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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.
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 the lost interest.
This is a distinctive property of gold. The hoarding of all other goods is
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 falls 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 rises 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 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 contemporary conditions the meaning of the term
‘time preference’ is not the preference for an apple available
today as against two apples available ten years from now. It is, rather, the
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.
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 Keynes 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 which, under a gold standard, shows up in 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.
The increase in the quantity of monetary gold shows up as 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, under which the gold price
is variable. 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 an increase in gold
hoarding and a fall in the rate of interest are linked (subject to leads and
lags), and conversely. Every ounce of hoarded gold is a concrete testimony to
the fact that the quality of savings instruments, and the
yield on them, are inadequate. By making the regime of irredeemable
dollar ‘untouchable’, the U.S. government deprives itself of the
possibility to channel people’s savings into ‘socially more
useful’ applications. To this extent it is the government, rather than
the people, who is responsible 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 gold available for
them to sell through 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. Moreover, there is an extreme concentration of
derivatives in the hands of three or four firms, namely, concentration of
long bond and short gold positions.
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 and, for this reason, 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 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 and
fast-increasing short interest in gold is more vulnerable and will act as a
trigger. 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.
Insatiable Appetite
The purpose of this paper is to establish another
‘early warning sign’: Barrick’s
share price, showing a profound shareholder
disillusionment. It significant that Barrick has
insatiable appetite for further acquisitions. 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. 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
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 to be
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 be averted.
Barrick loves to pay for its acquisitions with its own
shares. From the point of view of the 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 see in it another attempt by the management to fleece them. On
the other hand, shareholders of the company targeted for 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 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. 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.
ut if it could not, and Atlas
shrugged, then the short gold bubble would burst triggering the bursting of
the $300 trillion derivatives bubble. We could then expect to see 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 saver. He is the first to add to his bond
holdings on the next upwards move 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 rises 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 falls 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.
References
RobeRobert B. Barsky and Lawrence H.
Summers, Gibson’s Paradox and the Gold Standard, The Journal of
Political Economy, vol.96, no. 3(June 1988) p 528-50.
Antal E. Fekete, The Gold
Standard University, Monetary Economics 102:
Gold
and Interest, , January 1, 2003
Antal E. Fekete, The Last Contango in Washington,
June 3, 2006
Milton Friedman and Anna J.
Schwartz, From Gibson to Fisher, Explorations Econ. Res. 3 (Spring,
1976) p 288-91.
DISCLAIMER AND CONFLICTS
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