One factor is the lack of rapidly rising consumer prices. If consumer prices aren’t rising, then this eliminates the need to buy gold as a hedge. Gold speculators are like everyone else. They get frustrated waiting for a rapid price gain that isn’t occurring. They see the financial news where talking heads and prognosticators reiterate the conventional theory that gold is a commodity bought on fear, it will go down more according to the experts, etc.
“Why is gold plunging? The most important factor is that global inflation is falling, reducing gold’s value as a hedge against rising prices. Gold bugs who were betting on an outburst of inflation are scrambling to reverse their bets and exit their gold positions at any price.”
Here is a graph showing the prices of copper and crude oil. These prices were rising prior to February last year, but since then have been in a falling trend with cyclical bounces making lower highs, and now a lower low in copper. The purchasing power of the dollar is seemingly doing fine, if not gaining. Why hold gold indeed?
Copper and Oil Prices
Most people hold an imprecise definition of inflation. Inflation is not the phenomenon of rising prices, though this is a possible consequence of inflation (falling prices are another possible consequence as I will discuss in a future paper). Inflation is an expansion of counterfeit credit. This is typically when the borrower lacks the means or intent to repay. The inevitable outcome is defaults and losses to creditors.
The conventional view is not merely wrong descriptively. It is not just that prices don’t change as M0 or M2 “money supply” changes. The view also masks the problem with inflation: balance sheet stress. Every bank and financial intermediary can borrow enormous quantities of dollars at virtually zero interest, in order to buy every manner of asset. What happens if one of those assets should fall in price? The liability remains, of course. If liabilities > assets, then a bank is bankrupt.
Balance sheet stress can lead to forced selling, and not necessarily confined to the asset that fell initially. For example, a Japanese bank may have borrowed from the Bank of Japan in order to load up on Japanese government bonds. Then, they may have done a sale and repurchase agreement (Repo) to Bank B. B may have pledged the bonds as collateral in order to borrow and buy another asset.
As the Japanese government bond falls, the Japanese bank is now losing capital rapidly. If they are leveraged 20:1, then a mere 5% drop in the bond price will wipe out their equity in the trade (many banks, especially outside the US, are leveraged more than that). What can it do to stanch the bleeding? It could sell the bond. Alternatively, it might sell other assets that have gone up in price, and be happy to book a profit.
Still, the Japanese bank may have another problem. The Repo agreement may include a provision where it has a daily margin call, if the price drops. They may have to add cash or other assets every day that the bond drops.
On April 4, Japanese Government Bonds opened at $146.31 and hit a low of $143.18 (all prices from US futures markets), before recovering somewhat. By April 11, they closed at $143.77. Even assuming no intraday margin calls (the bank’s internal risk management group may be stricter than a third party creditor), the price fell over 2%. The government bond is defined as the “risk free asset”; 2% is a big drop.
Incidentally, high volatility may itself lead to an increase in margin requirements. For reference, CME raised the margin requirements for gold futures on Monday by 18.5%.
That’s not all. Bank B may also be facing margin calls or other pressure to shrink its balance sheet. Its sale of assets could put pressure on other balance sheets.
The backdrop to this discussion is the chronic falling interest rate. Financial intermediaries are pressured to take on ever more leverage. The cost of borrowing is lower and they need more leverage to make the same return on equity. Also, the falling rate encourages them to borrow using short-term funding. The problem is that, if there is a glitch because the borrower needs to find more collateral, or the lender is having liquidity problems, then assets must be rapidly dumped (sound familiar?) in order to raise desperately needed cash.
The system, based as it is on high and rising leverage, low and falling rates, borrowing short to lend long, and financial engineering, has become very brittle.
Inflation, understood in this light, can pump up asset prices for a while, and then cause a violent crash. Inflation directly undermines the stability of the system.
There is another dynamic that we should consider for its role in the formation of the gold price. Let’s use Cyprus as a microcosm. Prior to March 15, the average Cypriot thought of gold as an inflation hedge. He may have felt that since prices weren’t rising that much, despite unconventional monetary policy, it was not worth holding. Today, he is regretting not having bought gold. Why? Because Cypriot banks defaulted, and gold is as good as ever.
I emphasize that the reason to own gold has nothing to do with consumer prices. The problem with the system is that every financial asset, except gold, is the liability of another party. Every one of them is leveraging up in a desperate attempt to chase yield and keep mismatching the duration of their funding to their assets, and their assets consist increasingly of counterfeit credit. The probability of default is rising. Gold is the only way to avoid risking default and total losses.
This risk creates a highly non-linear dynamic. A bank deposit or even a paper currency note can hold steady or maybe decline at a slow rate for a long period of time. Until, suddenly, it’s worthless. If I told you that I am selling a bond that will formally default tomorrow, what would you pay for it? The US Treasury bond will someday default, but the whole world bids on the Treasury bond and the price is rising.
“It’s not a problem until it’s a problem,” as the expression goes. Another way of expressing it comes from Ernest Hemingway, who famously wrote in The Sun Also Rises, “How did you go bankrupt? Two ways. Gradually, then suddenly.”
Before I answer my rhetorical question of the title of this article, I have one more question for every gold bug. When the final collapse comes, and the gold price is doubling every week, then every day, then every hour and then finally there is no gold price—there is no gold available at any price—will you sell your gold, and take your dollar-denominated profits? At what point will you recognize it for what it is and begin to think of your wealth in gold?
I asked what is pushing down the gold price. Now here is my answer, though it may not be what you wanted to hear.
Everyone who thinks of his wealth in dollars, whose balance sheet uses the dollar as numeraire, and especially, everyone who borrows dollars to fund gold purchases is contributing to the unsustainable spikes up and vicious crashes down that characterize the current market for gold. And I have one other unpleasant thing to tell you.
Volatility will rise, as the financial system gets closer to the terminal phase!
If you think that $250 down in a week is painful, you can look forward to $250 up or down in a day. Not necessarily this year, but it’s coming.
Once most of the speculators are flushed, then other buyers can begin to push up the price with their more steady—and unleveraged—accumulation. Patient, and relentless, these people think of their wealth in terms of gold. They are the driver towards permanent backwardation, as they are not motivated to sell by higher prices.
I have 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
Here are the relevant facts:
(1) The U.S. government defaulted on its obligation to pay its short-term dollar 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 cheerleaders and other sycophants to shout from the rooftop that the gold standard was a 'barbarous relic' anyway, quite ripe to be gotten rid of – in an 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 obligations).
(2) Thus 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 consequences. Why, gold has been reduced to the status of frozen pork bellies. We know all that is 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.) We may 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.
(3) A scientific inquiry would have shown back in the 1970s that the gold basis (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 proves no 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 1930s appear as a blip on the screen.
(4) All bubbles, all currency and financial crises of the past forty years are direct or indirect consequences of the vanishing gold basis – whether we 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 scientists 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 debt is 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 U.S. 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.
(5) To summarize, in forcing the world off the gold standard in 1971 the U.S. government created a many-headed Hydra. The problem was compounded by the apparent gag order, muzzling research on the gold basis – as a face-saving exercise to cover up the fact of default.
Gold is not the same as frozen pork bellies after all
In waking 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 an 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.
Bernanke is trying to stop gold backwardation by selling an unlimited amount of gold futures contracts through his stooges, the bullion banks. He is underwriting 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
Ostensibly a lower gold price would solve the problem Bernanke has. Demoralized 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.
In fact, 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. A lower 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 backwardation irreversible. Welcome to the world of permanent gold backwardation.
From what hole does the evil deflationary wind blow?
Academia 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 – while he 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 ultimate in deflation – will be 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.
In this article I will argue that the recent slide in the gold price has generated substantial demand for bullion that will likely bring forward a financial and systemic disaster for both central and bullion banks that has been brewing for a long time. To understand why, we must examine their role and motivations in precious metals markets and assess current ownership of physical gold, while putting investor emotion into its proper context.
In the West (by which in this article I broadly mean North America and Europe) the financial community treats gold as an investment. However, of the global pool of gold, which GoldMoney estimates to be about 160,000 tonnes, the amount actually held by western investors in portfolios is a very small fraction of this amount. Furthermore investor behaviour, which in itself accounts for just part of the West’s bullion demand, is sharply at odds with the hoarders’ objectives, which is behind underlying tensions in bullion markets. To compound the problem, analysts, whose focus incorporates portfolio investment theories and assumptions, have very little understanding of the economic case for precious metals, being schooled in modern neo-classical economic theories.
These economic theories, coupled with modern investment analysis when applied to bullion pricing, have failed to understand the growing human desire for protection from monetary instability. The result has for a considerable time been the suppression of bullion prices in capital markets below their natural level of balance set by supply and demand. Furthermore, the value put on precious metals by hoarders in the West has been less than the value to hoarders in other countries, particularly the growing numbers of savers in Asia.
These tensions, if they persist, are bound to contribute to the eventual destruction of paper currencies.
The ownership of gold
The amount of gold bullion that backs investor-driven markets is not statistically recorded, but we can illustrate its significance relative to total stocks by referring back to the time of the oil crisis of the mid-1970s. In 1974 the global stock of gold was estimated to be half that of today, at about 80,000 tonnes. Monetary gold was about 37,000 tonnes, leaving 43,000 tonnes in the form of non-monetary bullion, coins and jewellery. Let us arbitrarily assume, on the basis of global wealth distribution, that two thirds of this was held by the minority population in the West, amounting to about 30,000 tonnes.
This figure probably grew somewhat before the early 1980s, spurred by the bull market and growing fear of inflation, which saw investors buy mainly coins and mining shares. Demand for gold bars was driven by the rapid accumulation of dollars in the oil-exporting nations, as well as some hoarding by wealthy investors from all over the world through Switzerland and London.
The sharp rise in global interest rates in the Volcker era, the subsequent decline of the inflation threat and the resulting bear market for gold inevitably led to a reduction of bullion holdings by wealthy investors in the West. Swiss and other private banks, employing a new generation of fund managers and investment advisors trained in modern portfolio theories, started selling their customers’ bullion positions in the 1980s, leaving very little by 2000. In the latter stages of the bear market, jewellery sales in the West became a replacement source of bullion supply, but this was insufficient to compensate for massive portfolio liquidation.
So by the year 2000, Western ownership of non-monetary gold suffered the severe attrition of a twenty-year bear market and the reduction of inflation expectations. Portfolios, which routinely had 10-15% exposure to gold 40 years ago even today have virtually no exposure at all. Given that jewellery consumption in Europe and North America was only 400-750 tonnes per annum over the period, by the year 2000 overall gold ownership in the West must have declined significantly from the 1974 guesstimate of 30,000 tonnes. While the total gold stock in 2000 stood at 128,000 tonnes, the virtual elimination of portfolio holdings will have left Western holders with little more than perhaps an accumulation of jewellery, coins and not much else: bar ownership would have been at a very low ebb.
Since 2000, demand from countries such as India and more recently China is known to have increased sharply, supporting the thesis that gold has continued to accumulate at an accelerating pace in non-Western hands.
Western bullion markets have therefore been on the edge of a physical stock crisis for some time. Much of the West’s physical gold ownership since 2000 has been satisfied by recycling scrap originating in the West, suggesting that total gold ownership in the West today barely rose before the banking crisis despite a tripling of prices. Meanwhile the disparity between demand for gold in the West compared with the rest of the world has continued, while the West’s investment management community has been actively discouraging investment.
The result has been that nearly all new mine production and Western central bank supply has been absorbed by non-Western hoarders and their central banks. While post-banking crisis there has presumably been a pick-up in Western hoarding, as evidenced by ETF and coin sales and some institutional involvement, it is dwarfed by demand from other countries. So it is reasonable to conclude that of the total stock of non-monetary gold, very little of it is left in Western hands. And so long as the pressure for migration out of the West’s ownership continues, there will come a point where there is so little gold left that futures and forwards markets cease to operate effectively. That point might have actually arrived, signaled by attempts to smash the price this month.
This admittedly broad-brush assessment has important implications for the price stability essential to bullion banks operating in paper markets as well as for central banks attempting to maintain confidence in their paper currencies.
Precious metals in capital markets
In the West itself, the attitudes of the investment community are fundamentally different from even those of the majority of Western hoarders, who are looking for protection from systemic and currency risks as opposed to investment returns. Western investors are generally oblivious to the implications, the most fundamental of which is that falling prices actually stimulate physical demand. Before the recent dramatic slide in prices the investment community undervalued precious metals compared with Western hoarders, let alone those in Asia, encouraging physical bullion to migrate from financial markets both to firmer hands in the West as well as the bulk of it to non-West ownership. There is now irrefutable evidence that these flows have accelerated significantly on lower prices in recent weeks, as rational price theory would lead one to expect.
Pricing bullion is therefore not as simple as the investment community generally believes. It is being put about, mostly on grounds of technical analysis, that the bull markets in gold and silver have ended, and precious metals have entered a new downtrend. The evidence cited is that medium and longer-term moving averages have been violated and are now falling; furthermore important support levels have been breached.
These developments, which arise out of the futures and forward markets, have rattled Western investors who thought they were in for an easy ride. However, a close examination of futures trading shows the bearish case even on investment grounds is flawed, as the following two charts of official statistics provided by weakly Commitment of Traders data clearly show.
The Money Managers category is the clearest reflection in the official data of investor portfolio positions, representing sizeable mutual and hedge funds. In both cases, the number of long contracts is at historically low levels, and shorts, arguably the better reflection of money-manager sentiment, remain close to high extremes. On this basis, investor sentiment is clearly very bearish already, with the investment management community already committed to falling prices.
Put very simplistically there are now more buyers than sellers.
Money Managers are in stark opposition to the Commercials, who seek to transfer entrepreneurial risk to Money Managers and other investor and speculator categories.
The official statistics break Commercials down into two categories: Producer/Merchant/Processor/User, and Swap Dealers. Both categories include the activities of bullion banks, which in practice supply liquidity to the market. Because investors and speculators tend to run bull positions, bullion banks acting as market-makers will in aggregate always be short. A successful bullion bank trader will seek to make trading profits large enough to compensate for any losses on his net short position that arise from rising prices.
A bullion bank trader must avoid carrying large short positions if in his judgement prices are likely to rise. He will be more relaxed about maintaining a bear position in falling markets. Crucially, he must keep these opinions private, and the release of market statistics are designed to accommodate these dealers’ need for secrecy.
Bullion banks’ position details are disclosed at the beginning of every month in the Bank Participation Reports, again official statistics. They are broken down into two categories, based on the individual bank’s self-description on the CFTC’s Form 40, into US and Non-US Banks. Their positions are shown in the next two charts (note the time scale is monthly).
In both gold and silver, the bullion banks have managed to reduce their exposure from extreme net short over the last four months. The reduction of their market exposure suggests that they have been deliberately transferring this risk to other parties, and is consistent with an anticipation that bullion prices will rise. It is the other side of the high level of bearishness reflected in the Money Manager category shown in the first two charts. The bullion banks control the market; the Money Managers are merely tools of their trade.
There has been little reduction in open interest in gold and it has remained strong in silver, because risk has been transferred rather than extinguished. Daily official statistics on open interest are provided by the exchange and summarized in the next two charts (note that data is daily).
From these charts it can be seen that recent declines in the gold price are failing to reduce open interest further, and in silver open interest remains stubbornly high. Therefore, attempts by bullion banks to reduce their net short exposure by marking prices down are showing signs of failure.
We can therefore conclude that investor sentiment is at bearish extremes and the bullion banks have reduced their net short exposure to levels where it risks rising again. Therefore the downside for precious metals prices appears to be severely limited, contrary to sentiments expressed by technical analysts and in the media.
This market position is against a background of a growing shortage of physical bullion, which is our next topic.
Casual observers of precious metal prices are generally unaware that the headline writers focus on activity in the futures markets and generally ignore developments in physical bullion. This is consistent with the fact that market data is available in the former, while dealing in the latter is secretive. However, as with icebergs, it is not what you see above the water that matters so much as that which is out of sight below.
It is not often understood in investment circles that gold and silver are commodities for which the laws of supply and demand are not overridden by investor psychology. Therefore, if the price falls, demand increases. Indeed, the increase in demand has far outweighed selling by nervous investors; even before the price-drop, demand for both silver and gold significantly exceeded supply. Evidence ranges from readily available statistics on record demand for newly-minted gold and silver coins and the net accumulation of gold by non-Western central banks, to trade-based information such as imports and exports of non-monetary gold as well as reports from trade associations reporting demand in diverse countries such as India, China, the UK, US, Japan and even Australia.
All this evidence points in the same direction: that physical demand is increasing on every price drop. There is therefore a growing pricing conflict between futures and forward markets, which do not generally involve settlement but the rolling-over of speculative positions, and of the underlying physical metal. Furthermore, analysts make the mistake of looking at gold purely in terms of mining and scrap supply, when nearly all gold ever mined is theoretically available to the market, in the right conditions and at the right price. The other side of this larger coin is that if the price of gold is suppressed by activity in paper markets to below what it would otherwise be, the stimulus for physical demand, being based on a 160,000 tonne market, is likely to be considerably greater on a given price drop than analysts who are myopic beyond 2,750 tonnes of annual mine production might expect. The numbers that are available confirm this to have been the case, particularly over the last few weeks, with reports from all over the world of an unprecedented surge in demand.
This is at the root of a developing crisis of which few commentators are as yet aware. Demand for physical has accelerated the transfer of bullion from capital markets to hoarders everywhere and from the West’s capital markets to other countries, which has been the trend since the oil crisis in the mid-Seventies. This is what’s behind an acute shortage of physical gold in capital markets, explaining perhaps why bullion banks feel the need to reduce their short positions.
While we can detail their exposure in futures markets, meaningful statistics are not available in over-the-counter forward markets, particularly for London, which dominates this form of trading. Forwards are considerably more flexible than futures as a trading medium, generating trading profits, commissions, fees and collateralised banking business. The ability to run unallocated client accounts, whereby a client’s gold is taken onto a bank’s balance sheet, is in stable market conditions an extremely profitable activity, made more profitable by high operational gearing. The result is that paper forward positions are many multiples of the physical bullion available. The extent of this relationship between physical bullion and paper is not recorded, but judging by the daily turnover in London there is an enormous synthetic short physical position. For this reason a sharply rising price would be catastrophic and any drain on bullion supplies rapidly escalates the risk.
Overseeing this market is the Bank of England co-operating with other Western central banks and the Bank for International Settlements, whose combined interest obviously favours price stability. They have been quick to supply the market if needed, confirmed by freely-admitted leasing operations in the past, and by secretive supply into the market, which has been detected by independent supply and demand analysis over the last 15 years. Furthermore, as currency-issuing banks, central banks are unlikely to take kindly to market signals that suggest gold is a better store of value than their own paper money.
We can only speculate about day-to-day interventions by Western central banks in gold markets. In this regard it seems that the slide in prices on the 12th and 15th April was triggered by a very large seller of paper gold; if this market story and the amount mentioned are correct, it can only be central bank intervention, acting to deliberately drive prices lower. Given the market position, with Money Managers in the futures markets already short and highly vulnerable to a bear squeeze, the story seems credible. The objective would be to persuade holders of physical ETFs and allocated gold accounts to sell and supply the market, on the assumption that they would behave as investors convinced the bull market is over.
For the last 40 years gold bullion ownership has been migrating from West to elsewhere, mostly the Middle East and Asia, where it is more valued. The buyers are not investors, but hoarders less complacent about the future for paper currencies than the West’s banking and investment community. There was a shortage of physical metal in the major centers before the recent price fall, which has only become more acute, fully absorbing ETF and other liquidation, which is small in comparison to the demand created by lower prices. If the fall was engineered with the collusion of central banks it has backfired spectacularly.
The time when central banks will be unable to continue to manage bullion markets by intervention has probably been brought closer. They will face having to rescue the bullion banks from the crisis of rising gold and silver prices by other means, if only to maintain confidence in paper currencies. Any gold held by struggling eurozone nations, theoretically available to supply markets as a stop-gap, will not last long and may have been already sold.
This will likely develop into another financial crisis at the worst possible moment, when central banks are already being forced to flood markets with paper currency to keep interest rates down, banks solvent, and to finance governments’ day-to-day spending. Its importance is that it threatens more than any other of the various crises to destabilize confidence in government-backed currencies, bringing an early end to all attempts to manage the others systemic problems.
History might judge April 2013 as the month when through precipitate action in bullion markets Western central banks and the banking community finally began to lose control over all financial markets.
In this, my 400th post, I will peer into the future, to the Freegold revaluation and beyond. But I do not have an actual crystal ball. All I have is logic and reason, and a little help from Another and FOA. So to quote FOA, "If you came with a notion that I am someone who sees the future, grab the children and run far away." But if you came bearing your own logic and reason, then perhaps you will find this post useful.
I will touch on a few topics that have been the subject of recent discussions, both here and elsewhere. The first topic is gold mining shares. I will explain why I do not own any. It is really simple logic, but I think that I would be doing a disservice if I did not make it perfectly clear right now. Anyone considering Freegold should at least be aware of this reasoning, whether they accept it or not.
Next I will discuss the difference between gold-denominated lending and the use of gold as physical collateral for currency loans following the Freegold revaluation. And, finally, we'll delve into the deep topic of gold's true function in the new Freegold paradigm. If Freegold frees gold so that it can function properly, what does that actually mean? This has been a topic of debate for a few months now, and I'll attempt to put that debate to rest.
But before we get started, let's take a moment to enjoy this Leonard Cohen video called "The Future" from my first Glimpsing the Hereafter post 15 months ago:
Mining Shares and the Freegold Revaluation
This is a touchy subject for those who are already deeply invested in gold mining. Indeed, mining shares had a great run in the 1970s. And gold mining is a big topic, but for today's Freegold investor there's one question that precludes everything else. Given the presumption of Freegold, are even the best mining shares a viable and comparable alternative to physical gold? If gold is revalued in real terms, as Freegold presumes, then the new value will be many multiples of the cost to pull new gold out of the ground. This is simple logic.
Therefore, if the value of gold is to become many multiples of the cost to pull it out of the ground, then this would constitute a windfall profit for gold miners. Whereas everyone else in the world would have to expend, say, $55K worth of resources to obtain an ounce of gold, a gold miner would only have to expend ~$1,200. On the surface, this makes gold miners seem like a good investment today, especially if you're expecting the revaluation of physical gold.
But here's the catch. I have written about what I call the moment of "peak risk" which is the moment of revaluation. The biggest risk in Freegold is that someone else will take or simply keep the windfall profit that you thought was yours. In my opinion, the best way to avoid someone else taking or keeping it is to possess your own gold.
In every case where someone else is holding your gold for you, there is some amount of risk. Here's a purely hypothetical example just to illustrate my point. Imagine you have a custodian holding your numbered bars when the revaluation occurs, but then he reports to you the very next day that your bars are missing from the vault. They must have been stolen!
The problem is that the LBMA is now closed indefinitely and the COMEX is frozen, and the last-known price was $1,400 per ounce. You know that your gold will soon be worth $55K per ounce, but your custodian has put in the insurance claim at $1,400 per ounce and is already in the process of sending you a check. It's a sticky situation, because now you're going to have to sue your custodian in court. But the bigger problem is that it wasn't just your gold that was stolen, it was all of the gold he was holding. His insurance is capped at the limit which is linked to the last London fix, and there's no way he'll be able to cover everyone's windfall profit, even with a total liquidation. He is judgment proof. The most likely outcome is that he'll file for bankruptcy and eventually disappear to a private island somewhere.
The point of this hypothetical is that, in the eyes of the law, all of the investors were made whole insofar as they recovered their initial investment. All that was lost was their expected windfall profit from the Freegold revaluation. That windfall was taken from them by someone else, and without the recovery of the underlying physical, there was no other way to recover that value.
Let me be clear. This is only an extreme hypothetical example and not a prediction. I certainly hope nothing like that happens. But the point is simply that the biggest risk in a revaluation is that someone else will have the opportunity to take—or simply keep—your expected gain. And the bigger point of this exercise is that *gold in the ground* is possibly the most at-risk gold in terms of someone else keeping the one-time windfall profit. The logic is simple enough that you should be able to decide for yourself if it is worth the risk. I'm not trying to tell you what to do, I'm only explaining the logic so that you can decide for yourself.
The government, which is the representative of the collective population, what I like to call the hungry collective, has a claim on that windfall that trumps even the miner's claim.
The miner has a claim on the ground, a claim recognized by the country. But the country owns the gold in the ground in extremis. The miner is licensed or permitted to dig it up. That permit comes from the country, from the government.
Another and FOA explained this point and, again, it's just simple logic. And the logic is this:
If the hungry collective has a claim on the windfall profit, a claim that is senior to the miner's claim, will they use it or not?
If not, then why not? Because they didn't know they could? And if they do claim the windfall, then how would they go about it? Here's how Another put it:
The world debt system and currency exchange, as we have known it, will implode and leave little room for political maneuvering. The governments will revalue gold and "demand" that the public carry it and use it! It will be the source of all gold, the mines, that will be controlled! That's Controlled, with a capital "C", not confiscated!
I can see that you like owning a fractional interest in a corporation licensed to dig up a country's gold! But what we are talking about here is maybe a 30x revaluation of gold against all other commodities as well as against the cost of mining. This will happen as a functional change for gold, a global shift away from its present treatment as just another commodity.
When that happens the mines will be treated in one of three ways: 1. They will be nationalized as gold in the ground will suddenly be viewed as national reserves (unlikely). 2. They will be forced to sell all production to the government at a low "commoditized" price (less likely). 3. They will be able to sell to the public at market prices but will have to pay a windfall profits tax and deal with many restrictions (most likely). In other words, the windfall profit of a 30x revaluation will not be passed on to those holding a government license to dig up gold that is still in the ground, a profit that can thereby be claimed by the hungry collective.
As a commodity, with the price of gold only slightly higher than the cost to mine it, governments grant license to the mining companies to dig it out as with all economic minerals. But when the value of that natural resource is suddenly worth 30 to 40 times the cost of mining, that government license will suddenly become very expensive.
When that Sunday evening announcement finally comes, that the banking system will be on holiday starting Monday morning, you want to be sitting on gold that has already been pulled out of the jurisdiction governed by the classification of gold as a simple economic mineral or commodity. FOA may be right that there will come a day on the other side of the punctuation when gold mining will be very profitable. But between now and then, few investors will be able to stomach the ride down to zero.
And here's what FOA wrote about mining shares back in 2000 and 2001:
Gold production, everywhere will eventually be extremely controlled with citizens reporting unofficial mining in much the same way as people report each other to the IRS. But, make no mistake, miners and citizens will all benefit. All mines, both big and tiny will make huge profits on the limited production allowed because the price will be so high. ($30,000+ in dollars (big smile) But, the road between here and there will more than likely price mine owners close to zero, first.
There will be some huge profits to be made by holding certain mine stocks. But, almost all of them will go close to zero first. I doubt many investors could hold their current percentage through this price action. Physical gold will find a new market and soar in that medium of trade. In the face of this, few if any stockholders will hold their falling mining shares while watching gold soar. Yes, some will (like me) hold through thick and thin because they have a right percentage of (the best) mine shares to bullion. But, many, many others will pressure the market as they attempt to adjust to (our) level of holdings.
An investment in the gold industry, not just mining, can be nothing more than an investment in a business that balances fiat production cost against fiat market prices for its product; gold. The return, if any, is always in fiat and places this portion of one's wealth smack on the tracks of more political manipulation. Today, we can see this play out all over the world as fiat returns in the gold business head towards and even sink below zero. The investor watches this fiat illusion of his net worth drain away while the opportunity to build a real wealth of "bullion ownership" escapes yet again.
Truly, if ever there was a way to profit from gold mining, today, it's by buying this almost free physical gold the mines are producing; while mine players and paper gamblers pound their wealth into the dirt. This is what PGAs [Physical Gold Advocates] call benefiting from the leverage in mining (smile).
Here are the questions that you should answer for yourself, now that I have explained why I don't hold mining shares, and also based on your personal understanding of Freegold. The issue isn't, "Will mine shares go up or down?" The issues are, "As compared to physical gold, are mines worth the risk?" and "Do mines offer any diversification value in addition to holding physical gold?" and "Are you prepared if mines go to zero for a time?" and "Can you pick the mines that will survive?"
Lastly, here's a wonderful video tribute to the tireless gold miners and their priceless product, by Freegoldtube. It is true that you can't really eat, wear or seek shelter in gold. We don't need it to breathe, and it's not very fun on the water. But once you come to understand gold's true function, you'll see that it is an irreplaceable, invaluable, truly priceless and almost incomprehensibly vital component in the human Superorganism's effort to survive and thrive. So God bless the miners, even if they don't get to keep the revaluation windfall on the gold that's still in the ground at the moment of revaluation:
Gold lending and collateral use in Freegold
On the subject of gold lending versus the use of gold as collateral for a fiat loan in Freegold, here are some thoughts.
This topic has been a source of discussion, debate and confusion for a long time. Does there need to be a law passed to prevent the reemergence of paper gold? No, I don't think so. I don't think Freegold requires any changes in the law, international or otherwise, but that doesn't mean there won't be some new laws. It only means they aren't a necessary prerequisite.
Gold lending and gold used as collateral are two totally separate issues. I have no problem with gold being used as collateral for fiat-denominated loans in Freegold, my only problem is with lending (credit/debt) denominated in gold ounces. But I also don't think there will need to be a law to prevent it for the simple reason that it won't be a profitable activity. The reason there may be a law passed is to simply preempt the reemergence of fractional reserve bullion banking somewhere down the road, and that would be more than enough of a motive for someone like the Eurozone to pass a simple law that otherwise didn't need to be passed. FOA never pushed this subject, he only explored it when others pushed for "but, but, what if…" answers.
One of the common arguments I hear is that people will still want to lend their gold. I disagree.
Where does the silly notion of gold lending even come from? Well, pre-1971 gold was money to one extent or another. Money is credit/debt which means that debts were more or less denominated in gold ounces, off and on, from 1971 going back to cavemen. So when money was gold, people lent gold, even if they didn't have physical gold to lend. They simply extended credit to credible people and the repayment was denominated in gold ounces, even if it was paid back in other ways. That's gold lending. Freegold is different because gold isn't money.
Around 1983-1985 was the birth of modern gold lending, via the European CBs actively encouraging and supporting the expansion of a new paper gold market meant to buy the time necessary to launch the euro. What we think of as gold lending today didn't really exist before the 80s for all intents and purposes. (You can read more about what changed in the 80s in Checkmate, and don't miss the great Freegoldtube video that sums it up at the bottom of the post!)
The fact of the matter is that, unless gold is money, there is no good reason other than price suppression for gold lending. There's no profit motive to lend gold when its price is falling, and there's no profit motive to borrow gold when its price is rising. So to bring both counterparties together, lender and borrower, one of them must be motivated by something other than profit. In the 80s and 90s, the lenders were CBs and the borrowers were mines and hedge funds. This is the crux of what Another explained. In Freegold, gold won't be falling in price so who'd want to borrow it, and the CBs won't have a reason to lend at a loss.
I can't think of one good reason why anyone would lend gold in Freegold, be it the lending of actual physical gold or simply lending dollars but denominating the repayment in gold ounces.
Let's think about one instance in which it might make sense to actually borrow physical gold, which is if you were a gold fabricator. You work with a very expensive medium to turn a profit that is tiny compared to the price of the raw material, so it would make sense to borrow your working stock. But would it make sense to the lender?
Your output is the sale of a finished product and your income is in dollars, so why would you need to borrow in ounce-denominated units? Why not borrow the cash to buy your working stock? Even if I'm the one providing you with raw gold, why would I lend you the gold? Why not extend you the credit to buy my gold and you pay me back in dollars after you have added value and sold the finished product to someone else? I'm not giving you gold to have you return it to me in a different form. I'm selling you gold to make a currency profit from the interest on the currency loan which you easily cover by adding value to the gold.
Can you think of a good reason why someone would lend gold in Freegold? And if there's no good reason why anyone would do it, then there's no pressing urgency for a law prohibiting it.
It is the existence of credit denominated in gold ounces that automatically suppresses the price of gold. Using gold as collateral for a loan denominated in fiat currency does not. The conflation of these two totally separate issues and the confusion it causes arises from FOA's explanation of how easy it would be to prohibit the denomination of credit in gold.
It's quite simple. It's about enforcing the seizure of, foreclosure on, or liquidation of attached collateral in the case of default on a loan. The courts will only enforce foreclosure on attached collateral in the case of default on a standard fiat loan. If the loan is denominated in anything other than fiat currency, like tractors, Renoirs or gold ounces, then it will be a non-standard loan and the most the courts will do is to issue a default judgment denominated in fiat which might be impossible to collect.
Like this. Say you want to borrow my car for a week. I say sure, but I'm going to need the deed to your house as collateral. So you give me the deed and we write up a basic loan contract where you borrowed 1 car and you owe me 1 car. Then let's say you lose the car, or crash it, or you simply sell it and ignore my phone calls; a blatant default on our contract. So I go to the court with the contract and demand to foreclose on your house since you defaulted on the 1 car loan. Absurd, I know. What's the court going to do? If the court doesn't tell me to get lost, at most it will issue me a fiat judgment in an amount equal to the value of the car, but it will not enforce the attached collateral of your house, not because the house is worth more than the car, but because it was a non-standard loan.
Remember, I don't really care if gold is used as collateral. The only thing I care about is the numéraire for repayment on the loan document. You can use any numéraire you want, but if it's not fiat currency, then the courts won't enforce the attachment of collateral.
In most gold lending, no physical gold is actually lent. It is simply a loan denominated in gold ounces and then converted to dollars at the current exchange rate so that it can be spent. If actual physical gold is lent, then it must be sold first before it can be spent.
Like this. Imagine you wanted a car loan and I said I would lend you a tractor so that you can buy a car. We draw up a contract, and your new car is going to be my collateral. I lend you 1 tractor and you owe me 1 tractor. And I will hold the pink slip on your new car as collateral against your repayment of 1 tractor. But you can't take my tractor down to the Chevy dealer and buy a new car with it. You have to sell the tractor first to get fiat currency and then you can go buy the car. And then, to pay me back one tractor, you'd have to buy it back or buy another one just like it. This is a non-standard loan. It is absurd on the face of it. And the same principle will apply to gold loans.
Why would I lend you gold when you're just going to have to sell it to buy whatever you want to buy? Why wouldn't I just sell the gold and lend you the fiat currency, that way I could attach your purchase as collateral in case you fail to pay. If I lend you the gold and make you go sell it and the loan is, therefore, denominated in gold ounces, then I'd better hope you don't default because the courts won't enforce the collateral attachment.
So it's not my fear of not being able to recover the lent gold that keeps me from lending it, it's my fear of not being able to enforce foreclosure on your property if you default on the loan.
Gold used as collateral for fiat loans is a totally different subject from credit denominated in gold ounces. I have no problem with gold used as collateral. But if I am a lender, I'll probably want to hold that collateral so it doesn't get lost in a boating accident. A house is easy collateral. You can't lose a house in a boating accident. A car is a little trickier because I have to hire a repo man to chase you down. Do they even have gold repo men? ;D
Here's how gold might be used as collateral in Freegold. Imagine I am a giant with 1 tonne of physical stored at my bank. I'm also a businessman and I regularly draw on my credit line at the bank. As long as I have no need to sell my gold anytime soon, I will allow the bank to attach my property as collateral to my credit line which will translate into a lower interest rate for me than I would have otherwise paid. This is not paper gold. It is not financial collateral. It's the same as a house, a car, a tractor or a Renoir being used as physical collateral for a fiat currency loan. If I died with an unsettled credit balance, the bank would have the right to sell some of my gold to settle the balance before turning the rest over to my estate. This reduces the bank's risk which is why I get a discounted rate of interest.
Gold's True Function
The debate I mentioned at the top began with this comment from Blondie last November. The question it raised is this: Will gold be the focal point store of value for savers as A/FOA and this blog have proposed, or will currency finally fulfill this role once gold has been revalued and is free to function properly? Because if "functioning gold" means gold will have to fluctuate wildly, including short term declines in purchasing power in order to transmit price signals and moderate the imbalance cycle, then it will make a poor medium of savings.
This section is my answer to the debate.
What if gold never declined in price again after revaluation? What if it only rose (in real terms, of course)? If that were true, then gold would indeed be the focal point for savers, would it not? If it never performed worse than base money in real purchasing power and, in fact, gained purchasing power more or less over any timeframe, then gold would be the medium for savings in Freegold. Can we at least agree on this hypothetical statement?
Okay, good! Now I will make two arguments that will, if not put this debate to rest, at least establish a new front for the other side to attack. Remember that we are discussing the future on the other side of a singularity called the Freegold revaluation, so keep in mind that the following glimpses are based mostly on common sense and reason, with a little help from A/FOA. And then each of you can decide for yourself whether I have settled the debate here, or whether you wish to follow Blondie and Victor down a slightly different trail, one which Poopyjim humorously dubbed "Freefiat".
Poopyjim wanted to mock what I wrote and said:
"I say we start calling it "freefiat" because what it really frees are CBs from their obligation to inflate against USD. Finally CBs will be able to shoot for that 0% inflation target they wanted all along."
I'd say he is spot on. Freegold frees the CBs from the obligation to inflate their fiat along with the old paper reserve currency (=dollar) and, for the first time in history, allows them to manage their fiat currency as a proper SoV.
This is really a debate about what it means for gold to "function" in Freegold. Victor and Blondie believe that gold's function will make it a poor medium for savings, therefore Freegold actually means a return to holding currency as your savings. They say that gold will "fluctuate wildly" with a guess of maybe 5% in a year, and this includes wild declines in the real purchasing power of gold by that amount, which would mean that the newly stabilized currency will be a much better store of value for the savers. And gold will, therefore, be an "investment" because it will carry short term price risk.
So I am going to make two related arguments:
1. I will show that, logically, gold should be expected to perpetually rise in real terms in Freegold. There is no logical reason it should ever decline in real terms again, once it is revalued, except in the case of economic disaster in which case fiat will most certainly be sacrificed so it won't be any better.
2. I will show that, theoretically, gold need never decline again in real terms in order to "function" in international settlement and to act as spur and brake in the cycle. It need only rise to greater or lesser degrees depending on what's happening in each zone, which makes perfect sense while "wild fluctuations" do not.
1. Why gold will always rise in Freegold
In Victor and Blondie's ideal 0% inflation world, this means both nominally and in real terms, since they are the same. So the price of gold would simply never decline. It would just rise and rise, at differing rates of speed of course.
I know… never say never. What I mean by never is almost never, and if it ever does decline, that would be a rare anomaly and certainly not significant enough to scare away the savers.
Now let's look at that word, "savers". Also, "savings" and "store of value", because these concepts seem to be at the heart of the debate.
Savings is not some perfect basket of purchasing power carried through time. Savings is a choice made by savers. And most people are savers, as opposed to investors, so they are a large group. Whatever savers choose to save in becomes the de facto savings medium.
Now when I say that most people are savers, that simply means they are more interested in preserving their surplus purchasing power than gaining from it. They will forego a gain in favor of a lower risk of loss. Today the focal point savings medium is fiat. So in the "Freefiat" world, that focal point doesn't change even though we move from a broken paradigm—broken by saving in fiat currency—into a new paradigm. That's a pretty big divergence from the Gold Trail that I have been following!
Back to gold…
The global supply of gold is relatively fixed. Today it grows at about 1.5% per year. There is disagreement on what will happen to mining after revaluation. Some think that 1.5% will increase, and I think it will decrease because surplus zones will likely choose to leave their reserves in the ground. But no matter. As long as the global economy is expanding faster than the global gold supply, the real value of gold will always be increasing.
So if the real value is always increasing, why would its price ever fall? Let's look at a few reasons why it could fall. If it had previously been overvalued then the price could fall. But in Freegold we expect gold to always be properly valued due to two major changes, the revaluation and the physical-only market, i.e. the elimination of paper gold.
Really, the only way for gold to fall in Freegold is for supply to exceed demand at some price. And if that excess supply isn't coming out of the ground, then it must be coming from dishoarders. The alternative is that demand drops, but that would be the disaster scenario. Since we're assuming a global economic growth rate greater than ~1.5% (greater than the expansion rate of the gold stock), we can assume a steady to growing demand for gold at all times, which leaves us with supply shocks as the only possible cause for a declining price. So let's look at some possible causes for supply shocks.
An aging community would be one. We tend to save during our productive years and then spend that savings in our retirement years. So imagine a dying society with such a low birthrate that every year the percentage of retired people grows. If this was a closed society like North Korea, then the real price of gold would fall as gold supply constantly exceeded demand. But in the real world it won't, because another society with more productive workers than elderly dishoarders will supply real goods to this aging community for its gold.
This is a good example of how the spur and brake is not a function of wild gold price fluctuations. Would you expect in this hypothetical dying society, where nearly everyone is simply dishoarding their gold until they die goldless, that the (real) price of gold would drop forcing them to get out of their Barcaloungers and build some factories, or at least greet people at Walmart? I wouldn't, because the spur isn't a punishing decline in the price of gold. It is much more subtle than that. And without young, productive workers to require an inflow of gold, all of the gold in this dying zone can theoretically flow out without ever declining in price until it is gone and no one else remains.
You've heard of the carrot and the stick? The Japanese have a similar saying, a whip and a candy. Two forms of motivation, punishment and reward. Rather than being the declining price of gold which punishes everyone saving in gold, the spur is simply the growing opportunity for easy profits that lures only the marginal gold saver (net-producer) into expansionary and/or different entrepreneurial pursuits with his ongoing surplus income, not necessarily selling gold to build a factory, but rather redirecting his current surplus income back into production. In fact, the opportunity to profit might even cause the migration of younger workers into our hypothetical aging society as long as culture, language and immigration laws weren't an obstacle.
So perhaps a painful spur isn't the best analogy. It's more like a carrot dangling in front of the horse than a painful jab. And then the brake, rather than being the pulling of the reins, would simply be the absence of the carrot once it is eaten. Like I said, much more subtle.
Now there's one other way that supply from dishoarders can overwhelm demand, driving down the real price of gold, and that is if gold was just one of many investment options rather than the focal point store of value. If that was the case, then we could see capital outflows from gold as gold is traded for different investment options according to changing investor preferences over time. But this becomes a circular argument. Like this: Gold is merely an investment choice among many because it will fluctuate wildly, but it will only fluctuate wildly if the majority of people consider it an investment choice among many.
Finally, let's talk about the real versus the nominal price of gold in Freegold, just in case we don't end up with Victor and Blondie's 0% inflation. If we have, say, 2% inflation, then I'm contending that the very worst gold will do is to track inflation. In real terms its value will rise more or less at the rate that global growth exceeds gold supply growth. So its nominal price will rise, more or less, at that rate plus the rate of inflation. But the very worst it will do in any zone, deficit or surplus, is to keep up with inflation. Therefore, the only way we'll ever see a declining nominal (but not real) price of gold in Freegold is during bouts of deflation. How likely is that? It is unlikely because, very generally, I expect to see higher price inflation in the deficit zones and higher gold appreciation (in real terms) in the surplus zones, which will of course switch back and forth from deficit to surplus (ex. gold) over a reasonably short cycle.
Gold does not need to beat long term investment returns. That is old-paradigm thinking. Savers don't have a real focal point choice today, they have to go with a "diversified portfolio" just to stay even with minimal risk. The most important concepts here are that "most people are savers," and that "savings," or the focal point store of value for savers, is a choice made by the savers.
Victor and Blondie's main point seems to be that, in Freegold, "currency will finally perform all three functions." Of course currency performs three functions, MoE, UoA and SoV. But the function of SoV is different from the focal point medium for SoV chosen by the savers as a group. It is no argument to say that currency will finally be stable. I have said that all along. Here's what I wrote in The Return to Honest Money:
The Money Concept
FOFOA: The measure of any money's store of value is a continuum of time. It is directly linked to demand and velocity. Even the worst money (say, Zimbabwe dollars during the hyperinflation) works as a very temporary store of value. Perhaps you read stories about workers in Zimbabwe getting paid twice a day and then running out to spend it before coming back to finish the shift. This is an example of the briefest time period in which currency stores value.
FOA: Was gold a medium of exchange? Yes, but to their own degree, so were the bowls. Was gold a store of value? Yes, but to a degree, so were dinner plates. Was gold divisible into equal lesser parts to define lesser barter units? Yes, but to a degree one could make and trade smaller drinking cups and lesser vessels of oil.
Here's the thing, 'store of value' and 'medium of exchange' are relative terms. Anything real stores value (a painting, a computer, a jewel), and lots of things are media of exchange in various settings (dollars, other currency, cigarettes in jail, etc). And for stores of value, there is a continuum as to how long things store value. What we are talking about is degree. And this gets to the heart of a semantic issue about money being media of exchange and a store of value.
Both of the above quotes get at the idea that, because money is a medium of exchange, it is also, to some degree, a store of value. Even Zimbabwe dollars were a brief store of value, but being a store of value isn't what money is all about. Being a store of value is not its central function—it is derivative of its being a medium of exchange. Being a medium of exchange is money’s essence—what makes money money. This means that, by definition, money’s ability to serve as a measure of value and store of value is secondary.
In the future, I think that if you are saving for something known, especially something with a known currency price like a down payment or a car, you'll save currency or "money". But if you're saving for the unknown future, you'll apply your newfound understanding of the difference between money and wealth and you'll probably choose gold, the most salient and liquid of the tradeable wealth items.
So if you want to believe that the savers will dishoard gold, not because they need the cash for retirement consumption, but to swap it for a different SoV, you need to explain how and why the real price of gold will have periods of "wild" decline even after revaluation and even in a physical-only market. I think this requires the swapping of gold for other investments rather than dishoarding for consumption spending, which is the circular argument I mentioned above.
I contend that, in Freegold, gold will be viewed and used as the tradeable wealth item that it is and, because of the two major changes in the gold market, it will perform better than currency in the short run and worse than good investments in the long run, making it the focal point store of value for savers in particular, while no longer being the plaything of investors, traders and speculators.
Here's something that's worth thinking about for a little while. The revaluation of physical gold does not require new buyers. It only requires the sellers *IN SIZE* (other than the mines) to stop selling, which may have already happened. So when gold is revalued, every single ounce will already be owned by a saver at that point, one who already understood gold, more or less. And if the savers-in-money who lost their savings during the transition don't take notice, I'll be really surprised. I'm not advocating a fundamental change in the savers' perception, I'm predicting it.
In the next section I'll explore price signal transmission in Freegold and gold's role in such. I'll also explore gold's role in trade settlement and how it is about the physical flow, not changes in the price, which will bring us right to the heart of gold's true function. It's "the gold must flow," not "the gold must fluctuate wildly."
2. Why gold doesn't need to decline or fluctuate wildly in order to function
Just above, I explained why gold would always rise in Freegold, sometimes faster, sometimes slower, but almost never declining in real terms/price/value outside of a disaster scenario. The following argument is a little different because I want to address why it doesn't need to decline in order to "function" in settlement and price signal transmission as Victor and Blondie claim. But before I dig in, I think a little background is needed.
First of all, I want you to keep in mind that when I talk about theoretical principles in the new Freegold paradigm, they will generally apply at any and every scale, from the individual to the family unit, to the neighborhood, to the city, to the state, to the region or nation, and even up to the most broad of categories, the East and the West. One of the things that I think Victor tends to do in his "Freefiat" arguments is to focus on international settlement as a key factor, when "distributed settlement" or "decentralized settlement" at all scales will not only effect international settlement, but it will also preclude its primacy.
Here is an example of what I mean. In Freegold, net-consumption over long periods of time will no longer be possible. It will be a thing of the past. This applies on all scales, although of course it doesn't apply to those who are simply incapable of surviving without assistance. And net-consumption over short periods of time is, of course, perfectly natural and will continue. But in general, any group, from the individual on up to the hemisphere, will not be able to net-consume indefinitely like we see happening today.
The reason is simple—settlement. The only way net-consumption can continue for long periods of time is for imbalances to accumulate without a mechanism for reversal. Economists and central planners struggle with this all the time, scratching their heads while trying to come up with an appropriate mechanism (i.e., motivation/incentive) to either reverse the trend or to at least cap it.
To give you one example, I remember recently that Aaron spent some time emailing with an economics professor at the college where he works. This was a while back, and I recall that he was trying to explain some of the principles in my Macrofreegold'nomics post. In her reply, it was apparent that she not only couldn't conceive of a natural adjustment mechanism, but that she wasn't even open to discussing anything other than a centrally-planned and administered one. Her proposed mechanism was to cap imbalances by automatically reducing the value of reserves by a set percentage if and when they came to exceed a predetermined level.
I'm just going off memory here, but it went something like this. Think about China's accumulation of Treasuries as being close to the imbalance cap. Today they are at about $1.223T according to the Treasury. Say the cap was $1.25T. If China ever exceeded that cap, then the total value would automatically receive a 6% haircut or something like that. So China could theoretically run a trade surplus with the US forever, but its reserves would never exceed $1.25T, and every time they reached that limit, they'd fall back to $1.175T. So the incentive would be to never reach that level; to stop buying Treasuries. This was a dead serious proposal.
The point of mentioning this story is that almost everyone, even the so-called experts, thinks only in terms of a centralized, controlled, planned and administered solution at one specific scale. Also, it is, without exception, a "whip" or "stick" solution, a potential punishment that can be avoided as the motivation for reversal. This makes sense, doesn't it? Because how can anyone other than the Superorganism itself offer a "carrot" or "candy" (reward-based) adjustment mechanism?
I see this same type of thinking from Victor as well, in his description of trade settlement in "Freefiat". An interesting idea from Victor recently was that settlement-by-proxy could be achieved by a CB like the ECB if the Eurozone's trading partners insisted on accumulating euros so as to run a perpetual surplus against the Eurozone. Instead of capping the nominal amount of reserves that could be accumulated as in Aaron's professor friend's proposal, the ECB would simply print euros in an amount equal to those being hoarded abroad and use them to buy gold.
This was an interesting concept, but I'm sure that some of you are already sensing a few problems with it. First of all, no real settlement will have taken place. The trading partner accumulating euros is running a trade surplus against the Eurozone, so for settlement to take place, gold should flow from the Eurozone to the trading partner. But instead, the ECB is buying gold, essentially on behalf of the trading partner.
But it's not really on their behalf, is it? Because any increase in the €PoG will go to the ECB and not to the trading partner. If we assume Victor's 0% inflation in the euro, then the imbalance could potentially accumulate indefinitely in real terms (in terms of goods and services), but would be capped in gold terms, not too much unlike the nominal capping proposed above, except that Victor's plan would isolate or de-link gold from goods and services.
This arrangement would probably be fine with the trading partner, especially if gold was fluctuating wildly! Imagine reserves of perfectly preserved purchasing power in goods and services! Yet if the €PoG was constantly rising as I contend, they might notice that even perfectly stable base money was a less than optimal reserve. But even if gold fluctuated wildly, making 0% inflation base money the perfect reserve, imagine what would happen if disaster struck in the trading partner's zone, wiping out most of the production capacity but leaving the people, the consumers, intact. This could force "trading partner" to liquidate those reserves very quickly.
The ECB's response, according to Victor, would be to sell gold in order to mop up the rapid inflow of excess currency, keeping its sound money stable in goods and services. Blondie says, "'Sound money' is just stable money, money stable in its purchasing power. No more, no less." (I have a different definition of sound or honest money—it's money that doesn't pretend to be something it's not—but we'll save that discussion for another time.)
If the ECB did this, it would give the disaster zone full purchasing power for all of its reserves, transferring the most immediate impact of the disaster right into the Eurozone where the outflow of "disaster support" in real terms would be disproportionate to what it would otherwise be. Or, the ECB might do the right thing and favor its own economic zone over its purely symbolic token currency in that moment of crisis. This would allow a temporary inflation to take effect, limiting the transfer of wealth in real terms. And here, in this moment of crisis, even one that happens outside of the Eurozone, we see that a perfect currency during normal times can be no more reliable than an FDIC sticker when the time finally comes that you need to cash in your reserves. Gold, on the other hand…
And this brings me to one last point I wanted to make before I dig into my argument, and that is regarding the Debtors and Savers dichotomy. Just above, I proposed a disaster wiping out the productive capacity while leaving the consumers intact. Why didn't I say it wiped out the producers, leaving the consumers intact? That's because everyone is a consumer.
Blondie has told me on a few occasions over the years that he never liked my Debtors and Savers dichotomy, even from the first time he read it. He thought it should be the Producers and the Consumers. But that's a false dichotomy, because everyone is a bit of both. "Savers" denotes a specific group, those who net-produce and attempt to save their excess purchasing power for later. They are still consumers. They don't save everything they produce. Others have also criticized my dichotomy saying it should be the debtors and the creditors. But that's also a false dichotomy, at least in this context, because
A) all savers are not engaged in lending, and
B) savers should not be engaged in lending because that's a recipe for a disaster that historically ranges from tears to bloodshed.
Okay, let's talk about price signal transmission and imbalance settlement. I'm going to start with settlement. Here's another statement I made with which Blondie once told me he had a problem: "It's all about savers." Blondie said that statement was too imprecise, that it should be changed to: "It's all about the reserve."
Now I want to point out something that may not be obvious on first glance, and it is that my statement refers to a group of living, breathing people while Blondie's correction refers to an inanimate object. I didn't say it's all about the "savings" or "the savings medium", I said it's all about savers. My full statement was this: "Freegold is all about savers. Everything else flows from that." And Blondie's full correction was: "Freegold is all about the reserve. Everything else flows from that." Blondie's point in this particular disagreement was to illustrate for me how I could make my statements more precise to avoid people misunderstanding them, and yet I'm still fine with my original statement while I disagree with his.
So what did I mean by "it's all about savers"? Well, this is a big concept that encompasses many elements of Freegold, not the least of which is the element of imbalances and the need for settlement, which directly affects price signal transmission which I'll get to in a moment. Imbalances occur when one zone produces more than it consumes in aggregate. Yet not everyone inside that zone is a net-producer. Some are net-producers and some are net-consumers. So if, on aggregate, the zone is running a trade surplus against the rest of the world, then the net-producers inside that zone must be producing enough for their own consumption + the net-consumption of the net-consumers in that zone + the amount of the trade surplus. In other words, the net-producers are the only group inside that zone who are directly responsible for the trade surplus. The surplus (i.e. imbalance) is entirely attributable to the savers as a group. It's all about savers.
It's also all about savers because, just as imbalance is a choice made by savers, so is settlement. Consuming less than you produce is a choice. We have good examples of people who produce huge incomes and consume equal or even greater amounts, so under consumption is a choice. Likewise, what the saver does with his surplus income is also a choice. To lend it to someone else is to not choose settlement. To lend is to choose imbalance rather than settlement. Likewise, to invest one's surplus is to not choose settlement. To invest is to bet on future imbalance changes.
Imagine a net-producer in a surplus zone investing his proceeds back into his own business. He is not choosing to settle, instead he wants to produce more; he is betting that his zone's surplus imbalance will expand even more, because if it doesn't, his investment will probably not pay off better than savings. Or he could invest in production in the deficit zone which would be a "foreign investment". This would, on average, be a better bet for a surplus-zone investor in Freegold.
But you don't have to worry about that choice, especially if you are a saver. Some people are just born investors, entrepreneurs and gamblers, while most of us are savers. They look for the best bet while we look for the least risk. Are savers better than investors? Nope. Or are investors selfless and giving while savers are greedy hoarders? No way!!! We both play important roles, and I am in no way casting moral judgments. I am only observing.
You see, the marginal saver will switch back to investing during the deficit leg of the cycle in his zone, but he is not the grain that tips the scale turning the cycle. Natural investors will "see around the corner" and invest wherever the best risk-weighted profit opportunities lie, either domestically or elsewhere. This dynamic movement, the expectation of growth potential, will shift real economic growth from the surplus zone to the deficit zone where it is needed, and then back again.
So then why did I say it's all about savers? Why didn't I say it's all about investors? Well, because an investor will do what an investor will do. That's not unlike saying that a debtor will do what a debtor will do. Think of them as relative constants when compared to the wild-ass variable of savers, the elephant in the room, or more like the bull in the china shop, as long as they don't have a good focal point to herd them out of the busy economic highway.
The best thing the savers can do for the economy is to get out of the price signal transmission business and settle their accounts. Simple as that. We don't need anyone to "help" the Superorganism in identifying and enabling credibility. That's a natural process. The savers, which most of us are, should simply get out of the way, settle their accounts and let the organism work. It is only the lack of such settlement that messes it all up. And that's the main point. That's why it's all about savers.
So what is settlement? Well, it's not lending. It's not investment. It's not speculating in commodities (i.e., betting on future price signals). It's not consumption. And it's not necessarily buying gold. It is simply spending your excess income on durable goods that are not consumable and are not economically important. And, for savers, this means goods that tend to have resale value because of the focal point and network effect principles. This includes all of the usual goods I list as collectibles, but without a real focal point, none of them suffices enough to do the job properly and get the savers, as a group, out of the way. The best durable assets currently are out of reach to most savers, and the ones in reach suck. So the savers turn to investments and speculation which messes with the price signal transmission system built into the human superorganism.
For a review of price signal transmission, I refer you back to "I, Pencil" in the Superorganism Open Forum. Price signal transmission is an impossibly complex symphony of price movements that direct the structure of production. From the post:
"First, while no central planner is responsible for pencil production overall, entrepreneurs and workers at each stage do have plans and expectations, which they strive to coordinate with one another across stages and time periods. The key to coordination is the price system. If there’s a brass shortage, rising prices will communicate that information to the ferrule and pencil makers. The downstream entrepreneurs will have to adjust their plans in response to the new conditions–say, by finding a substitute material. The demand for a substitute material will in turn set appropriate processes in motion as entrepreneurs react. In the real world of disequilibrium, change is the rule, so plans are always undergoing revision…"
You see, it's not the fluctuating gold price that is needed for price signal transmission… it is the exact opposite! It is the price of everything else that fluctuates, transmitting signals, and it is gold that remains stable enough to sequester the savers as a group and get them out of the way of the Superorganism so it can do its job! Gold does not need to beat investment returns. Born investors will not be drawn to gold, and we don't want them to be, because they are a fickle bunch which makes them an important component in the Superoganism's price signal transmission system. The savers just need to let them be, which is why I ended that post with "Let It Be" by the Beatles.
So "properly functioning gold" is not wildly fluctuating gold, it is steadily rising gold, not better than investments in the long run, and not worse than currency in the short run. This is not a hard money fantasy, it is a Freegold reality. It is not the result of stable money as Blondie says, it is simply the result of a revalued physical-only gold market.
One last thing. The settlement of a saver's account in gold doesn't deprive the economy of ANYTHING. Quite the contrary! Any money spent on gold that would otherwise have been lent or invested goes instead to a net-consumer who used to be a net-producer, and is spent on the consumption of chosen products. It thereby flows to deserving companies and their employees. One does the economy no favors by leaving the distribution of their excess income up to governments and banks, central or otherwise, who must engage—by definition—in central planning.
Forget about lending being something that someone has to lend. If someone has a credible plan to expand the economy, their credibility will be funded. They don't need to borrow the saved surplus of past production. They get credit based only on their future production, not on anyone's saved past production, and use that credit to rent whatever they need for their future production. Credit isn't something first earned, then saved, then lent. It is simply the enabling of the borrower's credibility. That's why we have banks that can "print money from thin air". Because that's how it has always been! If you're a saver, just buy gold and let it be.