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The gold basis is defined as the difference between
the nearby futures price and the cash price of gold in the same location. A
positive basis is called contango; a negative one, backwardation. Since there
were no organized futures markets in gold prior to 1971, the history of gold
basis is confined to the last 35 or so years Gold futures trading started on
the Winnipeg Commodity Exchange in Canada in 1971 at a time when ownership
and trading of gold was still illegal in the United States. Upon becoming
legal the bulk of gold futures trading moved to New York and Chicago For all
these 35 years the gold markets have been in contango (with minor exceptions
due to temporary friction in the delivery mechanism). The basis cannot
theoretically exceed the carrying charge (the lion’s share of which is
interest, usually calculated on the basis of LIBOR). If it did, speculators would
be able to pocket risk-free profits in buying the cash gold and selling the futures
contract against it. This arbitrage would quickly push the basis back to the level
of carrying charge. By contrast, should the market ever go to backwardation,
there is no theoretical limit below which a negative basis could not fall. One
should see clearly the economic significance of gold backwardation. It is an
unmistakable indication of shortages of deliverable supplies.
On the face of it, backwardation in gold would be a
rank aberration of the world economy as most of the gold produced throughout
the ages is still inexistence in marketable form. For this reason profit is
to be made by selling cash gold while replacing it through buying the much
cheaper futures contract. If people hesitate to do it, there must be a
reason. Indeed, the reason is the lack of confidence on the part of people
controlling gold (including the central banks!)that paper gold can be
exchanged for physical gold at maturity as specified byte futures contract
The basis for agricultural commodities shows a clear
annual cyclical pattern that closely follows the crop year. It starts with
contango just after harvest, and ends with backwardation when supplies are
drawn down just before the new crop is brought in
2The behavior of the gold basis lacks this cyclical
pattern characteristic of the markets for agricultural goods. Contango
obviously follows the fluctuations of the interest rate up or down, the
adjustment being practically instantaneous
But, in addition, there is a rather curious
phenomenon that can be described as the secular vanishing of the gold
basis. This means that, as a percentage of the carrying charge (interest)
the gold basis has been steadily eroding and by now has all but reached zero.
Reversals in the trend, if any, are minor and temporary
It is difficult to imagine any combination of
circumstances in which there could be a major reversal in the trend of the
gold basis, unless there was an explosion of interest rates
It is incumbent upon economic theorists to explain
the peculiarity of the secular vanishing of the gold basis, which is not
observed in the case of the basis of other non-agricultural commodities such
as the base metals, for example
The overwhelming fundamental fact about gold during
the past half a century is the steady and relentless absorption of new
supplies from the mines through individual hoarding demand. Half a century
of gold production at peak rates of output has disappeared without a trace
and is by and large unaccounted-for. This is more gold than had ever been
produced previously. At the same time also absorbed was whatever monetary
gold governments and central banks have in their wisdom dishoarded. It can
hardly be doubted that if further supplies of monetary gold were dishoarded,
it would be easily absorbed as well, and any setback in the price of gold on
that account would be temporary. One should also remember that net
dishoarding of gold by governments and central banks is a thing of the past.
Countries such as China, Russia, Brazil, to mention but a few, are on record
as wanting to buy all the gold they can without unduly disturbing the price.
This means that the combined net private and official demand for gold will be
insatiable for the foreseeable future. This is in full agreement with the
secular vanishing of the gold basis
The burning question is what happens when gold
markets go to permanent backwardation, as is likely if present trends
continue. Clearly, the gold futures markets will be no longer viable as they
are presently constituted. The main source of gold for investment purposes
will be permanently shut, as a negative gold basis means that all offers to
sell cash gold have been withdrawn. To see this we have only to remember that
paper gold promising future delivery can no longer be trusted under the
regime of a negative basis, as explained above
The huge volume of trade in paper gold would
disappear with the advent of permanent backwardation. The demise of the paper
market means that governments and central banks have abruptly lost their
power to control the price of gold. They would no longer be able to sell
unlimited amounts of futures contracts. Paul Volcker has admitted in public
that he made a mistake as Chairman of the Federal Reserve in allowing the
dollar price of gold to rise as far and as fast as it did in 1979-1980. By
implication, he and his successors have learned from his
“mistake” and succeeded in subsequently driving down the3dollar
price of gold during the period 1981-2001, or to contain increases during the
period from 2001 onwards. They did it through offering unlimited amounts of
paper gold in the futures markets. As we approach the landmark of permanent
backwardation, the question arises how will the Federal Reserve control the gold
price once the facility of gold futures trading is gone
Another question is how the gold mining industry
will react to the disappearance of the futures market. There is a possibility
that they will stop selling gold against dollars altogether until normalcy
returns to the market
However, an announcement to withdraw the offer to
sell newly mined gold would make the upheaval in the gold market even worse
The implications for the international monetary
system, in which the U.S
dollar is
supposed to play the role of ultimate means of payment and extinguisher of
debt, are devastating. The international monetary system is facing its
greatest crisis for the past forty years as it confronts the threat of
permanent backwardation in gold. Yet there is no sign that the financial
press, or academia, let alone the U.S. Treasury and the Federal Reserve, take
notice. They appear to think that the futures price of gold has no more
relevance to the international monetary system than that of frozen pork
bellies. They are under the illusion that gold has been demonetized. It has
not. Not by the people anyhow, who had monetized it in the first place
This crisis is a gold crisis,
just as the last one in 1968 was. If anything, this one is the more serious
of the two. In 1968 the crisis could be “papered over”,
literally, by making the dollar irredeemable. Debt could still be liquidated
in paper dollars because paper gold was still available. Presently this
availability is the residual extinguisher of debt. Without it the debt markets
could not function because bonds would, in effect, become irredeemable
In 1968 policy-makers at the Treasury and the
Federal Reserve were granted a “breathing space” during which
they could devise a new international monetary system that would provide for
orderly liquidation of debt. One hopes that they have used this breathing
space fruitfully, and they have by now contingency plans ready for
implementation when permanent gold backwardation engulfs the system and paper
gold is no longer available, effectively removing the last
“pacifier” from the debt markets
It is not an encouraging sign that the planning, if
any, has been done behind closed doors. There should have been an open debate
on the debt crisis that threatens the world as gold markets go to
backwardation. A blueprint for anew international monetary system should be
drawn up publicly, with the participation of economists of all stripes and
persuasion. Monetary reform should not be the exclusive turf of Keynesians
and Friedmanites, according to who there are
compelling reasons to dismiss the gold standard out of hand as unfit, both
conceptually and in practice, to play any role in a future international
monetary system. They argue that its “disciplines” would be politically
unacceptable in today’s world
However, there is no way of telling what is
politically acceptable and what is not in the throes of a great depression,
with double digit unemployment, past the teens, when law and order is about
to break down. Our debt crisis and the threat of gold backwardation are
not unrelated. Aggregate debt as it exists in the world today is
comparable to a runaway train on a down-sloping track
The train started picking up speed back in 1971 when
the golden brakes were disabled. By now it is accelerating beyond any safe
speed limit, and a crash appears inevitable. In order to slow the train down
one needs an ultimate extinguisher of debt that is universally acceptable as
a means of payment. The dollar no longer answers this description. Gold does.
Everything else has been tried “to paper over” debt, all in vain.
Already, the debt crisis wiped out an enormous amount of wealth indiscriminately,
causing great economic pain. We ought to remember that if all the remaining
paper wealth is wiped out, gold will still survive intact. It is the only
financial asset that has no counterpart as liability in the balance sheet of
someone else. That is its main excellence, a property lacking in all other
financial assets
The hour is late. It calls for statesmanship. This
is no time for fingerpointing and rancor. Having recognized the threat of
gold backwardation for what it is: the greatest financial crisis in all
history, we should act responsibly
If we do, it will be our “finest hour”.
Antal E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
DISCLAIMER
AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING
THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL
ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND
SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT
IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
Copyright
© 2002-2008 by Antal E. Fekete
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