All Paper is STILL a short position on gold

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From the Archives : Originally published March 23rd, 2009
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Category : Gold University





Think about this great business idea for a minute. Let's borrow some surplus stuff and sell it for whatever we can get. We'll buy a futures contract to get it back at some certain future date, so we're covered. Meanwhile, we'll earn an interest spread plus commissions. While we're at it, let's sell puts and calls against the stuff even if we don't have it on hand. Our mathematical models will guarantee that our position is always neutral, and we'll clean up on commissions, interest and other fees on the options too.

The foregoing approximates the rationale of the present day, little-known gold derivatives pyramid. John Exter, a famous gold analyst almost two generations ago, was the first to suggest that gold related to paper assets in the form of a pyramid. He described the relationship of gold to paper assets as an inverse pyramid balanced on trust. Currency at one time was a gold derivative. Government issue was backed by physical gold held by central banks. Because currency was a claim on gold, it was in effect a short position against a physical asset that was relatively easy to calculate. Governments hated the idea because they could never seem to stop issuing new paper. Even the pretense of a link has been long abandoned. Since currencies no longer have gold backing, and the world still appears to function, nouveau central bankers assert that gold is superfluous.

The gold derivatives pyramid is a vigorous free market creature. It cannot be put down with a simple declaration that the paper is no longer redeemable in gold, as governments did with currency. It is a short selling scheme that has become a trap from which few short sellers will escape. Paper claims in the form of derivatives far exceed the underlying physical metal on which they are based. The trust, which balances this new pyramid, is based on false assumptions and lack of information. Paper gold claims have proliferated at a pace rivaling any government printing press. A surfeit of paper gold has driven down the price of the physical on which it is based.

The above was written by
John Hathaway in 1999. Here is John Exter's inverse pyramid:

Today I read an article titled "
Hyperinflation is Impossible: Part 1" by Matt Stiles. It articulates the position of the deflationists well and it makes some powerful arguments in this regard. The most powerful argument is quoted in this article. It is:

It is often said that we live with a "fiat currency" or with "paper money." This is not entirely accurate. A very small portion of our total supply of money and credit is in the form of physical currency. It depends on how you count it, but regardless, it is under 10% of the total. This is what differentiates our monetary system with that of Zimbabwe or Weimar Germany circa 1920's. Their economies were based on nearly 100% physical currency because nobody would accept the promises of government in order to issue credit.

The vast majority of our money supply is in the form of electronic credit. Electronic credit can be destroyed, while physical notes issued by a central bank cannot. This is why deflation is possible in a credit based monetary system, but not in a paper based monetary system.

This is an argument that seems very convincing on first glance. So I decided to make a few comments on Stiles full article. Here they are:

Hyperinflation is Impossible: Part 1
by Matt Stiles

The government and Fed only control a small portion of the total supply of money and credit

I get a lot of emails and questions from readers and friends about whether I think the U.S. Dollar could collapse and start a bout of terrible hyperinflation. The questions are usually stemmed from watching an interview on TV with extremely biased energy/gold analysts. People who have every reason to sell you on hyperinflationary doom in order to make themselves a quick buck. I have no respect for these people, so I will not publish their names. They know who they are. I call them the "opportunistic hyperinflationists."

FOFOA: With the people he says he greatly respects in the next paragraph, I'm not sure who he is referring to here. Are Jim Sinclair and John Williams out to make a quick buck? Perhaps he is talking about Jim Willie who charges for a newsletter, but also writes many public articles as well. Chris Laird? Same story. Even some of the deflationist newsletter writers like The Privateer are now talking about a hyperinflationary collapse. So I'm not really sure who it is that he disrespects so much that he won't name. Maybe it's Glenn Beck.


But there is another group of "inflationists" who I do respect greatly. Guys like Peter Schiff, Jim Rogers, Doug Casey and Jim Puplava. These guys have spent years, if not decades, railing against the growing debt bubble and warning that it would end badly. A large faction of the Austrian School of Economics (of which I consider myself a student) had been doing the same. They are the "ideological hyperinflationists."

However, this group of economists/pundits/analysts have been terribly wrong in predicting how this debt bubble would unfold. And I am certain that they will continue to be wrong as it continues and reaches its ultimate conclusion. Typically, these folks have a fundamental dislike of our current system of currency. They feel it is immoral, illegal by the U.S. constitution and is doomed to failure as all paper currencies have been since the beginning of civilization. I agree with them on all counts. But as a function of their dislike for paper money, they have been enchanted by its most obvious replacement: gold. They carry it around with them and flash it at interviews. They become walking salesmen for the return to a gold standard. And they point to a rising price of gold as proof that they have been right all along.

They haven't and aren't.

FOFOA: Matt, in this section I think you expose your anti-gold bias, and you also draw into question your statement that you are a student of the Austrian School. I realize from later statements you make that you are paying attention to the psychology of the markets instead of just the math (which is an Austrian tenet), but that may be where your Austrian similarities end. Let's see.


Their arguments are usually the same. That in order for the massive amounts of debt to be repaid, the Federal Reserve and other central banks are going to have to resort to monetizing that debt via the "printing press." Their claims are well documented. Even the chairman of the Federal Reserve has promised to do this, should it prove necessary, earning him the nickname "Helicopter Ben" (after promising to drop money from helicopters to prevent deflation). And it appears he has already started. We can see it in their own figures. By now, I'm sure all of my readers are familiar with the Monetary Base "Hockey Stick" graph below that shows how the Fed has essentially doubled the monetary base in just a few short months. This, claim the inflationists, is visual evidence that hyperinflation is already occurring and will inevitably start showing up in everyday prices:

Another common claim by these folks is that inflation is running at far higher levels than what is reported by the very flawed CPI measurement. For proof of this claim, they'll point to John Williams' "Shadowstats" counting of inflation in charts like the one below. It shows that if we only counted inflation like we did pre-Clinton Administration, inflation would be much higher than we're told.

In this article, I will explain why these arguments are wrong.

Money and credit

First and foremost is the apparent misunderstanding of the differences between money and credit. At times, they may appear to have the same characteristics. At other times they act completely opposite from one another. As an economy is expanding, an increase in the total amount of credit would appear to have the same effect as an increase in physical dollars because credit is widely accepted as an equal to money. In a sense, they are the same. They are both "fiduciary media" (in english they are both a representation of something else, rather than having intrinsic value themselves). But when the economy is contracting, the prospect of default is thrown into the equation. When this happens, money increases in value relative to credit. Money is more valuable than credit because in the event of default, the physical dollar holders are king. Yes, the U.S. treasury could default on it's obligations. Holders of treasury bonds would get a big, fat zero, while holders of physical currency would still have a claim. In effect, they act similar to a preferred share as opposed to common stock. They are a step above in terms of priority.

FOFOA: You make a very good point in this paragraph. Physical currency (M0) is farther down on the inverse pyramid than the higher M's, and certainly farther down than debt like TBills. And during an asset deflation, capital flows down the pyramid. In deflation "Cash is King", a point I made in
On "Hyperinflation". But the question is what is really the "cash" that statement is referring to? What is really the bottom of that inverse pyramid that capital is striving for? Is it government paper? Or is it still the old foundation, gold?


It is often said that we live with a "fiat currency" or with "paper money." This is not entirely accurate. A very small portion of our total supply of money and credit is in the form of physical currency. It depends on how you count it, but regardless, it is under 10% of the total. This is what differentiates our monetary system with that of Zimbabwe or Weimar Germany circa 1920's. Their economies were based on nearly 100% physical currency because nobody would accept the promises of government in order to issue credit.

The vast majority of our money supply is in the form of electronic credit. Electronic credit can be destroyed, while physical notes issued by a central bank cannot. This is why deflation is possible in a credit based monetary system, but not in a paper based monetary system.

FOFOA: The differentiation you are making here needs to go even further. Yes, electronic money credits can be spent just the same as paper money. But the actual electronic money credits that can be spent, cannot be destroyed, unless a bank fails and actual M1 deposits are not replaced by the government (FDIC). The only credit which is destroyed is money that has been stored in assets (asset deflation) and the ability of people to draw money into the present from their future productivity (credit cards, financing, etc...). The destruction of those do not reduce the money supply. They create "asset deflation", but not monetary deflation more commonly known as "price deflation".

So yes, we have more electronic money, and less actual paper money in circulation than either Zimbabwe or Weimar Germany. But that electronic money, especially if it is backed by the government through the FDIC, is just as hyperinflationary as the paper in Zimbabwe. In fact, it may be even more so, as it can be created cheaper, faster, and easier than physical printing. (See my last post,
New Stimulus Plan).

There are hundreds of trillions of dollars floating around the world in credit. Much of that is an insurance contract on top of another insurance contract, on top of a securitized mortgage, on top of an asset. The total value of all the aggregate claims on the asset vastly outnumber the value of the asset itself. That is what this crisis is about at its very heart. Picture an inverse pyramid with assets occupying the bottom bit, securitized mortgages in the middle, and credit derivatives at the top. A stable economy would have a right-side-up pyramid with assets occupying the bottom, etc.

FOFOA: Here, let me help you out with this picture. During a credit expansion like we have had for the last 27 years or so, capital flows UP the inverse pyramid. And as the private sector leverages up and creates credit money in many multiples of real money, it creates new products to buy. New places to store this "wealth". John Exter created his inverse pyramid in the 1970's, so let's add some new, monstrous levels for the 21st century. The arrows show how capital flows during a credit expansion:


Our problem now, is not that the assets are going to go to zero. It's the value of the much larger derivatives and mortgages that back the assets going to zero. Their values were derived from faulty computer models that grossly underestimated risk in the underlying asset, but more importantly in the ability for a counterparty to make good on their promise in the event of a default. The counterparties, like AIG or Citi, issued 30 or 40 times more in insurance than there were in assets to back them up. Their models told them that the possibility of all the different assets declining at the same time was negligible, therefore justifying such enormous leverage. Now that the assets have fallen by at least 20-30%, the holders of the securities that were tied to them want to be paid for their insurance. Only there's nothing to pay them with. So the people that hold these contracts are trying to get rid of them as fast as they can, and for whatever price, because they fear that if the counterparty goes belly-up, they'll get nothing. If they can sell, they take the loss. If not, they keep the asset off their balance sheet in what's known as a SIV (Special Investment Vehicle) until they can be sold. While they are kept off the balance sheet, they are still considered to be worth 100% of their original value.

FOFOA: Here, let me help you with this one too. Again, it is the flow of real capital that we need to look at. And which direction is it flowing now?

That's right, it's flowing down the inverse pyramid as those upper levels shrivel and dry up. There is much loss of perceived value in this downward flow. In fact, that's what's causing it. But as we bail out entities like AIG so they can pay off the winning tickets held by Goldman Sachs and others, we are feeding more good money into this downward cascade. What should have been a loss of perceived wealth is actually being converted into REAL, SPENDABLE wealth at the taxpayer's expense. "Whew!", says Goldman Sachs as he collects on his winning ticket. Do you think that fresh digital money he just collected is going to go back UP the inverse pyramid? Not a chance! It will go down to safety along with everything else.


The total amount of these assets is far greater than the equity banks have and their sum represents future losses that eventually need to be realized. No, the value of these assets is not completely nil - because the value of the underlying assets are not nil. But for all intents and purposes, it might as well be zero because it dwarfs their tangible equity.

FOFOA: In the inverse pyramid, each level you go up is essentially a derivative of the lower levels. And during expansionary times those derivatives yield a little more than the lower levels. That is why capital climbs during the good times. But when PRINCIPLE is destroyed, this dwarfs the meager benefits of a yield and the capital scurries down the ladder to safety.


That was a very long-winded explanation of what the difference is between "money" and "credit" but it is essential to understand this difference. Not only if you want to be an econo-weenie like myself, but in order to understand the very essence of our economy, banking or investing. Any other information is essentially useless unless you can wrap your mind around this concept.

FOFOA: Got it! Thanks. But wasn't that more of a long-winded explanation of the difference between "money" and "assets" (or let's say between "wealth" and "perceived wealth")? Credit is essentially the ability to pull future capital into the present. Digital money credits are different, they are actually money, just like printed paper money. And wealth held in shitty assets is neither credit nor money. Right? It is simply an asset, or a derivative of an asset that gives you the perception of holding wealth, until "all that paper starts to burn".


So the next time you hear that the Federal Reserve is "printing money," please do not automatically assume that they are printing physical notes. They are creating electronic reserves (credit) to support the balance sheets of the big banks. There is absolutely nothing inflationary about this. The banks are simply taking it and using it to cancel out their derivative losses or are hoarding it in order to prepare for future losses. Previously, banks would have used the electronic reserves to go out and make 10x that amount in loans to consumers or businesses (in reality the order was the other way around - loans first, then reserves). That is not the case anymore, and until the bad assets are completely liquidated, it will not be the case again.

FOFOA: With all due respect, I think you are wrong here. If the Fed "prints" electronic reserves (credits) it is absolutely as inflationary as printing physical notes. These "electronic credits" are being used to "make whole" some investments that went bad because of counterparty failure. And when someone's misfortune is reversed, when they are made whole, they now have real spendable currency. And with that currency they are able to pay their people. And those people (that may have otherwise been out of a job) can now go spend their bonuses on whatever they want. It is not credit at that point, it is spendable money they wouldn't have had if the Fed had not created "electronic credits".


Thus far, we have a total of $9.7 Trillion dollars in total government/central bank assistance in the United States. An amount equal to that and more has been provided by their counterparts around the world. More is promised. But the fact remains that the minimal inflationary impact these actions have are negligible in comparison to the amount of "problem assets" being devalued around the world. Much of it is just in guarantees - that is, more insurance. The Federal Reserve will offer to swap good assets for bad. All this does is cancel out debt from somewhere else. It's like moving money from one pocket to another. The act of putting money in your right pocket does not make you any richer.

FOFOA: No, it is making a bad investment that should have been a total loss whole again. In fact, it is turning an "asset" into "money", which the free market already ruled should be a loss. Those top levels of the inverse pyramid are already dead. And you will notice that the lower levels of the pyramid are much smaller. So it will only take a small portion of the capital from higher up being made whole and flowing down to overwhelm the bottom of the pyramid. We are already seeing this in the Treasury bubble and the US dollar bubble. But you've got to ask yourself, are those really the final destination of this downflow?

Zimbabwe and Weimar Germany never had those higher levels of the pyramid. They never had the credit system to create them. But as those levels collapse here they offset all that credit that made them possible, and the downflow of remaining capital here in America will be like Niagara Falls trying to fill a plastic kiddie pool.


All in all, the central banks are not nearly as powerful as they'd have you believe. The amount of the total money supply that is controlled by them is minimal. They won't tell you that. They'd prefer you to think that just by them moving their lips they can affect the entire economy's decision making processes. It simply ain't so.

FOFOA: This is a true statement, but not for the reasons you think and not to the ends you expect. See my posts on Freegold.


This begs the question: why is gold going up? Who knows. It has a mind of it's own. But if it really only moved due to inflation concerns, it wouldn't have declined 75% over two inflationary decades (80's, 90's) would it? If inflationary concerns were real, we would see TIP yields rising along with the gold price. They're not. We'd also be seeing other typical inflation hedges rising - like property prices. That is obviously not the case. A better explanation is that gold is rising because of increased instability. People want to own a little bit "just in case." As they should. But an even better explanation is that it is going up because it is going up. Pure speculation.

FOFOA: Matt, you must be talking about "paper gold". It is true that the prices you follow are heavily driven by speculators in the paper markets for gold. But what you are missing is that real physical gold is not an inflation hedge, it is simply a wealth reserve. And it is a wealth reserve that will survive and prosper even through the nuclear annihilation of paper assets. It is a hedge against the collapse of the system. This, and the official control of the gold price as presented by GATA, are the reasons the price of gold stagnated through the 80's and 90's. But that era is over now. We are entering a new era.

But I do understand why you think the way you do. You are 26, right? Born in 1982? You see, ever since 1971 the establishment has convinced you and almost everyone else that they successfully moved the very foundation of the inverse pyramid and placed it up amongst the investments categories:

But ask yourself this. Did they actually move it? Or did they just create the illusion that they moved it? As John Hathaway said at the top of this post, "The gold derivatives pyramid is a vigorous free market creature. It cannot be put down with a simple declaration that the paper is no longer redeemable in gold, as governments did with currency. It is a short selling scheme that has become a trap from which few short sellers will escape."

All Paper is STILL a short position on gold!

No matter how much credit is issued, it cannot make up for the massive contraction elsewhere. The net result will be deflation - even though it will be less than it would be without any interventions. Japan has discovered this over the last two decades - and they had huge demand for their exports, whereas the current situation is global. America discovered this in the 30's - and they had a far smaller debt burden than now. We will discover the same.

FOFOA: No, the net result will be ASSET deflation, not deflation. Japan had a slight net INCREASE in the CPI during the lost decade even though they had massive ASSET deflation. Asset deflation and monetary hyperinflation are completely compatible with each other, they happen at the same time, and they happen together in all cases of hyperinflation. Hyperinflation and currency collapse are basically the same thing. Hyperinflation and deflation are almost the same thing. And hyperinflation and inflation are similar in name only. Please read the Daniel Amerman articles linked at the bottom to learn about the differences between asset deflation and monetary or price deflation. You will also learn that what was discovered in the 30's was actually the opposite lesson. It was that a determined government CAN stop deflation on a freaking dime whenever it wants to. Yes, we will discover the same... very soon!

Will the U.S. Dollar collapse?

Closely tied to the belief in imminent hyperinflation and a skyrocketing gold price is the misplaced belief that the U.S. Dollar is on the brink of collapse. Essentially, they are one and the same. Many of my arguments against hyperinflation are the same against a dollar collapse. But there is even more evidence stacked against such an occurrence.

Ultimately, the Dollar will end up at zero - but that is not going to happen any time soon, and I would argue is likely decades away. Until then, the massive amounts of deleveraging will increase our appetite for dollars to pay back debt. There is too much credit in the system, and as we rid ourselves of it slowly, we need to acquire dollars. A large portion of the credit derivatives I mentioned above are denominated in dollars even though the underlying asset may be priced in another currency. This is a theoretical short position on the dollar. A "carry trade" in other words. It must be unwound, just like the Yen carry trade.

FOFOA: It is all about the flow of capital. You will notice that the dollar is at the bottom of the inverse pyramid, right above gold. So as capital flows down the dollar certainly sees a rally. But that will be short lived. You see, the dollar is not the true foundation of the pyramid and it is neither an asset nor real money. It is merely a "symbolic currency". And as such, its value can be EASILY controlled by the Fed. We saw a hint of this last week. It is not decades away, it is happening right now. Sure, it is true that we need dollars to pay off our debts. That is because it is legal tender. But we don't need to store our extra wealth in dollars. That would be silly. And foreigners don't either. That would be even more silly. And the higher levels on the pyramid have simply become too dangerous for storage of wealth right now. So there is really only one place for capital to flow to. Gold!

If everything above the dollar is a "theoretical short position on the dollar", then it is all (including the dollar) STILL a theoretical short position on gold. Think about it. Yes, this carry trade WILL be unwound!

This is what is meant when we call the U.S. Dollar the world's "reserve currency." Most people hear the word "reserve" and automatically conclude that because many other countries hold the dollar as their primary currency in their foreign exchange "reserves," that is what is meant by "reserve currency." It is not. Total foreign exchange reserves of dollars are far smaller than total foreign credit contracts denominated in U.S. Dollars (reserves worldwide are "only" ~4.6 Trillion). It is the reserve currency because it is the default currency for international trade and commerce in general. In order for that to change, 100's of trillions in contracts would need to be re-written. Not practical.

As such, demand for U.S. Dollars will persist.

FOFOA: Close, but not quite. The dollar is the reserve currency because it currently supplies the "usage demand" of the world. That is changing. As such, demand for U.S. Dollars will die down. Once necessities on the world market, like oil, are priced in something other than the dollar, no one will need to hold dollars, dollar reserves, or contracts denominated in dollars anymore. The global flight from dollars will be so fast we will likely hear a sonic boom.

Additionally, the U.S. Dollar is not alone in its state of affairs with an overindebted government and central bank getting itself in all sorts of trouble. In fact, nearly every other currency has the same issues facing it. And even though the numbers aren't quite as dire elsewhere, they are far more likely to collapse than the U.S. Dollar due to the reserve status. Fair? No. But neither is life.

FOFOA: True, all fiat currencies are in a race to the bottom. And as such, the floating exchange rate system which first appeared on this planet in 1971 is likely to be the greatest systemic threat out there. Time will tell. But one thing the dollar has that all those other currencies don't have is an Achilles heel. That heel is the fact that the dollar has been spread so far and wide being the reserve currency for decades that when it collapses, the flood of dollars coming home will make the collapse of other currencies seem like a local boom in comparison. The dollar itself was hyperinflated long ago as it was shipped off by the boatload to all of our trading partners and creditors.

In summary, there are many multiples more debt than capital in the world economy. Debt is being liquidated and will continue to do so until it reaches a sustainable level relative to capital. The process of this debt liquidation puts a higher value on dollars relative to debt, thus ensuring an oversupply of dollars is impossible.

FOFOA: So in your view, Ben Bernanke, Geithner, Obama and our fine Congress can keep printing and buying their own debt with more printing for years and years to come? And those newly created dollars will keep increasing in purchasing power the whole time? The government can build bridges, trains, museums, wind power, and all the other great projects with newly printed money and each year that money will buy more and more because it is increasing in value? All because an oversupply of dollars is impossible?

Matt, I have some reading recommendations for you as I mentioned earlier.

Here are the two articles by Daniel Amerman that will explain the difference between asset deflation and price or monetary deflation:

Puncturing Deflation Myths, Part 1

Puncturing Deflation Myths, Part 2

I also recommend that you read
Another and FOA to give you a different perspective on gold, the new gold market, and the possibilities for the future of gold, Freegold.

Most sincerely,



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