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Dear
Paul:
In
35 years our paths have crossed for the second time. In 1974/75 you and I
were Visiting Fellows at Princeton University. Now, in 2009, both you and I
are attending the Santa Colomba Conference on the
present debt crisis at the invitation of Bob Mundell.
In
1975 you conducted a seminar on the international monetary system and invited
me to contribute a paper on gold which I did. Those were halcyon days by
comparison. The United States, after the turbulence of 1971, successfully
consolidated the international position of the dollar and could confidently
lift the 42-year old ban on the ownership and trading in gold. On December
31, 1974, trading of gold futures contracts started in New York and Chicago.
It showed a robust contango at full carrying
charge, that is to say, the gold basis (the spread between the futures and
the cash price) was at its peak. It indicated that monetary gold was
available in great abundance to meet any demand for any reason. It showed
that the gold
futures markets could serve as the fulcrum in seeking out
the equilibrium between the supply of and demand for gold. They could act as
a safety valve, releasing occasional pressures that, in the absence of paper
gold, may be a threat to the monetary system. It looked as if the gold
problem has been solved for once and all.
But
as I feared, and as the intervening 35 years have proved, rather than moving
towards equilibrium we have been constantly moving ever farther away from it,
as measured by the gold basis. The secular vanishing of the gold basis is a
most ominous danger signal. It indicates that monetary gold is increasingly
unavailable, and in case of a crisis it can no longer be relied upon to come
to the rescue. Basis started out at 100 percent of the prevailing interest
rate, but has been steadily eroding all the way to zero percent today.
Permanent gold backwardation (negative gold basis) is staring us in the face.
The gold basis is trying to tell you something. It heralds the greatest
monetary crisis of all times. It warns about the possible collapse of the
international monetary and payments system.
Let
me explain. Gold is the only ultimate extinguisher of debt. Other
extinguishers do, of course, exist but they are not ultimate in that they
have a counterpart in the liability column of the balance sheet of someone
else. Gold has no such liability attached to it. Gold is where the buck
stops. It is this property that makes gold unique as a financial asset.
Historically, gold discharged its function as the ultimate extinguisher of
debt through the gold clauses written into the bonds of the U.S. government
before 1933. Gold could also discharge this function, albeit rather
imperfectly, under the gold exchange standard of 1934 with gold redeemability limited to foreign holders. Still more
imperfect was the system of fluctuating gold prices
introduced in 1971, thanks to the availability of paper gold.
Imperfect as though these stratagems were, they served as a pacifier to the
bond market. But as the threat of permanent backwardation indicates, all
offers to put monetary gold at the disposal of the international monetary
system could be abruptly withdrawn. In that event there would be no ultimate extinguisher
of debt. The world is totally unprepared for such a momentous development. I
ask you: are there contingency plans in the U.S. Treasury and in the Federal
Reserve what to do if backwardation makes monetary gold unavailable for the
indirect retirement of debt?
The
message to debt holders would be: sauve
qui peut. There would be a rush to the exit
doors and people would trample one another to death in trying to get out. The
debt crisis of 2008 was a dress rehearsal. It gave the world a foretaste. This
crisis is a gold crisis. It is a crisis indicating the threat of a
shortage of the ultimate extinguisher of debt, without which our runaway debt
tower is doomed. When it topples, it will bury the world economy under the
rubble, as the Twin Towers buried the people working inside in 2001.
All
kinds of ad hoc explanations have been offered for the debt crisis.
But the real explanation is that under the threat of gold backwardation
creditors are scrambling for liquidity. There will be no recovery unless
provision is made for the orderly retirement of debt through a mechanism
using gold as the ultimate extinguisher. The alternative is a Great
Depression worse than that of the 1930’s. To understand this we have
only to contemplate the shock to the world if it was revealed that the debt
of the U.S. government was in fact irredeemable. The Emperor is naked. As
long as bonds carry a gold clause, or the bond market is supported by the
trading of paper gold, bonds are deemed redeemable. But once permanent backwardation
makes gold unavailable, debt becomes irredeemable in the eyes of the
bondholders. Paying U.S. bonds at maturity in F.R. notes does not establish redeemability. The latter is just evidence of debt
secured by the former as collateral revealing that bonds are not really
redeemable at all. An interest-bearing bond is replaced by a
non-interest-bearing bond, that is, by an inferior instrument. All you do is
shuffle various forms of irredeemable debt. When the world wakes up to this
prestidigitation, the international monetary system will not be able to
survive the shock-waves. The chaos that will engulf the world is appalling.
The
solution is relatively simple. The world’s monetary gold should be
remobilized. This can be accomplished by opening the U.S. Mint to the free
and unlimited coinage of gold. There should be no attempt to fix, cap, or
otherwise control the dollar price of gold. The gold coins of the United
States ought to be made available to bondholders in order to provide for an orderly
retirement of debt, if that is what the bondholders want. When they become
convinced that this avenue is open to them through the unlimited availability
of gold coins of the realm, the scrambling for liquidity will peter out and
stability return. If other great nations wanted to join opening their Mints
to the free and unlimited coinage of gold, so much the better. It should not
be beyond the power and the wit of the U.S. government to rein in this crisis
and make a decisive move in the direction of full recovery through opening
the U.S. Mint to gold, as demanded by the Constitution.
Gold
is a great world resource. It would be foolish if, for parochial or
ideological reasons, we failed to enlist it in the cause of economic
development — even in the absence of a great crisis. But given the
present crisis situation, remobilization of gold is imperative.
Yours
very sincerely,
Antal E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
Read
all the other articles written by Antal E. Fekete
DISCLAIMER
AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. THE
AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT
IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY
SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND SOURCES
BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS
COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE
TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
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© 2002-2008 by Antal E. Fekete
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