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In an
earlier article Backward Thinking on Backwardation I explained that
backwardation in gold is the flipside of the phenomenon of a drastic
contraction of world trade and employment. This brings out the danger in
denying the fact of gold backwardation or to belittle its significance, as
most observers seem to be doing. I am reminded of the saying of the Swiss
educator F.W. Foerster: "if you don't use your eyes for seeing, later
you will use them for weeping." In this article I want to enumerate the
reasons why I believe that permanent backwardation in gold would bring about
the descent of our civilization into lawlessness similar to that following
the collapse of the Western Roman Empire.
The
consensus seems to be that, even if backwardation in gold occurred at one
point, it would not be a significant event given the zero-interest
environment. Forward thinking on backwardation shows that this is wrong.
Tom Szabo
observes (see References below): "If somehow short-term interest rates
were to go into significant backwardation, it should be no surprise that gold
and silver may go into significant backwardation. THIS WOULD NOT BE A SIGN OF
IMMINENT MONETARY COLLAPSE [his emphasis]. In fact, a pretty strong argument
could be made for the opposite - that the negative interest rate is a sign of
excessive monetary demand (in relation to demand for capital goods and
investments). I've looked but have been unsuccessful in finding an historical
example of a monetary collapse that occurred while money was actually in high
demand. Of course, high demand for money could be extremely deflationary and
the only known cure for this is to create a high supply of money, otherwise
known as hyperinflation."
While I
would disagree with the use of the word "imminent" in describing
the coming monetary collapse, I must maintain my stand that a durable
backwardation, such as we have experienced for two weeks earlier this month,
is a premonition that there will be repeated episodes of the same kind, ever
more frequent, ever deeper, ever longer, each episode significantly weakening
the monetary system - regardless of the zero or negative short term interest
rate. (Let us leave the question aside that zero or negative interest rates
in and of themselves show an alarming pathology of the monetary system!)
I have
argued that we must carefully distinguish between a fiat money regime with an
undisturbed flow of gold to the futures market; and a fiat money regime where
the flow of gold to the futures market has been blocked by an unprecedented
surge in the demand for cash gold. In the first case confidence in fiat money
is high; in the second, it is low and waning fast. In the first case paper
gold is an effective substitute for physical gold in most applications; in
the second, paper gold has been unmasked as a fraud, and discredited beyond
repair. In the first case the economy works pretty well the same way as under
a gold standard; in the second, all hell is turned loose as the exchange of
goods and services is on the decline and autarky on the rise.
Tom says
that "it is incorrect to claim that gold and silver could be in true
backwardation without at least some inversion of the futures price curve
where the nearer contracts are trading at a higher price than the further out
contracts. Well, exactly that's what has happened at Tocom during the first
two weeks of this month and is happening still. Tocom publishes its trading
summary at the close of trading every day on the Internet: www.tocom.or.jp/souba/gold/index.html. I don't
understand how Tom could miss it. Backwardation is jumping off the Internet
page covering the standard kilobar contract, even as I write this, on
December 19.
Tom is
complaining that the spot price for gold is difficult to ascertain: "the
spot price for gold is elusive... because they are third-party quotes that
suffer from a variety of problems that can make them unreliable and
imprecise." I disagree. I have asked my student, Mr. Sandeep Jaitly of
Soditic, Ltd., London, U.K., who is tracking the gold basis for me, to
explain. Here is what he had to say on December 15: "Tom Szabo comments
that spot prices are difficult to obtain. Not true! They are not. You just
have to be plugged into the right feeds. My spot price quotes include all the
five price fixers at the LBMA, plus everybody else worthy of quoting... The
spot gold price I use is the best or highest bid (and the best
or lowest offer) from 300 banks world-wide [list attached, not reproduced
here]. The data I use is directly from the exchange, and the prints I see for
the carry available are super precise. I can get 90¢ per oz profit on
the December contract versus my spot quotes that come from every bank on
earth..." Sandeep goes on, dateline December 18: "Everybody of note
is inferring that gold is in backwardation because of the zero interest. Let
us explore that a little further. One can achieve 0.25% annualized by
carrying gold for 190 days till June 26, 2009. 190 days in maturity is about
equivalent to a 6-month T-bill with a current yield of 0.18%. The cost of
carry for 190 days is 0.25 - 0.18 = 0.07%. If we compare this with the cost
of carry for 11 days till December 27, 2008, and, again, for 69 days till
February 27, 2009, [calculation included, not reproduced here], then we get
that the cost of carrying gold is as follows (all percentages are annualized)
for 11
days:
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1.005%
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for 69
days:
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0.9%
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for 190
days:
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0.07%
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That is
pathological without any need of further explanation! It costs more to carry
gold for shorter periods of time than for a longer period - according to the
futures market. That puts a hole in the zero interest-rate
argument, and explodes the explanation that the extra-low contango or
outright backwardation in gold is nothing more than "normal
backwardation" of a non-monetary commodity!"
Tom says
that he does not see things evolving in the same catastrophic manner as I do.
For example, he believes that "there will always be willing buyers and
sellers of gold in some quantity if the price is right." Buyers - si,
sellers - no! That's just the whole point. The lack of credibility of
irredeemable currency will be such that no one in his right mind will accept
it in exchange for gold, the ultimate liquidator of debt. Previously, people
were willing to trade their gold because they could always replenish their
supply from Comex warehouses. That means, in other words, that the
irredeemable dollar could still be used as a liquidator of debt (i.e., gold
still has a competitor). But let them close the Comex gold warehouses. This
is a quantum jump; it means that the irredeemable dollar can no longer be
used to liquidate debt, e.g., debt incurred by those holding short positions
in gold futures. It is essential not to belittle the import of this
observation.
Tom
thinks that I am an alarmist in believing that the permanent closing of the
gold window at the Comex will mean a cessation in gold mining, loss of
segregated metal deposits, and institutionalized theft of ETF holdings.
To answer
this I have to go back to the collapse of the Western Roman Empire after the
abdication of the emperor Romulus Augustus on September 4, 476 A.D. It was
followed by the Dark Ages when the rule of law, personal security, trade of
goods against payment in gold and silver could no longer be taken for
granted. Gold and silver went into hiding, never to re-emerge during the
lifetime of the original holders. It is plausible to see a causal relationship
between the fading of the rule of law and the complete disappearance of gold
and silver from trade. Virtually all observers say that the first event
caused the second.
I may be
in a minority of one to say that causation goes in the opposite direction. The
disappearance of gold and silver coins as a means of exchange was a
long-drawn-out, cumulative event. In the end, no one was willing to exchange
gold and silver coins for the debased coinage of the empire. At that point
the empire was bankrupt; it could no longer pay the troops that defended its
boundaries against the barbarians threatening with invasion. This is not to
say that the empire did not have other weaknesses. It did, plenty of it. But
the overriding weakness was the monetary weakness. Centuries after centuries
the Mint of the empire could attract less and less gold and silver. Because
of this, the empire was forced to debase its coinage and the deterioration
continued until the bitter end, when the gold flow to the Mint completely
dried up.
Compare
this with the Eastern Roman Empire that lasted until the fall of Constantinople to the Ottoman Turks in 1453 A.D., or almost one thousand years longer than
the Western half, and during most of this time it could keep its Mint open to
gold, producing the gold bezant, which also became the coin of the Muslim
world. Is this difference between the two empires trying to tell us something
about the importance, from the point of view of political and economic
survival, of keeping the Mint open to gold?
The
history of the monetary system of the United States shows an ominous parallel
to that of the Western Roman Empire. As long as gold and silver was still
used in trade at least to some extent, the Western Roman Empire was limping
along. The modern equivalent of the disappearance of gold and silver is
epitomized by the progressive vanishing of the gold basis.
There is
simply no continuous transition from the paper dollar cum contango to
the paper dollar cum gold backwardation, Tom's prayer notwithstanding.
The transition will necessarily involve a sudden and fatal weakening of the
legal system. Remember, the legal system works only as long as most citizens
are law-abiding. It breaks down as soon as the majority of the citizens find
that the law protects thieves in high places, but offers next to no
protection for the honest hard-working middle class. I am not going to
elaborate here on the proposition that irredeemable currency is a system that
protects thieves in high places, but robs the little guy by plundering his
savings.
Tom notes
that it may be technically possible to delay the collapse of the fiat money
system by "allowing" gold to appreciate in a hyperinflationary
scenario. That is precisely the phase that will end with the entrenchment of
backwardation in gold. Thereafter one can no longer talk about an
"appreciating gold price", or any gold price for that matter, as
the pricing mechanism will have self-destructed, at least as far as the price
of gold is concerned. As Tom himself observes in the same article, local
prices in India, China, and in the jungles of Papua are not relevant. Only
gold prices in New York and London are, and the arbitrage between the two.
I have
nowhere said that the end of the fiat money system will follow the closing of
the gold window at the Comex in a matter of days. Sure, finance ministers and
central bankers will try to "muddle through". It is not possible to
predict how long the death throes of fiat money will continue. Tom may be
right in suggesting that it will take many years, and claims of an imminent
monetary and economic collapse will again turn out to be wrong.
But where
Tom is certainly mistaken is his suggestion that all this agony will take
place while the Last Contango in Washington is still going on. You can't have
contango and backwardation at the same time. Backwardation is like a black
hole, once it grabs a currency, it will swallow it, and gold quoted in that
currency will never return to contango.
I think
Tom's greatest mistake is to interpret the move into backwardation, or gold
to enter the 'fever phase', as "gold's regaining fully-recognized
monetary status". Unfortunately, just the opposite is the case. Whether
officially recognized or not, gold's monetary status was never in doubt. Gold
has always been the monetary commodity par excellence, due to the fact
that it has constant marginal utility (or, if you will, the fact that the
marginal utility of no other commodity declines at a rate slower than that of
gold).
What we
are witnessing is a transition that deprives gold of its monetary qualities. Gold
in hiding cannot and will not act as money. More to the point, absent gold, nothing
else can or will. The disappearance of money, that can be trusted,
fatally undermines the legal system, the sanctity of contracts, habeas
corpus, any and all provisions of law and order that we take for granted.
Under these conditions nobody can operate a gold mine, nobody can run a gold
refinery, nobody can guarantee segregated gold deposits, and nobody can
prevent the institutionalized theft of ETF holdings. Welcome to the Madoff
economy! (See References below: Paul Krugman's column in The New York
Times). Jail one Madoff, two others will jump into his shoes.
As a
consequence of the permanent backwardation in gold, we shall have a world
gone Madoff.
References:
Tainted Research: Lysenkoism -- American
Style, June 4, 2003
Monetary versus Non-monetary Commodities, April 25, 2006
The Last Contango in Washington, June 30, 2006
Red Alert: Gold Backwardation!!! December 4, 2008
Has the Curtain Fallen on the Last Contango in Washington? December 8, 2008
There Is No Fever Like Gold Fever, December 10, 2008
Backwardation That Shook the World, December 14, 2008
Backward Thinking on Backwardation, December 18, 2008
These and other articles of the author
can be accessed at the website: www.professorfekete.com.
Backwardation Update - Still No in Gold,
but Maybe in Silver! by Tom Szabo, www.silveraxis.com, December 12, 2008
The Madoff Economy by Paul Krugman, www.nytimes.com, December 19, 2008
Acknowledgement:
The author wishes to express his thanks
to Mr. Sandeep Jaitly of Soditic Ltd., London, England, (e-mail: Sandeep.Jaitly@soditic.co.uk) for tracking the gold basis for him.
Calendar of events:
Szombathely, Martineum Academy, Hungary, March 28-29, 2009
Encore Session of Gold Standard University Live.
Topics: Is There Life after Backwardation?
Will the Gold Standard Be Released from Quarantine?
The Vaporization of the Derivatives Tower
Labor and the Unfolding Great Depression
San Francisco School of Economics,
June-August, 2009
Money and Banking, a ten-week course based on the work of Professor
Fekete. TheSyllabus of this course is can be seen on the website: www.professorfekete.com.
Antal E. Fekete
Professor,
Intermountain Institute of Science and Applied Mathematics, Missoula, MT
59806, U.S.A.
Gold Standard University
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IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
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