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My
approach is different from that of other monetary scientists in that I take
speculation into full account. The theory of speculation is conspicuous only
by its absence from mainstream economics. (Keynes' attempt to create one was
a dismal failure.) But it is not a strong side of Austrian economics either.
I reach back to Carl Menger and construct a theory of interest directly on
his economic principles.
In
this concluding part of my two-part series I suggest that the year 2006 has
decisively changed the nature of gold speculation. Speculators no longer take
the bait of riskless profits. They no longer short gold at the first sign of
a rising gold price. It is only a matter of time before the marginal gold
bull decides to short not gold, but the gold stock par excellence, Barrick.
Faux pas of
Mises
My
theory of interest is centered around the constant marginal utility of gold.
It is this property that makes gold 'most hoardable'. That there is a
limit to gold hoarding is due solely to the institution of interest. The
opportunity cost of hoarding gold is just forgone interest. This is a
distinctive property of gold. The hoarding of all other goods is severely
limited by declining marginal utility. Mises missed this fundamental
connection between gold and interest. (This is not to mention David Ricardo.
If Mises missed by inches, Ricardo's 'bullion plan', adopted by Britain in
1925 and the by U.S. in 1934, missed by miles.) All this is fully worked out
in my Gold Standard University lecture series, which has been in the public
domain for many a year.
It
follows that the rate of interest is just the rate of marginal time
preference. In practical terms this means that the agent to regulate the rate
of interest is the marginal bondholder*. He is doing arbitrage between the
gold market and the bond market. As the rate of interest is falling below the
rate of marginal time preference, he takes profits in selling his overpriced
gold bond and puts the proceeds into gold. This action makes the rate of
interest turn around. As it is rising above the rate of marginal time
preference, the marginal bondholder will buy back his gold bond at a lower
price.
It is
interesting to note that Mises explicitly referred to this particular
arbitrage, although without using that word.** So he was actually pretty
close to discovering the real force driving the rate of interest. Yet he went
astray because, for him, paper currency was a present good no less than the
gold coin -- a faux pas.
Should
the marginal bondholder accept paper currency in exchange for his gold bond,
he would take zero in exchange for a positive income. Thus his protest
against low interest rates would be counter-productive. In effect, he would
jump from the frying pan into the fire.
This
irrefutably shows that the action of the marginal bondholder aims at hoarding
gold, and not currency in general. Under modern conditions the meaning of the
term 'time preference' is not preference for an apple available today as
against two apples available ten years from now. It is, rather, preference
for holding the gold coin, a present good, as against holding the gold
bond, a future good -- unless the rate of interest is sufficiently
high to compensate for the unequal exchange.
Key to Gibson's
Paradox
Imagine
my surprise when I learned that mainstream economists have also discovered
gold as the only instrument to give teeth to time preference that would
otherwise remain but a pious wish. See in particular the joint paper of
Barsky and Summers. The correlation between the rate of interest and the
price level under a gold standard was named 'Gibson's Paradox'. Paradox,
because monetary theory according to Keynes would call for a correlation
between the rate of interest and the rate of change (rather than the level)
of prices. Gibson's, because Irving Fisher named Gibson as the first
author to make this observation. Keynes stated in 1930 that two centuries of
data failed to confirm that a correlation existed between the rate of
interest and the rate of inflation. Instead, between 1730 and 1930, the rate
of interest and the price level showed a positive correlation which Keynes
described as "one of the most completely established empirical facts in
the whole field of quantitative economics". No one has been able to come
up with a full theoretical explanation. Friedman and Schwartz in 1976
concluded that "the Gibsonian Paradox remains an empirical phenomenon
without a theoretical explanation". It was not for want of trying,
either. Irving Fisher wrote in 1930 that "no problem in economics has been
more hotly debated". Barsky and Summers also state that "Gibson's
Paradox has proven to be an especially stubborn puzzle in monetary
economics".
Yet to
find the key to the 'paradox' we have only to observe that suppression of the
rate of interest will intensify gold hoarding by the marginal bondholder
which, under a gold standard, squeezes bank reserves and leads to a falling
tendency of the price level. Conversely, we observe that when the rate of
interest rises the marginal bondholder will, in buying the gold bond, release
hoarded gold. Increase in the quantity of monetary gold increases bank
reserves, and leads to a rising tendency in the price level. The 'Gordian
knot' finds its 'snap solution' in Menger's concept of marginal utility.
The regime of the
irredeemable dollar
The
validity of Gibson's Paradox clearly extends to the regime of the
irredeemable dollar with a variable gold price. It varies directly with the
price level. In particular, as the irredeemable dollar loses purchasing
power, the price of gold will rise for the stronger reason. In terms of
Gibson's Paradox, the price level rises less if the rate of interest
is suppressed; otherwise it rises more.
Properly
interpreted, there has never been an episode in history when Gibson's paradox
failed to operate. It is the empirical description of the apodictic truth
that suppression of the rate of interest brings about increased gold
hoarding, subject to leads or lags. Every ounce of hoarded gold is a
testimony to the fact that somebody, somewhere, has found the quality of
savings instruments, and their yield, inadequate. By making the regime of
irredeemable dollar non-negotible, the U.S. government has foolishly deprived
itself of the possibility to channel people's savings into 'socially more useful'
applications. Therefore it is the government, not the people, that is to be
blamed for the present negative savings rate in the United States.
Government
manipulation
In
Part 1 I advanced the hypothesis that the U.S. Treasury and the Federal
Reserve have been manipulating both the rate of interest and the price of
gold. In more details, they encourage bull speculation in bonds and bear
speculation in gold. They do it by making unlimited quantities of bonds
available for the speculators to buy, and unlimited quantities of paper gold
available for them to sell in the derivatives markets. Lures, in the form of
risk-free profits, are planted along the path of the speculators.
Clandestine
government policy to manipulate the bond and gold markets is revealed by
statistics on the number of outstanding contracts in derivatives, showing an
inordinate open interest in bonds on the long and in gold on the short side.
Neither has any rhyme or reason to exist, in view of the underlying economic
reality. What is more, the long interest in bond and short interest in gold
derivatives are increasing exponentially, far outpacing the amount of bonds
in existence, and the amount of gold available for delivery. Significantly, there
is an extreme concentration of derivatives in the hands of three or four
firms on the long side of the bond market, and on the short side of the gold
market.
A most
alarming development occurred recently as observed by Pinank Mehta
http://www.gold-eagle.com/editorials_05/mehta100706.html (October 7). The net
long open interest of the 10-year US bond contract, as reported by Morgan
Stanley Research, has increased explosively and is now greater than six
standard deviations. This level is unprecedented.
The Twin Towers
of Babel
In
Part 1 I explained why the government was interested in manipulating
speculators so that they compulsively construct such uneconomic Twin Towers
of Babel. The purpose of Part 2 is to show that, in view of Gibson's Paradox,
there is a conflict involved in the dual manipulation. In fact, the two
desiderata in the agenda of the government: the propping up of the bond price
and the suppression of the gold price, are contradictory. In encouraging bull
speculation in bonds the government prompts more gold hoarding, making gold
scarcer and the gold price more buoyant still. On the other hand in
encouraging bear speculation in gold, in so far as it is effective, gold
hoarding is reduced pushing interest rates higher. Rather than canceling out,
the two effects could ratchet up both the gold price and the rate of interest
simultaneously. As a result, the Twin Towers will self-destruct in due
course.
The
regime of the irredeemable dollar is subject to the 'sudden death syndrome',
a malady afflicting all fiat currencies with a 100 percent fatality rate.
Creditors know this, and add a risk-premium to the rate of interest they
charge on their loans. If it weren't for bond derivatives, the dollar would
have gone the way of the assignats and mandats already in the
twentieth century. But the government plants lures, to induce speculators to
buy the bonds. This keeps interest rates low, and props up the dollar.
However,
in terms of Gibson's Paradox, the suppression of the rate of interest means
increased gold hoarding. To counter that threat, the government has to have
recourse to a devious scheme to induce speculators to sell unlimited amounts
of gold through the gold derivatives market. In Part 1 I described an
imaginary mining concern, Sarrick Gold, with a phony hedge plan involving
forward selling, to the exclusion of forward buying, of gold. Speculators are
offered risk-free profits on the short side of the market. All they have to
do is to pre-empt Sarrick's forward selling strategy, that is, sell before
Sarrick does.
Thus
the Twin Towers of Babel, the long-bond pyramid and the short-gold pyramid,
are interdependent. Neither one will prosper without the other prospering.
Conversely, if one topples, so will also the other. It follows from standard
theory of speculation that, in commodities, a short position constitutes unlimited
risks, as opposed to a long position the risk of which is limited as the
price cannot fall below zero. This suggests that the inordinate,
fast-increasing and extremely concentrated short interest in gold is
vulnerable and will act as a trigger when it gets wounded (that's what the
word 'vulnerable' makes you expect to happen). Delivery may encounter
difficulties, backwardation may develop in gold futures, and the weakest link
in the short chain may snap. Some shorts may default. That would cause other
short positions cascade and defaults spread. The collapsing gold basis will
accurately gage the development leading to the toppling of the short gold
pyramid. In an earlier paper entitled: The Last Contango in Washington
I conjectured that the collapsing silver basis may act as an 'early warning
system' to herald the coming collapse of the gold basis.
The
long bond-pyramid is at the mercy of the bond-bears, and the short gold-pyramid
is at the mercy of the gold-bulls. Moreover, in terms of Gibson's Paradox, a
run on gold still available for delivery against gold derivatives would cause
a panic in the bond market to sell. Thus the equilibrium of the Twin Towers
of Babel turns on the knee-jerk reaction of the marginal bull speculator in
gold. When he decides that Barrick is in fact bankrupt as it will never be
able to make good on its forward sales commitments, he will do two things:
(1) short Barrick stock, (2) take delivery on his long positions in the gold
derivatives market.
Insatiable
Appetite
Thus
we have another 'early warning sign' for the collapse of the Twin Towers of
Babel: the Barrick share price, already showing a profound shareholder
disillusionment. It is significant that Barrick has worked up an insatiable
appetite for further acquisitions. Its purpose is to confuse the issue
through window-dressing of the balance sheet.
One
might have expected that, having become No. 1 in the world, Barrick would
want to catch its breath and rest on its laurels. Not so. Barrick is still
looking for other gold producers to gobble up. This looks like a sign of
desperation to me. As long as you are No. 2, appetite for acquisitions is
understandable. You try harder. But when you are No. 1, it no longer makes
sense. However, Barrick is in the limelight. The share price as compared with
assets is lamentably low. It would be more fitting for the last than for the
first in the business. The reason is the curse of the hedge book. It just
won't go away. Barrick will neither repudiate nor repair its faulty policy of
forward selling of gold, in spite of dire warnings that it may eventually be
the cause of its downfall. The hedge book is deep under water. It shows only
forward sales, no compensating forward purchases.
Barrick
has been challenged to mark its hedge book to market. The challenge was
ignored. For all we know, there may be a good reason for that. Perhaps the
rumors are true and, when liabilities are marked to market, all the assets of
Barrick are wiped out. Barrick would be seen as being bankrupt. Could this be
the very reason why Barrick is so desperate to acquire other gold mining
assets? If it could buy badly needed time before share value declined more
relative to assets, the worst could perhaps be averted.
Barrick
loves to pay for its acquisitions with its own shares. From the point of view
of its shareholders, this policy is disastrous. Not only does it mean further
dilution of their share, but so low is the value of shares relative to assets
that Barrick's shareholders fear another attempt by management to fleece
them. On the other hand, shareholders of the company targeted for a hostile
takeover are increasingly reluctant to accept Barrick's 'stained' shares in
exchange for their 'clean' (read: not stained with forward sales) shares.
One
wonders why targeted companies could not force Barrick to mark to market its
existing commitments to sell gold forward. After all, the seller has the
right to ask whether the check offered in payment by the buyer is backed as
represented. Maybe they did try, whereupon Barrick decided to come up with
the cash rather than make the uncomfortable revelation.
Atlas Shrugged
One
can only guess that the urgency with which Barrick acquired Placer Dome is
explained by the 2006 surge in the gold price. We may take it for granted
that Barrick anticipated the surge, but could not close out the deal in time
before it happened. At any rate, the two events are connected and their
concurrence has materially changed the course of history. First, the utter
futility of the short gold pyramid has convincingly been demonstrated.
Speculators no longer take the bait: they no longer mindlessly short gold on
the first sign of strength in the gold price. Second, Barrick has changed its
strategy from forward selling to unlimited acquisitions. This is symptomatic
of the problems Barrick is going to face in the future. The new battle cry
is: "Acquire or die!" However, in doing so Barrick will be racing
against a buoyant gold price.
This is
the unpredictable part. Can Barrick acquire gold properties fast enough to
win the race against a rising gold price no longer fettered by forward sales?
If it can, this may be a set-back for the gold price. Atlas may be able to
carry the $300 trillion derivatives market on its shoulder awhile longer.
But if
it could not, and Atlas shrugged, then the short gold bubble would burst,
triggering the collapse of the $300 trillion derivatives bubble. We could
then expect to witness the ruination of the credit of the United States, and
the close of the dollar system.
********
Endnotes
*In Human
Action Mises treats time preference as if it were the same for everybody,
paupers and nabobs alike. As I have found this too crude, I refined it by
introducing the concept of the rate of marginal time preference, that
is, the rate of the time preference of the marginal bondholder. He is doing
arbitrage between the bond market and the gold market. The marginal
bondholder is the first to reduce his bond holdings on the next downturn of
the rate of interest.
Strictly
speaking, there are two agents: the marginal bondholder regulating the floor,
and the marginal entrepreneur regulating the ceiling of the range to
which the rate of interest is confined. The ceiling is the rate of marginal
productivity of capital as it is regulated by the marginal entrepreneur in
doing arbitrage between the bond market and the capital goods market. As the
rate of interest is rising above the rate of marginal productivity of
capital, he sells his capital goods and invests the proceeds in the bond
market. This action will make the rate of interest turn around. As it is
falling below the rate of marginal productivity of capital, the marginal
entrepreneur takes profits and sells his overpriced bonds. With the proceeds
he re-equips his productive enterprise and starts production once more. For
full details, see my Gold Standard University lecture series.
In
this paper I have, for the sake of simplicity, assumed that the rate of
interest is the same as the rate of marginal time preference, and the agent
to regulate it is the marginal bondholder.
** The
word 'arbitrage' does not occur in the Index of Human Action or in that of
The Theory of Money and Credit.
Antal
E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
Read
all the other articles written by Antal E. Fekete
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