WHO SAID THE
HYDRA WOULD TAKE IT LYING DOWN while its
several heads were being chopped off one-by-one?
Austrian School of Economics
never appealed to the so-called conspiracy theories in trying to explain the
strange world of fluctuations in the price of monetary metals. But neither have I
ever said that the fiat-money Hydra will take it lying down when it comes to
chopping off its several heads one-by-one.
Markets for the
monetary metals under fiat money
the relevant facts:
U.S. government defaulted on its obligation to pay its short-term
debt to foreign governments and central banks in gold at a fixed rate, as confirmed
by several international treaties and by the solemn pledges of several sitting
presidents, on August 15, 1971. Subsequently it has been bankrolling a chorus of
servile academic cheer-leaders and other sycophants to shout from the roof-top
that the gold standard was a ‘barbarous relic’ anyway, quite ripe to be gotten rid
effort to cover up the shame of fraudulent default (fraudulent
because the U.S. did have the gold and could have lived up to its international
the U.S. confiscated some of the gold belonging to institutions outside its own
jurisdiction, but could not confiscate all of it. University economics departments and
research institutions have failed to investigate what gold at large will do in the
long run. They just assumed that it will be business as usual without gold in eternity. Well, it didn’t quite
turn out that way. Speculators soon started trading gold futures, first in Canada, then in 1975 in the U.S. as
well. No universities and think-tanks showed an interest in studying gold futures trading and its long-run
has been reduced tothe status of frozen pork bellies. We know all thatis to be
known about trading frozen pork bellies, don’t we? Supply and demand, right? And when push comes to shove, it is
easier to increase the supply of paper gold than that of frozen pork bellies, isn’t it? (With due apologies to
the late Fritz Machlup of Princeton
University for this interpretation of his theory of gold futures trading.)
bypass the question whether our institutions ignored problems connected with futures
trading of monetary metals on their own volition, or whether they did so under
duress. As it turned out two scores of years later, the failure to study the consequences
of the so-called demonetization of gold (euphemism for highway robbery)
has caused an unprecedented world disaster: the disintegration of the world’s
payments system that is now unfolding before our very eyes.
scientific inquiry would have shown back in the 1970’s that the gold
(defined as the difference between the nearby futures price and the price for
immediate delivery of gold) would be robust, in fact, it would be at its maximum
(equal to the carrying charge, or opportunity cost of holding gold). But soon
it would start its relentless decline all the way to zero and beyond. A negative
gold basis, a condition known as backwardation of gold, would create an
extremely unstable situation in international finance because it meant risk free
profits for holders of gold. Knowledgeable market participants realize that persistently
falling basis means increasing scarcity which, in the case of gold, is not and
cannot be alleviated by current output from the mines. Output ultimately
match for the mass movement of gold going into hiding, first gradually, eventually reaching crescendo when the
threat of permanent gold backwardation
starts looming large. At that point all deliverable supplies of physical
gold would be gobbled up by gold hoarding. In case of monetary metals, in
contrast with all other commodities, high and increasing prices may not bring
out new supply. Rather, they might make supply shrink. Monetary
metals are exempt from the law of supply and demand. Under
permanent backwardation, as no gold were offered for sale at any price, the
‘price of gold’ would become a vacuous concept. Gold, silver and, soon
enough, all other highly marketable goods would only be available through barter. In
other words, paper money as we know it would simply cease to function.
We cannot fathom how our complex world economy could operate under such
circumstances. One thing was certain, though: the world economy would
contract in a way that would make the contraction in the 1930’s appear as a blip on
bubbles, all currency and financial crises of the past forty years are
indirect consequences of the vanishing gold basis –
admit it or not. A
few years ago Professor Robert Mundell of Columbia University invited me
to attend his annual seminar at Santa Colomba, with most of the leading
monetary scientist in attendance. I circulated a statement warning of the danger of
permanent gold backwardation and how it would adversely affect the world
economy. I argued that permanent backwardation of gold would be a watershed-event.
As long as the gold futures markets are open, U.S. Treasury debtis still
gold-convertible (albeit at a fluctuating rate, never mind that the rate is minuscule).
But no sooner had gold futures trading stopped after the advent of permanent
backwardation than gold was no longer to be had in exchange for
Treasury debt. The entire outstanding debt of the U.S. was worth not one ounce of
gold. Not one gram of it. It is insane to pretend that this would make no difference
in world trade, as pretended by official doctrine. This event would mark the
transition from monetary economy to barter economy. My missive
did not provoke a single rejoinder. It was simply ignored. All the same,
I have reasons to believe that people in the U.S. Treasury and the Federal
Reserve started to listen and they took a crash course on the problem of vanishing
gold basis and the threat of permanent gold backwardation.
summarize, in forcing the world off the gold standard in 1971 the
government created a many-headed Hydra. The problem was compounded by the
apparent gag order, muzzling research on the gold basis –
to cover up the fact of default.
Gold is not the
same as frozen pork bellies after all
up too late that there was a problem after gold futures markets have been
flirting with backwardation for a year or so, officialdom was forced to act. Act it did
in a typically haphazard fashion. A few days ago, on April 12 and 15 the paper
gold market was demoralized by a ferocious attack on the lofty gold price.
This in and of itself is proof that Bernanke is fully aware that permanent gold
backwardation is imminent, and that it will create and unmanageable situation.
It’s got to be stopped in its track at all hazards. Well, well, well. Gold is
not the same as frozen pork bellies after all. The Hydra is not taking it lying
down. The kid gloves have finally come off!
is trying to stop gold backwardation by selling unlimited amount of
gold futures contracts through his stooges, the bullion banks. He is
losses they are certain to suffer in due course. We can take it for granted
that they haven’t got the gold to make delivery on their contracts. In fact,
delivery of gold will be suspended under the force majeure clause. Short positions
will have to be settled in cash, to be made available by the Fed’s printing
presses. Gold futures trading will be a thing of the past. Bernanke
and columnist Paul Krugman, formerly his subaltern colleague at
Princeton don’t understand that the issue is not the price of gold. The issue is backwardation
or contango. In trying to wrestle the gold price to the ground the Fed makes
“the last contango in Washington”* an accomplished fact.
From the frying
pan into the fire
a lower gold price would solve the problem Bernanke has.
gold bugs would be forced out of their holdings through margin calls.
Disillusioned investors would shun gold. This would make physical gold available
to rescue the strapped gold futures market.
however, a lower gold price is making the problem more intractable, not less.
The Fed is diving from the frying pan into the fire. This is the point
missed by almost all observers and market analysts. They ignore the underlying
flight into physical gold that continues unabated, in spite of (or, better
still, because of) the panic in the paper gold market. The Fed’s intervention
in bankrolling short interest is going to back-fire, for the following simple
reason. The Fed’s strategy is inherently contradictory.
price for paper gold makes it easier, not harder, to demand delivery on
maturing futures contracts. The more paper gold Bernanke sells, the lower the cost of
acquiring physical gold in exchange for paper gold becomes. The price of the nearby futures
contract will drop to hitherto unimaginable depths, relative to the cash price,
making backwardation worse, not better. Ultimately this will make
irreversible. Welcome to the world of permanent gold
From what hole
does the evil deflationary wind blow?
and the financial press have utterly failed to recognize the relevance of gold
backwardation as regards deflation. They might fret about hyperinflation as a
result of unbridled money-printing (euphemism for the monetization of government
debt). Yet the real danger is not on the inflationary but on the deflationary
front as realized even by Krugman –
is perfectly clueless on the
question from what hole the evil deflationary wind blows (other than conservative
wishful thinking). Well, I can pinpoint the location of the hole to within
yards for the benefit of Krugman. It is on Constitution Avenue, in Washington,
D.C. The evil deflationary wind is blowing from the building of Federal
Reserve Board. If Bernanke thought that his attacks on the gold price would stem
deflation, well, his efforts were counter-productive, to put it mildly. They have,
in fact, made the flight into physical gold accelerate. Permanent backwardation of gold, and its concomitant,
the re-invention of barter –
the result. There is no reason to fear that the Fed is pushing the world
into hyper-inflation. In fighting the gold price the Fed unwittingly pushes the world
into hyper-deflation. All the same, it is destroying the dollar and the international
monetary and payments system.
Contango is the market condition wherein the price of a forward or futures contract is trading above the expected
spot price at contract maturity. The futures or forward curve
would typically be upward sloping (i.e. "normal"), since contracts for further dates would typically
trade at even higher prices. (The curves in question plot market prices for various contracts at different
maturities—cf. term structure of interest rates)
A contango is normal for a non-perishable commodity that has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold). For perishable
commodities, price differences between near and far delivery are not a contango. Different delivery dates are
in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in 6 months' time,
90-day treasury bills will have matured, etc.
The opposite market condition to contango is known as backwardation.