that they offer to take your cash gold and let you have gold futures in exchange at a discount price. (The discount is contango minus the basis, so that the two are inversely related: as the basis falls, the discount increases.) This will allow you to invest an amount equal to the price of gold (less five percent, the margin on the gold future) in any way you want and, having paid the reduced contango, you can keep the profits. The point is that you will still benefit from any advance in the gold price, same as you would if you owned cash gold. You can have your cake and eat it. Remember, in a full carrying charge market, such as the gold futures markets were at inception, no such bribe money was offered.

But, lo and behold, people who are willing to take the bribe are few and far in between. So the pot is sweetened. The basis is lowered. Maybe at one point gold will be coaxed out of hiding, once the bribe is high enough.

No such luck. When the basis gets as low as zero, it means that the discount on gold futures has gone so high that it is equal to the opportunity cost of holding gold. Therefore, again, if you give up your cash gold in exchange for gold futures, you can invest an amount equal to the price of gold (less five percent) in any way you wish, but now they let you keep your profit in its entirety. And you can still benefit from any advance in the gold price, same as you would if you had the cash gold in your hands.

This is where we are now. Indications are that the game fish still does not bite. What now? Where do the futures markets in gold go from here? Well, the pot can be further sweetened. The basis can be pushed down into negative territory. Gold could be forced into backwardation. Let’s see what that means. It means that you can sell cash gold and buy it back for future delivery at an outright discount. Somebody wants your gold so badly that he is willing to pay you for the privilege of holding it for a few days, few weeks, few months paying your storage and insurance fees. You get your gold back at a cheaper price. You make a risk-free profit on this deal. If the gold price goes up in the meantime, you benefit fully, just as if you have held on to the cash gold.

Now risk-free profits are a promise of unlimited profits because, if you are nimble enough, then you can make any number of round trips. However, opportunities to earn risk-free profits from arbitrage do not last. Other nimble speculators would jump in and their unlimited action would close the spread that gave rise to the risk-free profit in the first place. Yet I predict that, after a period of initial vacillation between backwardation and contango (due to action by misinformed traders) gold will settle in permanent backwardation.

Wouldn’t that be lovely? Risk-free profits galore. No need to bother with storage charges and insurance premiums. Just sit back and enjoy the ride to riches.

But hey, wait a minute! Is the arbitrage really risk-free? You give up your cash gold, but what if your gold futures contract expires and they refuse to return your gold? Commodity markets can change the rules of the game mid-stream. They just declare ‘cash settlement only’ for outstanding contracts. Unsaid and unstated, not even mentioned in small print, is the fact that the trap door may be slammed shut. The investor who has taken the bribe is neatly separated from his gold when the hairy godfather waves his magic wand. “Gold is pale because it has so many thieves plotting against it.” There are all too many trap doors, sprung wide open, ready to devour gold belonging to the unwary.

That’s it. That’s why more people do not fall for the bribe even when tickled with promises of risk-free profits. The promise is mendacious. There is a risk: the risk that you lose your gold and you may never be able to buy it back at any price. There is no other explanation for the fact that the promise of risk free profits does not eliminate the discount on the futures price of gold. This is the true explanation for the coming permanent backwardation in gold.

Gold futures trading is clearly a con-game, but it is in a symbiotic relation with the regime of irredeemable currency and irredeemable debt, on which our ‘democracy’ is based. So we have a double con-game. We have a smaller con-game of gold future trading inflicted upon gullible people who want to have their cake and eat it and, then, we have the much bigger, all-embracing con-game of irredeemable currency, inflicted upon the rest of us, innocent bystanders. It is inflicted by the United States government that stoops so low as to trample on the Constitution mandating a metallic monetary system for this country precisely in order to outlaw all Ponzi-schemes. The government could never muster the moral courage to propose an Amendment that would make the Constitution conform to its monetary system – as it would open Pandora’s box. Rather, it would live with the onus of being in contempt of the Constitution. The government of the United States had looted gold from its own subjects in 1933. It looted even more gold from people not under its jurisdiction in 1971. It continues to operate in the same tradition.

The larger con-game of the irredeemable dollar could not have gone on so long, but for the smaller con-game of gold futures trading from which it takes its strength. Historically, every regime of irredeemable currency has met its Nemesis in no more than 18 years. The present experiment with irredeemable currency has been going on for twice that long. Of course, gold futures trading is a relatively new invention that was not available to the managers of the assignats, mandats, or the Reichsmarks. Nor was it available to the managers of the most recent experiment with the Zimbabwe dollar. But, as the relentless fall in the gold basis clearly shows, people cannot be conned forever. The clock is ticking. Sand in the hourglass keeps dropping. When it runs out, the present experiment with fiat dollar will also meet its Nemesis, as all the earlier experiments have. That’s the good news.

The bad news is that the government of the United States persists in continuing the double con-game and Ponzi-scheme through thick and thin. It is callous to the economic damage it is causing world-wide, and it disregards the danger of permanent gold backwardation that would inflict utter economic pain on the innocent people of this country, to say nothing of the people of the rest of the world. As explained above, it would make the runaway debt-tower of Babel topple, burying people under the rubble as the Twin Towers of the World Trade Center buried people working inside.

When that happens, the government of the United States will not have the excuse that it has not been warned. I have delivered the message in person to the Chairman of President Obama’s Economic Recovery Advisory Board, Paul Volcker, when we met at the Santa Colomba Conference last July. I also consider it my moral duty to warn all the people who are willing to listen of the danger lying ahead. It is incredibly na?ve to believe that gold can be removed from the international monetary system with impunity at the stroke of a pen, as they pretended to do it in 1973. The gold corpse still stirs. When it rises from its prostrate position it will, like Gulliver, dust off the Lilliputians who like ants have been scurrying all over his body. The day of reckoning will have dawned.

Keynesian and Friedmanite economists bear a special responsibility for the disaster. They dug in and monopolized their positions at universities and research institutes. They never allowed a free discussion on the gold standard. They did everything to aggrandize and perpetuate their own power as the sole advisors on government policy.

They will not be able to live down this shame in a thousand years.