Managing
currencies is simple. People today don't know how to do it, so it seems hard.
But, actually, it is simple.
You
can set up all sorts of currency systems. Hong Kong has a dollar peg. Singapore
has a peg to a currency basket. However, the best system is to have a
currency pegged to gold. Gold is the most stable thing out there, in terms of
monetary value, so if you peg to gold you'll have the most stable currency
possible. Not only is gold more stable than any alternative, but it is so
stable that you can treat it as being completely stable, in an absolute
sense.
Many,
many governments have tried to peg their currencies to one thing or another
-- usually a major international currency -- and most of the time, it has
blown up in their face. This makes them rather hesitant to do so again. But,
their failure is really a failure of technique. They didn't know what they
were doing. So, of course it blew up. What did you expect?
Unfortunately,
most gold standard advocates today also don't know how to peg a currency
properly. They talk a lot about gold "backing," which is totally
meaningless. You can tell they don't know what they are talking about,
because if they knew what they were talking about, they wouldn't be talking
about gold "backing." If these people wanted to set up a gold
standard system -- with the best of intentions -- it would eventually blow up
in their face. Probably pretty quickly.
I've
said many times that the secret is supply
and demand. Or, really it is just supply, because you can't
control demand. You manage the supply to maintain the peg at your specified
level. "Supply" is known as "base money." It is not MZM,
M1, M2, M3 or any of these other measures which
are measures of credit, not money.
Sometimes
people halfway understand what I am talking about here, but they basically
don't think it would work. The history of failed "pegs" weighs
heavily in their mind. I mention in my book that the exchange rate between
dollar bills and ten-dollar bills -- namely, 10:1 -- is maintained exactly by
this method, and it always works. How is it that one worthless piece of paper
-- a "$1 bill" -- is always worth 1/10th that of another worthless
piece of paper, known as a "$10 bill"? It's not due to government
coercion. There's no black market in $1 bills and $10 bills. Nobody goes to
jail for exchanging seven $1 bills for a $10 bill. The Fed doesn't intervene
in the domestic exchange market. The 10:1 ratio is not just a government
edict, it is these paper chits' real market value. However, sometimes people
need a little more help than that.
What
is a currency? It is a worthless piece of paper. Why does it have value at
all? It is a combination of two things. First, there is at least some demand. People want to
use it as a facilitator of transactions. Probably the government demands that
taxes be paid in that currency, and probably bans the use of other currencies
domestically. What if I decided today to make my own currency, and printed up
$200 worth? The supply is very small. Only $200. And limited, since I control
it. However, nobody would take my funny paper in trade for goods and
services. In other words, it would have no value, because there is no demand.
Second,
supply is limited.
For example, what if everyone was allowed to print $20 bills on their color
laser printer, and this was totally legal? But, at the same time, the
government would not take the homemade $20 bills in trade for anything. Of
course the value of $20 bills would collapse to their production cost.
Oddly
enough, the value of $1 bills and $10 bills may not collapse, if their supply
was controlled. The exchange rate between $20 bills and $10 bills would
float. For example, my 90% silver dimes from the 1950s are worth more than a
$1 bill today. This is because their supply is limited by the fact that they
are made of silver. However, it is not necessarily
the fact that they are made from silver that makes them valuable, but rather
the limited supply. My MS65 $20 Saint Gaudens are worth about three times the
value of their contained gold bullion. In this case, the supply is limited by
the fact that they are not being produced anymore, and are in good condition.
Probably
anyone would agree with this in principle. But, observe what we didn't say: we didn't say that a
currency's value results from an interest rate policy, or because some
government buffoon talks about a "strong dollar policy" in public.
We also didn't say
that there needed to be a vault full of gold, or foreign currency
"reserves" or "backing" or whatever. These things are
secondary, and ultimately unnecessary. The important thing is supply and demand.
So, as
an example, let's take the GLD gold ETF. What is it?
The
ETF is a "piece of paper." Actually, it is not even a piece of
paper, but electronic ephemera. Literally, it is a liability on the part of
your stock brokerage, set against an asset (presumably a "deposit")
at the Depository Trust and Clearing Corporation. The DTCC doesn't own the
ETF either, but rather has an asset with Cede & Co., which owns
(supposedly) most of the equity in the United States. I don't think you could
get an actual piece of paper -- a real stock certificate, which is a legal
document indicating direct ownership -- even if you asked nicely. You might
be able to get direct registration, so you would directly own the ETF rather
than going through a chain of counterparties, but you would have to make a
special request.
Who owns your stocks?
So,
you own a commitment based on a committment, based on a committment, based on
ownership of the ETF. What is this ETF? It is a legal contract, signifying --
well, what exactly? I suppose it's in the prospectus. Presumably, it
indicates a fractional ownership of the assets of the trust. However, the GLD
prospectus is very, very complicated. There is all sorts of language
indicating that, if push came to shove, nobody is obligated to do anything
for anyone ever. A paper currency signifies nothing whatsoever. It is not a
legal contract for anything. GLD is more-or-less the same thing, which is to
say nothing at all, though this is clouded in billows of legalese.
Robert
Landis: What the heck is GLD?
We do
know one thing: the ETF is "pegged to gold." Its market value is
linked to gold bullion, in an apparently reliable fashion. How does the ETF
accomplish this? Via the adjustment
of supply.
Sometimes
there are lots of buyers of the ETF. The market value of the ETF may threaten
to rise above the market value of gold bullion. In this case, the manager of
the ETF sells additional
shares of GLD, on a real-time basis to meet the increased demand,
and maintain the value of the GLD in parity with gold. The total number of
GLD shares in existence increases. In central bank terminology, this is an unsterilized intervention.
This is how the vast majority of GLD shares have come into existence.
Does
the trust then buy gold bullion with the money from these new shares? Maybe.
Maybe not. Who knows. The point is, GLD remains pegged to gold whether or not there
is actually any gold (or tungsten!) in some vaults somewhere.
Note
something else here: the shares outstanding of GLD has increased by a huge
amount. However, the value of GLD is unchanged. It is pegged to gold. (Since
we assume that gold is stable in value, that means that GLD is stable in
value too.) There are all sorts of people who say that "printing
money" -- in any quantity at any time -- is "inflationary."
However, we see that the enormous increase in the GLD shares outstanding over
the past three years or so was not accompanied by a decline in the value of
GLD. This is because the increase in GLD was
in response to rising demand. If the trust didn't sell
freshly-printed shares of GLD in the open market, the market value of GLD
would have risen! So, it is perfectly possible to have increasing "base
money" without a decline in currency value, if that increase in supply
matches an increase in demand.
Sometimes
there are lots of sellers of the ETF. The market value of the ETF may
threaten to fall below the market value of gold bullion. In this case, the
manager of the ETF buys
shares of GLD, to support the market value of the ETF. The total
number of GLD shares in existence decreases. This is also an unsterilized intervention,
in central banker-speak.
Let's
say that, for whatever reason, nobody wanted to own GLD anymore. Why? I don't
know. It doesn't matter why. Maybe they all wanted to switch to PHY, Sprott's
new gold ETF which promises (unlike GLD) to hold gold bullion in physical
storage on a 1:1 basis with shares outstanding. Heck, I would.
Info on Sprott's new physical gold ETF
GLD
now has a market cap of $43 billion. Let's say that, within a month, 90% of
the holders want to sell, and there are no new buyers.
Assuming
that GLD maintains its link with gold bullion, then the GLD managers would
have to buy 90% of the shares outstanding of the ETF. These shares would
disappear from circulation. At the end of the month, the number of GLD shares
outstanding would have fallen by 90%. However, the value of GLD would remain
the same -- pegged to gold.
Think
about that. We have a 90% reduction in "demand" in the very short
time period of a month. But, the "currency" -- GLD -- remains
pegged to gold. Unless you were paying close attention to the shares
outstanding, you might not even notice that anything happened at all.
Some
other important points here. The shares outstanding of GLD fell by 90%. That
is a big reduction. However, the value of GLD did not rise. Thus, a decline in
"base money" by itself does not create monetary deflation. It was
in response to a change in demand. In fact, if the shares outstanding was not reduced by 90%,
the value of GLD would have fallen below its gold parity.
Now
let's take a different example. Let's say that 90% of GLD holders want to
sell, but the GLD manager does
not buy shares on the open market. Supply does not decrease. The
number of shares outstanding ("base money") remains unchanged.
Obviously,
with demand down, and supply unchanged, the value of GLD would fall. It would
fall below its parity with gold bullion.
The
second thing that would happen is that GLD holders would observe that the
value of GLD is falling below its gold parity, and that the GLD managers are
not doing what they said they would do. As a result, there would be even more
selling, and even less buying, as it has become apparent that the GLD
managers are either incompetents or criminals. The demand for GLD would
absolutely plummet. In other words, GLD would have a "currency
crisis."
This
is how most currency crises come about. For whatever reason -- any reason
will do -- there is a decline in demand for a currency. The currency managers
fail to address this decline in demand by reducing supply (base money)
appropriately. The result is that the currency does something unpleasant,
which leads to an even larger decline in demand, which is normally followed
by a similarly incompetent response. Kaboom!
Observe
that there is no "interest rate policy" for GLD. Nor is there a
"strong GLD policy." Nor is there a "forex intervention"
of the manipulative, invasive, coercive sort. Nobody cares about MZM, M1, M2,
M3 yadda yadda for GLD. GLD has no government deficit, unemployment rate,
stock market, or associated economy. The GLD manager does not have to make
public pronouncements with carefully worded language. The IMF doesn't have to
make promises, carefully balanced with demands. None of this is necessary.
The only thing that is necessary is that supply is adjusted to meet demand,
in accordance with the GLD:gold bullion parity.
"Aha!"
the gold-"backing" people say here. "But GLD has 100% gold
bullion reserve coverage of its outstanding shares!"
Oh
really? Maybe it does. Maybe it doesn't. It
doesn't matter.
After
all, the reason that Sprott is introducing PHY -- a real, 100% physical
gold-storage fund -- is that GLD is nothing of the sort, even if they like to
make vague inferences that they are.
Now,
here's the catch: it doesn't matter
in principle.
Let's
take our example above. The "demand" for GLD falls by 90% in the
space of a month. There is huge selling of GLD (not gold bullion). The shares
outstanding of GLD have to be contracted by 90%. In other words, the trust
needs to buy 90% of the shares outstanding of GLD on the open market to
maintain GLD's peg with gold.
Obviously,
to do this they need money. Not gold -- money.
If the
market cap of GLD is $43 billion, then the trust needs $43B * 90% or $38.7
billion of cash to buy up GLD in the open market. Theoretically, the fund
gets this cash from selling gold bullion on the physical metal market, and
then taking the cash and buying GLD in the stock market. I say
"theoretically." Because, actually it doesn't matter where the cash
comes from. It could be diverted out of the budget of the Defense Department,
for example. The Fed could print it out of thin air.
Now,
let's say that the GLD trust didn't actually go and buy any gold. The trust
doesn't actually have any assets at all -- no futures, derivatives, forwards,
no nothing. Rather, the managers of the trust took the money they got by
selling shares of GLD and parked in a personal Cayman Islands bank account.
In other words, GLD is a Ponzi scheme.
The
problem, of course, is that there is now no money to buy GLD in the open
market. Like a Ponzi scheme, it works as long as the shares outstanding is
growing. When the shares outstanding is shrinking, there are no assets to
trade for GLD in the open stock market. This
is why people want 100% backing of their "currencies."
So it doesn't become a Ponzi scheme.
GLD
also supposedly offers direct exchange of shares for bullion, for large
accounts. I would be surprised if anyone was actually capable of doing this.
It's probably one of those promises which is broken as soon as someone asks
for someone to perform on that promise. Today, even the Comex futures market
is not delivering in bullion, but rather in shares of GLD! Do you really
think you're going to get gold bullion out of GLD? Not in any meaningful
size, I'd guess.
The
point, however, is that as long as the trust is able to buy GLD in the stock
market -- in other words, as long as the manager of the currency is able to
adjust the supply -- then GLD will remain pegged to gold.
For a
real currency, the process is a little different. Instead of trading GLD for
cash in the stock market, the central bank trades cash (base money) for
government bonds. This reduces the supply of currency (base money). As long
as the central bank has something to trade for base money, and that base
money disappears (unsterilized), the value of the currency will be supported.
The central bank doesn't have to sell bonds. It could sell stocks, or real
estate. The government could even take tax revenues, and simply make them
disappear, thus reducing base money. The point is, the supply is reduced.
Once
you understand this process, then the fear factor is greatly reduced. People
have confidence that, when they establish a gold standard system, it won't
blow up in their face. Also, we can see that it is not necessary to have lots
of gold in a vault somewhere. It's all about managing the value of a paper
chit via supply adjustment. Gold
in a vault does not manage the supply of paper chits. Gold
doesn't have a brain. It cannot act. Gold, by itself, does not increase or
decrease the supply of base money. Hoping that "100% backing" -- a
big pile of gold in a vault -- will somehow manage the supply of paper chits
for you is extremely
irrational.
Nathan
Lewis
Nathan
Lewis was formerly the chief international economist of a leading economic
forecasting firm. He now works in asset management. Lewis has written for the
Financial Times, the Wall Street Journal Asia, the Japan Times, Pravda, and
other publications. He has appeared on financial television in the United
States, Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada, call
800-567-4797.
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