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Executive Summary
Analysts keep talking about supply/demand factors,
instead of concentrating on the falling basis and looking for other signs of
the coming backwardation in the gold and silver markets. They should also
answer the question: Whatever happened to the Chinese silver, remnants of China’s
defunct silver standard?
Phantom Supply and Demand
As his starting point in trying to explain prices
Ted Butler, among other analysts, chose the supply of and the demand for gold
and silver. This is a mistake. Under the regime of an irredeemable currency
the supply and demand of a monetary metal are indeterminate. In other words,
they cannot be quantified in any meaningful sense of the word. For example,
the supply of gold from official sources is on a 24-hour basis, in spite of
the Washington
agreement and similar declarations largely drafted in order to obfuscate
rather than to enlighten. Supply from private sources, too, can change on a
moment’s notice together with demand as speculators have no firm commitment
either to the long or short side of the market. It is a mistake to assume
that the dealers are committed to the short and the tech-funds to the long
side. Such commitments, to the extent they exist, are subject to many an
overriding consideration such as profit-taking, stop-loss, to say nothing of
herd-instinct that may induce a massive stampede from one side of the market
to the other based on nothing more substantial than a rumor.
It is futile to analyze the gold and silver markets in the same way as one
would other commodity markets. It is dangerous to ignore the fact that gold
and silver are monetary metals.
Phantom “Free Market”
To call for a free market for gold or silver is
calling for the impossible. Once again we must remember that we have
irredeemable currency. The gold market could only be free if the official
supply were available on demand to the private sector at the official price. This
is clearly not the case as a result of the wholesale default of governments
to pay their gold obligations in the 20th century. Never mind if
governments are shouting from the rooftop that silver and gold as money are passé
since the former was demonetized in 1871 and the latter a century later. At
best, this is wishful thinking, at worst, malicious misinformation. It is not
up to the governments to monetize or demonetize a commodity. It is the
prerogative of the market. In picking a monetary commodity the market will
make its marginal utility decline at a rate more slowly than that of any
other. There is always such a commodity, no matter what the government says. It
can be recognized by the fact that its above-the-ground supply is a large
multiple of annual output, whereas that for a non-monetary commodity is a small
fraction. We shall express this by saying that the stocks-to-flows ratio is
the largest for the monetary commodity. For this reason, once it has been
picked, it is virtually impossible to change. Such a change would involve the
dispersion of the large existing hoards of the old, and the accumulation of
similarly large hoards of the new monetary commodity. That would take
centuries to complete, longer than the week-end declaration of a
default-prone government.
What Is the Value of a Broken Promise?
In prehistoric times the market picked the monetary
metals: gold and silver. The rest is history, replete with government
bluffing. It is easy to see through this. Paper money was originally issued
as a promise to pay a definite amount and fineness of gold to bearer on
demand. Later the government reneged on its promise, which promptly started
losing value in terms of gold. There have been ups following downs, but the
downtrend is unmistakable. Why the ups?
Nothing is more natural than for a banker to try to
keep his dishonored promises in circulation by hook
or crook lest their value go to zero, as it has happened every time in
history. It makes no difference whether the banker runs a wildcat bank or
whether he runs the most powerful government in history with the most
formidable armor and weaponry imaginable at its
disposal. The banker may be able to pull new tricks from his sleeves and
thereby to fool the public a little longer. But no tricks will turn upside
down the natural law that written evidences of broken promises are destined
to end up in the garbage bin. Regardless how fine the paper and how beautiful
the print is.
Under the regime of irredeemable currency the price
has nothing to do with the value of gold. It has to do with the success of
the government to fool the public. It has to do with the failure of the
people to see through government bluffing. It helps if the government (or
central bank) has a large hoard of gold. It can be used to intimidate other
holders, bombarding them with propaganda that the supply/demand fundamentals
for gold are most unfavorable.
The existence of such hoards will induce speculators
to place bets as to the ultimate disposal of the official stocks. Those who
bet that these hoards will eventually be used by the government to stabilize
paper money will go long. Those who bet that the government will commit harakiri in bluffing its way down to the last bar
of gold in its coffers will go short. The contest of the longs and shorts
will cause the price of gold to fluctuate. As we shall see below, ultimately,
the shorts are destined to be the losers but, in the meantime, they can make
a lot of mischief. Especially if they are right in assuming that the
government really intends to bluff its way down to the last gold bar.
Keynes’ Blunders
The enfant terrible of British economics John
Maynard Keynes assumed that there was inherent symmetry in speculation that
was supposed to furnish a natural limit to the size of the markets in
derivatives. By derivatives we mean futures contracts (or options thereon) to
make or take delivery of a definite quantity and quality of a commodity at
the price prevailing at the time of contracting. Those who contract to take
delivery are the longs (a.k.a. bulls) and those who contract to
make it are the shorts (a.k.a. bears). Keynes argued that,
since to every long there must correspond a short,
the net effect of the derivatives on supply and demand is neutral. According
to him derivatives-trading is a zero-sum game: the gain of one
speculator is the loss of another. Samizdat* economists (my term for
those publishing on the internet) see it differently. If we depict the
underlying cash market as the dog and the corresponding derivatives market as
the tail, it is foolhardy to suggest that always the dog wags the tail. The
trouble with the regime of irredeemable currency is that under it the tail
may often be wagging the dog.
It is patently false to suggest that symmetry
prevails in trading derivatives. The risks taken by the longs and shorts fail
to be symmetric. In case of commodities the risk of the longs is limited
while that of the shorts is unlimited. Nor is it hard to see why. The risk of
the longs is that the price will fall. But fall as though it may, it will
definitely not fall below zero. This limits the exposure of the longs.
Compare this with the risk of the shorts, which is that the price may rise. As
there is no obvious limit above which the price may not be allowed to rise,
the risk of the shorts is unlimited. The lopsided nature of speculation in
commodities is revealed. Another way of expressing this is to assert that the
longs can squeeze, and sometimes corner, the shorts. By contrast the shorts
cannot squeeze, let alone corner, the longs in the commodity markets
(although, of course, they are free to bluff that they can).
Speculation in interest-rate derivatives is no less
lopsided, albeit with a switch between the roles played by the longs and the
shorts. Here the risk of the shorts is limited while that of the longs is
unlimited. Indeed, the risk of the shorts is that the rate of interest may
fall (so that bond prices will rise). But fall as though it may, the rate of
interest will definitely not fall below zero. Compare this with the risk of
the longs, which is that the rate of interest may rise (so that bond prices
will fall). As there is no obvious limit above which the rate of interest may
not be allowed to rise, the risk of the longs is unlimited (in comparison to
that of the shorts). Another way of expressing this is to assert that the shorts
can squeeze, and sometimes corner, the longs. By contrast, the longs cannot
squeeze, let alone corner, the shorts in the financial markets (although, of
course, they are free to bluff that they can). Examples of the bond-bears
cornering the bond-bulls are provided by the various historic episodes of
hyperinflation.
Keynes was wrong in declaring that the net effect of
derivatives on the cash markets is neutral, and thereby the volume of
derivatives trading is capped. Just the opposite is true. Derivatives
trading in gold and silver has grown beyond rhyme and reason. The
growth in trading interest-rate derivatives has been even greater. These
cancerous growths are part of the self-destroying mechanism of the regime of
irredeemable currency.
It Takes Three to Contango
Keynes’ theory of speculation is wrong beyond
the possibility of repair. He insisted that the natural condition for the
futures markets for commodities is to be in backwardation. This is the
name for the condition that the market quotes a lower price for a more
distant and a higher price for a nearby delivery date. The opposite
condition, one that obtains when the market quotes a higher price for a more
distant and a lower price fore the nearby delivery date is known as contango.
Keynes called what he saw as the natural condition
for the futures markets in commodities “normal backwardation”. He
reasoned that there is a risk involved in carrying a commodity, namely, the
risk that the price may fall. The producers and distributors want to unload
this risk onto the shoulders of the speculators. However, the speculators
will shoulder the price-risk only for a consideration, as manifested by the
backwardation. The role of the speculator, according to Keynes, is analogous
to that of the insurer who charges a premium for insuring specific risks.
This is a complete misrepresentation of the facts of
the markets. The speculator is no insurer shouldering specific risks in
return for a premium represented by backwardation. Just the opposite is the
case. The speculator is interested in taking small risks in the hope of a
large payoff. He will not be bribed with a pittance. The speculator is
willing to take a number of small losses because he expects the few bets he
will win to be big. Keynes’ analogy between the roles of the speculator
and the insurer is a colossal blunder.
It is interesting to note that the market for
monetary metals seemingly justifies Keynes’ theory. The shorts appear
to be the master who takes the initiative, while the longs appear to be the
servants who take orders. The shorts are the aggressors while the longs are
on the defensive, whereas the asymmetry of speculation would justify the
opposite cast. This reversion of roles will not ofcourse determine the final outcome that must be
the utter defeat of the shorts and the apotheosis of the longs. What
it suggests is that the road ahead is going to be arduous, full of
backtracking that will often raise doubts in the hearts of the longs. In
particular, it is not likely that silver will go straight up after one last
short squeeze forcing traders to cover all short positions for good, as
predicted by some analysts. More likely the market will follow the classical zig-zag pattern of lots of profit-taking and stop-losses
on the long side. Meanwhile the shorts will continue to stand guard at the
gates of the Underworld in their role of Cerberus, the triple-headed dog. The
blow-off is presumably still a long way away.
Contrary to the teachings of Keynes, the normal
condition of the futures markets is one of contango,
not backwardation. The proper way to view the futures markets is a place
where warehousing services are traded. Contango is
the premium from which the warehouseman derives the fee for his services. If
there is no contango, no warehousing is possible.
Accordingly, it takes not two but three to contango:
the producer, the speculator, and the warehouseman.
This is especially clear in case of the monetary
metals, of which a supply many times larger than annual demand for
consumption exists. We have expressed this by saying that the stocks-to-flows
ratio for a monetary metal is a large multiple (it is estimated to be greater
than 50 for gold), whereas the same number for a
non-monetary commodity is a small fraction (it is estimated to be less than
0.25 for copper). The large stocks-to-flows ratio reveals the willingness of
people to carry the monetary metal, in spite of carrying charges, and defying
government propaganda. The longs have a choice. Either they carry the
monetary metal in inventory, or they replace it with a futures contract. In
the latter case they sell the metal and invest the proceeds at interest
(taking care that maturities match). In the normal situation arbitrage
between the two ways of being long in the monetary metal will bring about contango. It tends to equalize the carrying charge with
the premium over the cash price. Therefore it is not “normal
backwardation” as preached by Keynes. If anything, it is “normal contango”. Here a very important question arises:
Can contango in a monetary metal turn into
backwardation, and if so, under what condition?
Abnormal Backwardation
It appears to be a theoretical impossibility for the
gold and silver market to be in backwardation for any extended period of
time. Such a situation would guarantee unlimited and riskless
profits for all those holding gold and silver. They could replace their cash
holdings with futures at a lower price. When their futures contract
matured, they could take delivery and repeat the procedure. The mere
possibility of unlimited and riskless profits
suggests that there is an error in the calculation. And indeed, there is. The
profits are not riskless. As the ancient
adage says: “A bird in hand is worth a dozen in the bush”. When
cash gold or silver is replaced with futures, a risk is created, namely, the
risk that it may not be possible to convert the futures contracts back into
cash gold or silver at maturity. There is the risk of default in the futures
markets. Of course, exchange officials, bullion bankers, and government
watchdog agencies vehemently deny the existence of such a risk. But the fact
remains that under the regime of irredeemable currency it is possible to
corner a monetary metal. It is true that cornering a monetary metal goes by
another name: that of hyperinflation. There have
been any number of hyperinflationary episodes ever since paper was
invented by the Chinese. What people don’t generally realize is that
every one of these episodes was a corner in gold or silver. It is foolish in
the extreme to suggest that in the 21st century we are immune to
the threat of a corner in gold and silver, since we have the wisdom of Keynes
and Friedman at our disposal. These men were writing for the benefit of their
employers, the British and the U.S. governments. They were not
committed to the truth any more than the government that had hired them was. Governments
are committed only to perpetuating and aggrandizing their own power, if need
be, by trampling on the Constitution. Inflicting irredeemable currency on the
people is part of this aggrandizement.
The Basis for the Basis
In order to understand how the monetary metals may
go to backwardation we need to refine our investigative tools. We need the
concept of a basis. First we raise the question of how the warehouseman
knows what and how much stuff to put into his warehouses. Well, his guiding
star is the basis, the term he uses for the difference between the futures
and cash prices of the commodity. If the basis for corn is higher than for
wheat, then the grain elevator operator will fill his elevator with corn in
preference to wheat, regardless of prices. He will cover his need for wheat
by purchasing wheat futures rather than cash wheat. It is more profitable for
him to carry wheat in the form of futures than cash, in view of the basis.
The basis is the measure of contango.
If it is greater than the carrying charge, then the warehouseman will
increase his stocks in warehouse and sell an equal amount of futures; if
less, then he may sell stocks from his warehouse and buy an equal amount of
futures. Note that, once again, a lack of symmetry obtains between these two
cases. If the basis is greater than the carrying charge, then the warehouseman
is treated to riskless profits. If less, then the
warehouseman has a dilemma. On the one hand the already quoted adage:
“a bird in hand is worth a dozen in the bush” applies. On the
other, he has a powerful incentive to sell the cash commodity and buy the
futures. Because of this asymmetry the basis hardly ever goes higher than the
carrying charge while it may well go lower. In fact, there is no theoretical
limit below which the basis may not go. It may even go negative creating
backwardation. The warehouseman will have to be very careful in choosing the
point where he sells cash commodity and buys the futures. He must remember
that shortages are always heralded by a falling basis. This is called the
basis-risk.
The important fact to keep in mind is that a low and
falling basis and, in particular, backwardation, are always a warning signal
indicating tightness in the cash market. The size of the shortfall of the
basis from full contango is an indication of the
magnitude of the shortage. In a nutshell, cash prices always appreciate
relative to futures prices in case of a shortage, showing that delivery
problems exist as the warehouseman is unable to replenish his dwindling supplies fast enough. The basis-risk of the
warehouseman who sells the cash commodity against buying the futures is
unlimited.
Up and Down the Elevator
All this may be illustrated through the cyclical
business of the grain elevator operator. In the harvest season he is buying
grain. Selling futures against grain in the elevator is called hedging,
with the short futures position being the hedge. The objective of
hedging is to neutralize the price-risk that goes with holding the grain in
storage. The elevator operator has only a limited amount of capital available
to cover various risks in his business. The amount of grain in the elevator
is so huge that even a small decline in the grain price could wipe out his
entire capital and bankrupt the grain elevator operator. Hedging highlights
the economic significance of the futures markets. They make it possible for
the operator to ignore price variations, and concentrate on what he does
best, the handling and distribution of grain until the new crop is brought
in. He can focus his attention on the basis, from the variation of which he
derives his income. As he puts the new crop in his elevators, the basis will
go higher. If it didn’t, then the elevator operator would buy the
futures instead of the cash grain. As the elevator is filled to capacity, the
basis approaches the carrying charge.
During the course of the year grain is gradually
consumed, supplies at the elevator are drawn down, and the basis falls. The
successful elevator operator anticipates these changes correctly. He will
sell grain just before the bounce-back in the basis after every major fall,
simultaneously lifting his hedges in the futures market. Moreover, he will
sell only so much, as he is trying to sell most of his grain at the end of
the season when the basis is the lowest, and there may even be backwardation.
It bears repeating that the grain elevator operator must keep it in mind that
in selling cash grain against buying futures he is incurring a basis-risk
that is unlimited.
Speculation versus Gambling
Speculation in grains is legitimate business as it
addresses risks given by nature. Both the price-risk and the basis-risk are
nature-given. They are influenced by the weather, the possibility of floods
and other natural disasters. We have no other means to alleviate market
dislocations such as shortages caused by crop failure (hurting the consumer)
and price busts caused by bumper crops (hurting the producer) than organized
speculation.
By contrast, organized speculation in the monetary
metals is an aberration due to irredeemable currency. In fact, to call it
speculation is a misnomer. Speculation in gold and silver is of the nature of
gambling. The risks it addresses are not nature-given but man-made, like
those addressed by foreign exchange and interest-rate speculation. We use the
term “man-made” in its broadest sense, to include manipulations
by the government and central bank. If we compare the government to the
casino owner, then the speculators are the gamblers. The government creates
the risks artificially in the gold and silver market for the speculators to
place their bets on. Few people today realize that under the gold standard
there was no organized speculation in foreign exchange and interest rates, as
the variation in these rates were too small rendering speculation
unprofitable. And, of course, there was no organized speculation in gold. This,
incidentally, is one of the merits of a gold standard. It channels talent and
manpower away from gambling and into productive enterprise. The main negative
effect of the destruction of the gold standard by the government was the
creation of a long list of artificial risks that had not existed before, e.g.,
the foreign-exchange risk and the interest-rate risk. The regime of
irredeemable currency is seen as a most wasteful one. It creates phantom
markets, phantom supply and demand, channeling
talent and manpower away from socially desirable production into socially
undesirable gambling. The derivative markets trading gold, silver, foreign
exchange, and interest-rate futures (options) are a monument to government
obtuseness and inefficiency. Rather than reducing, as it should, the number
of ever-present risks that man has to face in his struggle for survival, the
government in embracing irredeemable currency creates new and wholly
unnecessary risks, thereby undermining the efficiency of production,
distribution, and saving. Worse still, the government also exposes society to
unimaginable dangers such as the sudden impoverishment and permanent
pauperization of the majority of the people, as it happened in pre-Hitler Germany.
Hedging the monetary metals is also of the nature of
gambling. The risks addressed here are all man-made. While exchange officials
and government watchdog agencies strictly enforce the rule that the total
short position in grains must at no time exceed annual production, they look
the other way when gold mining companies sell several years’ of future
production forward. In no way does hedging by the gold and silver mining
industry serve the shareholders. On the contrary, it is a scheme whereby the
management dispossesses them.
Having made the point that speculation in monetary
metals is of the nature of gambling, we want to understand it as it vitally
influences our own well-being and financial security. We wish to study it
based on sound economic principles rather than the phony
ones pronounced by so-called economists in the hire of the government.
Recall that the normal condition of the markets in
the monetary metals is that of contango. Backwardation
is abnormal, yet it may occur. When it does, the regime of irredeemable
currency will start to crumble. People in trying to save their financial
future will take flight to the monetary metals. They will scramble to mop up
the dwindling supply that is allowed to trickle down. Then all of a sudden
all offers to sell the monetary metals are withdrawn. Supply goes to zero,
facing an infinite demand. That such a development is not fanciful but a true
description of economic reality as it unfolds is confirmed by history. Supply
of the monetary metals went to zero and demand to infinity many times before,
in France (the assignat and mandat
inflations), in the United States
(the continental inflation), in Germany (the Reichsmark
inflation), to mention but a few of the notable
cases.
Analysts of the gold and silver markets make a
mistake when they use monetarist models, try to balance a phantom demand with
a phantom supply, and cry for a free market. Instead, they should be watching
the gold and silver basis as they fall, and look for other signs of the
coming backwardation, first in the silver, then in the gold market. For
practical purposes the basis for gold and silver is the difference between
the two nearest futures prices, in more detail, it is the settlement price
for the nearby future month less the settlement price for the current cash
month. We shall see that the basis for gold and silver behaves perversely
when compared to the basis for agricultural commodities. This fact is quite
important as it explains the self-destroying mechanism for the regime of
irredeemable currency.
Understanding the Silver Market
By no stretch of the imagination can the silver
market be called free at any time since 1871. In that year two
powers demonetized silver: Germany
and the United States.
The governments of both were cashing in on the war-booty from their
respective victories. Prussia
had just defeated France,
and in the United States
the North had just defeated the South. These governments were dumping silver
in order to raise the gold needed to run a gold standard. The price of silver
fell from $1.29 an oz and continued falling for more than 60 years to a low
of 0.25 ¢, or less than one-fifth of the old official price (although
there was a brief spike back to $1.29 at the end of World War I) as all other
countries with the significant exception of China followed suit in abandoning
silver and turning to gold. In the meantime the U.S. Treasury was made by law
to purchase silver from the Western states at prices above market. The
silver-purchasing program of the United States remained in effect
for over 75 years, after which the Treasury initiated a silver-selling
program at prices below market. All in all, 6 billion oz of Treasury
silver was sold during the past fifty or so years and, by now, the U.S. is
allegedly out of silver. Well, maybe out of silver, but not out of the silver
business. Holding the line on the silver price, or at least yielding ground
to higher prices only gradually, is considered the first line of defense by the U.S. government protecting the
dollar. If silver were allowed to be cornered, then gold would follow and
that would be the end of the dollar, and the financial domination of the
world by the U.S.
government.
Ted Butler and other silver analysts have properly
noticed the structural deficit for the past twenty years or longer, the
draw-down of the visible supply deliverable against futures contracts, all in
the face of stable or declining silver prices. They have also noticed what
they took to be naked short position of traders that is increasing by leaps
and bounds. The analysts say that behind it all there is illegal price
manipulation. They contend that silver prices would be much higher by far if
it wasn’t for the traders’ selling of unlimited amounts of silver
futures naked illegally. The analysts claim that the naked short position of
a few big traders amounts to several years of mine production. At any rate,
it is a high multiple of the existing stores of deliverable cash silver in
existence. It is a disaster waiting to happen. And happen it will before the
last bar of deliverable silver is gone.
In trying to explain these anomalous developments
Ted Butler and other silver analysts charge that there is a conspiracy
involving the “silver insiders” (namely, the four to eight
largest traders), the exchange officials and, possibly, the government
watchdog agencies. The insiders have made obscene profits at the expense of
the outsider investors and the shareholders of the mines. They could do it as
they enjoy special privileges and may get off scot-free with violating both
the exchange rules and the laws of the land. Dark hints are dropped about the
possibility of kickbacks to officials whose duty it is to enforce the rules
and the law. It has also been suggested that silver mine executives have been
bribed not to complain about low silver prices but to keep producing at a
loss.
Without trying to refute these accusations I should
point out that, before charges are made, one ought to make sure that all
other possible explanations have been exhausted for the aberration that the
price of silver declined significantly in the face of structural deficits and
the draw-down of visible supplies. Even if there is no other explanation, the
existence of a conspiracy does not logically follow. Without trying to refute
the conspiracy theory I should point out that the market behavior
of the shorts may find a spontaneous explanation. Speculators may be prompted
to congregate on the same side of the market by the idiosyncrasies of the
regime of irredeemable currency. It is not an outrageous assumption that all
speculators read the mind of government and central bank manipulators in the
same way. While uniform behavior would not be
possible in the case of speculation in agricultural commodities where the
risks are nature-given, it is quite possible in the case of speculation in
monetary metals precisely because here the risks are man-made.
Whatever Happened to the Chinese Silver?
The most populous country, China has one
of the oldest civilizations on earth. It had been on a silver standard since
time immemorial before the Communists overran the mainland. Nobody knows how
much silver was involved in running China’s monetary system,
but the amount must be mind-boggling. In addition, China was forced to absorb
enormous amounts of silver (both through legal channels and through
smuggling) after silver was demonetized by the rest of the world and the
price of silver collapsed. We do know that this addition to the Chinese money
supply created an inflation horrible enough to cause
the fall of the Kuo-min-tang regime and the
ascension of the Communists to power in 1949. We do not know what proportion
of the monetary silver the Communist government left in the hands of the
people while confiscating the silver in the banks with characteristic ruthlessness.
Finally, we do not know whether or not China was buying silver
clandestinely during the twenty-year period between 1980 and 2000 when the
price was falling.
Be that as it may, the silver left over from the
silver-standard days, plus the silver subsequently flowing into China, is
largely unaccounted for. The question is: where is this Chinese silver? It
appears that China
does hold the silver wild card, and hasn’t played it yet. We cannot
lithely assume that China
will play it stupidly. The possibility exists that China will play it intelligently.
For all we know, China
may already be active, if only clandestinely, in the silver market and has
been deriving handsome profits from it. The alleged naked short positions in
silver may in fact be genuine hedges for Chinese-owned silver. In other
words, China
may have decided upon a strategy to derive a steady income from her silver
treasure, at least for as long as prices remain low, in preference to the
alternative strategy of driving up the price of silver and then cashing in. I
haven’t examined the evidence and I am not suggesting that this is the
case. All I am saying is that there is another possibility that could explain
the anomalous market behavior for silver. One
reason why I find the theory of inordinate and growing naked speculative
short positions unattractive is because it assumes that the insiders are
either stupid or suicidal or both. It is dangerous to underestimate
one’s opponents.
Serial Crimes of 1871, 1933, and 1971
The right of the people to free and unlimited
coinage of silver at the Mint is carved into the corner-stone of the U.S.
Constitution. This right was abolished with a sleight of hand in 1871. “The
Crime of 1871“, as William Jennings Brian called the unconstitutional
demonetization of silver, may get its just punishment after a 130-year hiatus
before our eyes.
It wasn’t an isolated crime. It was a serial
crime through which politicians deprived the American people of all their
Constitutional rights and prerogatives pertaining to money,
that started even before 1871. The crime was repeated on a bigger
scale in 1933 when a Democratic president tricked the American people out of
their gold. The crime was crowned in 1971 when a Republican president tricked
the rest of the world out of its gold, while inflicting a regime of
irredeemable currency on the American people and everybody else. Although
through the betrayal of the economists the people were left in darkness about
what has happened to their money, these crimes cry to high heaven for
justice.
While I am somewhat doubtful about the theory of
conspiring private parties, I find the theory of a secret government plot to
suppress the price of silver plausible, even persuasive. This plot may also
include collusion between the governments of the United
States and China to fend off a price
explosion. According to this scenario China would supply cash silver to
deliver against futures contracts, in return for the right to collect the
income flowing from her short positions in silver.
Even the obvious delivery problems cannot serve as
conclusive proof that the insiders (also called “silver
managers”) have rigged the silver market in an effort to cap the price.
After all, the silver to be delivered may have to be brought in from China. That
takes time. Silver analysts would do well to compile intelligence as to what
percentage of the delayed deliveries to the Central Fund of Canada and other
longs has originated in China.
If it was a large percentage, then we would have evidence that the silver
managers were neither stupid nor suicidal. They merely acted as the agents of
the government China.
Understanding the Gold Market
Before the United States defaulted on its
obligations in 1968 and subsequently demonetized gold in 1971 all economists,
including the arch-conservative Ludwig von Mises,
predicted that demonetization would send the price of gold way down. They
pointed to the episode of silver demonetization one hundred years earlier,
followed by the collapse of the price of silver. They also adduced a
pseudo-theoretical argument that the disappearance of the lion’s share
of demand, namely the monetary demand, cannot help but make inroads into the
gold price.
Of course the economists fell on their face when
gold was demonetized yet its price, instead of falling, rose more than
twenty-fold in less than ten years. Nobody dared to confront the economists
with their embarrassing failure. Why did they fail so miserably? I shall now
give the answer to this so far unanswered question. The economists fell
victim to one of the most elementary fallacies known as post hoc ergo
propter hoc (after this, therefore because of this). When silver was
demonetized in 1871, no government default was involved. Owners could
continue to redeem their silver certificates without let or hindrance. Since
its price showed a falling trend, a lot of people rushed in to sell silver. Even
the silver mines redoubled their efforts to produce all the silver left in
the shafts, before they had to be closed down and abandoned for good. Genuine
silver mines have all but disappeared. Whatever silver production survived
was byproduct from the gold and copper mines. It
was not demonetization that caused the price of silver to fall but dumping,
official and unofficial, that followed it.
By contrast, the demonetization of gold a hundred
years later was a default on the gold obligations of the U.S.
government. Nobody has ever seen a dishonored
promise to go to a premium. Yet this is exactly what the economists were
predicting that would happen to the dollar. The gold obligations of the U.S. were
internationally recognized. By the Bretton Woods
Treaty of 1944 that was responsible for hatching the IMF, foreign governments
could treat their dollar balances as gold-equivalent at the rate of $35 to
one oz of gold. These gold obligations were solemnly reconfirmed by three
sitting presidents. Browbeaten by Washington,
foreign governments wouldn’t dare to protest the breach of faith and
the unilateral abrogation of international obligations. They meekly swallowed
the loss that arose. They pretended that nothing much happened and the dollar
was still as good as gold. They ignored the market and continued to count
their dollar balances at “the official price at which the U.S. Treasury
refused to sell gold”. They called it the “two-tier monetary
system”. Of course, that hare-brained scheme could not endure. The
market trumped the governments, as it always does when they do something
foolish. It is interesting to note that the financial annals are silent on
the biggest default in history. Well, you can get away with it if you are the
paymaster of the annalists.
As there was no point in pretending any more that
the dollar was as good as gold, the U.S. government put measures in effect
designed to drive down the price of gold or, at least, to prevent it from
rising further. IMF gold auctions were followed by U.S. Treasury auctions. Both
backfired badly. The market obliged in bringing down the price of gold
temporarily to allow the IMF and the US Treasury to unload the bothersome
surpluses. But no sooner had the auction been completed than the price of
gold returned to its pre-auction level to resume its upward march.
It is hard to find another example of such an inane
market action in the long catalog of government
blunders. If a bank needs to sell an asset, then it does so discretely in
order that it may fetch the best possible price. Fanfare and the Dutch
auction method were used for their propaganda value in demonstrating how the
price falls when gold is put on the block. It is clear that these gold
auctions were not an exercise in high finance but one in low propaganda. More
recently the Bank of England auctioned off more than half of her gold
reserves at record low prices, to replace it with U.S.
government securities at record high prices. In doing so the Bag Lady
of Threadneedle Street was replacing her best asset
gold, that is nobody’s liability, with the
worst, obligations of a default-happy government. This made the portfolio of
the bank weaker, not stronger. Once again, the completion of the auction gave
the green signal to gold that it may resume its upward move.
It should be abundantly clear that in sacrificing
their remaining ordnance governments are fighting a desperate rear-guard
action in an effort to fool the public. In this situation it is puerile to
call for a free market in gold and to go to court accusing the government of
price manipulation. Once more without trying to refute the conspiracy theory
I wish to point out that, given the idiosyncrasies of the regime of
irredeemable currency, the uniform action of the shorts may find a
spontaneous explanation. The gold mining executives, the bullion bankers, and
other speculators may read the mind of the government and central bank manipulators
in the same way.
Self-Destruction
of Irredeemable Currency
The explanation of hyperinflation in terms of the
quantity theory of money is untenable. You cannot explain non-linear
phenomena in terms of a linear model. The proper explanation must be sought
in terms of a non-linear model. Such a model can be developed using the
concepts of basis and backwardation. If applied to the monetary metals, we
shall see the cataclysmic conflict that will bring about the end of the
regime of irredeemable currency. No one can predict the future, but science
makes it possible for us to find the most likely course of events. It is in
this spirit that I offer the following observations.
As the regime of irredeemable currency threatens to
crumble under the weight of the inordinate debt tower of Babel,
people increasingly take flight to gold. Supplies will get tight and the gold
basis will fall. The gold futures market may even go to backwardation briefly
at the triple-witching hour, i.e., the hour when gold futures, as well
as call and put options on them expire together. Later, flirtation with
backwardation may occur even more often, at the end of every month when gold
futures expire. Gold will get caught up in a storm.
Backwardation in gold has a perverse effect. In the
case of agricultural commodities backwardation provides a most powerful
incentive for traders to sell the cash commodity and buy the futures. Not so
in the case of gold. Rather than bringing out deliverable supplies of gold,
backwardation tends to remove them. The more the gold basis falls the less
likely it becomes that owners will exchange their cash gold for futures. Please
remember that you have seen it here first. This perversion of the gold
basis constitutes the self-destroying mechanism of the regime of irredeemable
currency. The longs tend to take delivery on their gold futures contracts
in ever greater numbers, and refuse to recycle cash gold into futures,
regardless how low the gold basis may go. As it is not set up to satisfy
demand for delivery on 100 percent of the open interest, the gold futures
market will default. Exchange officials will declare a “liquidation
only” policy to offset long positions in gold. At that point all offers
to sell cash gold will be withdrawn. Gold is not for sale at any price. The
shorts are absolved of their failure to deliver on their gold futures
contracts.
Previous descriptions of hyperinflation purporting
to explain the descent of a currency into the abyss of worthlessness do so in
terms of the quantity theory of money. My explanation of the hyperinflation
that is staring us in the face is very different. I dismiss the quantity
theory of money as a linear model that is not applicable. Every previous
episode of hyperinflation took place in the context of a war replete with
shortages caused by the destruction of stockpiles and productive facilities. In
this situation it is not possible to sort out the effects of an increasing
demand (due to a flood of printing-press money) and a decreasing supply (due
to the destruction of stockpiles and production facilities). We want to show
that prices may also explode in the presence of unsold stockpiles and ongoing
production.
Moreover, previous episodes of hyperinflation
affected isolated countries which had embraced the regime of irredeemable
currency out of desperation, while the rest of the world stayed the course of
monetary rectitude. In the present situation the entire world has been
inflicted with irredeemable currency. There are no gold standard
countries around that could lend a helping hand to countries that want to
stabilize their currency. My description of hyperinflation is not in terms of
the quantity theory of money, but in terms of a model where the relentlessly
declining gold basis leads to backwardation destroying the gold futures
market. When all offers to sell cash gold are withdrawn, producers of
essential commodities such as grains and crude oil refuse payments in
dollars, and demand gold in exchange for their product. The dollar and other
irredeemable currencies will go the way of the assignat.
Backwardation in gold should therefore be considered
the self-destroying mechanism for the regime of irredeemable currency that
“only one man in a million may identify and understand” (my
thanks to Keynes for the felicitous phrase). This is where supply/demand
analysis is utterly useless. The huge stocks of monetary gold are still in
existence, yet zero supply confronts infinite demand.
The only way to fend off this outcome is for the
government of the U.S.
to come up with a credible plan to stabilize the dollar in terms of gold. Presently
there is no hint that contingency plans for the rehabilitation of the gold
standard exist. It doesn’t matter. Any country, e.g., China, India,
Iran,
could do it through the back door by opening the Mint to the free and
unlimited coinage of gold and silver. The alternative may be mass starvation
in the midst of plenty as world trade comes to a halt for want of a
universally acceptable medium of exchange.
Here is a question for the U.S. President and
Treasury Secretary to contemplate: How many innocent lives are they willing
to sacrifice on the altar of doctrinaire purity in defense
of their untenable gold policies?
Note. I have taken a pause in my lecture series on Gold Standard
University in order to
bring you this essay on the failure of gold and silver analysts to include
the basis as an instrument of analysis. My lecture series Gold and
Interest will be resumed in June. The Gold Standard University is brought
to you courtesy of your website: www.goldisfreedom.com.
(* Ed: Samizdat' is Russian for
"self-printing/publishing")
Antal E. Fekete
Professor Emeritus
Memorial University
of Newfoundland
St.John's, CANADA A1C 5S7
e-mail address: aefekete@hotmail.com
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