The Root of the
Problem is Debt
Worldwide,
an incredible tower of debt has been under construction since 1971, when
President Nixon defaulted on the gold obligations of the US government.
His decree severed the redeemability of the dollar for gold and thus
eliminated the extinguisher of debt. Debt has been growing exponentially
everywhere since then. Debt is backed with debt, based on debt,
dependent on debt, and leveraged with yet more debt. For example, today
it is possible to buy a bond (i.e. lend money) on margin (i.e. with borrowed
money).
The
time is now fast approaching when all debt will be defaulted. In our
perverse monetary system, one party’s debt is another’s
“money”. A debtor’s default will impact the creditor
(who is usually also a debtor to yet other creditors), causing him to
default, and so on. When this begins in earnest, it will wipe out the
banking system and thus everyone’s “money”. The paper
currencies will not survive this. We are seeing the early edges of it
now in the euro, and it’s anyone’s guess when it will happen in
Japan, though it seems long overdue already. Last of all, it will come
to the USA.
The
purpose of this article is to present the early warning signal and explain
the actual mechanism to these events. Contrary to popular belief, it
will not be that the central banks increase the quantity of money
to infinity. The money supply may even be contracting (which is what I
expect).
To
understand the terminal stages of the monetary system’s fatal disease,
we must understand gold.
Defining Backwardation
First,
let me introduce a key concept. Most traders define
“backwardation” for a commodity as when the price of a futures
contract is lower than the price of the same good in the spot market.
In
every market, there are always two prices for a good: the bid and the ask. To
sell a good, one must take the bid. And likewise, to buy the good one
must pay the ask. In backwardation, one can sell a physical good
for cash and simultaneously buy a futures contract, and make a profit on the
arbitrage. Note that in doing this trade, one’s position does not
change in the end. One begins with a certain amount of the good and
ends (upon maturity of the contract) with that same amount of the good.
Backwardation
is when the bid in the spot market is greater than the ask in the futures
market
Many
commodities, like wheat, are produced seasonally. But consumption is
much more evenly spread around the year. Immediately prior to the
harvest, the spot price of wheat is normally at its highest in relation to
wheat futures. This is because wheat inventories in the warehouses are
very low. People will have to pay a higher price for immediate
delivery. At the same time, everyone in the market knows that the
harvest is coming in one month. So the price, if a buyer can wait one
month for delivery, is lower. This is a case of backwardation.
Backwardation
is typically a signal of a shortage in a commodity. Anyone holding the
commodity could make a risk-free profit by delivering it and getting it back
later. If others put on this trade, and others, and so on, this would
push down the bid in the spot market, and lift up the ask in the futures
market until the backwardation disappeared. The process of profiting
from arbitrage compresses the spread one is arbitraging.
Actionable
backwardations typically do not last long enough for the small trader to even
see on the screen, much less trade. This is another way of saying that
markets do not normally offer risk-free profits. In the case of wheat
backwardation, for example, the backwardation may persist for weeks or longer.
But there is no opportunity to profit for anyone, because no one has any
wheat to spare. There is a genuine shortage of wheat before the
harvest.
Why Gold Backwardation
is Important
Could
backwardation happen with gold?? Gold is not in shortage.. One
just has to measure abundance using the right metric. If you look at
the inventories divided by annual mine production, the World Gold Council
estimates this number to be around 80 years.
In
all other commodities (except silver), inventories represent a few months of
production. Other commodities can even have “gluts”, which
usually lead to a price collapse. As an aside, this fact makes gold
good for money. The price of gold does not decline no matter how much
of the stuff is produced. Production will certainly not lead to a
“glut” in the gold market pulling prices downward.
So,
what would a lower price on gold for future delivery mean compared to a
higher price of gold in the spot market? By definition, it means that
gold delivered to the market is in short supply.
The
meaning of gold backwardation is that trust in future delivery is
scarce.
In
an ordinary commodity, scarcity of the physical good available for delivery
today is resolved by higher prices. At a high enough price, demand for
wheat falls until existing stocks are sufficient to meet the reduced demand.
But
how is scarcity of trust resolved?
Thus
far, the answer has been via higher prices. Higher prices do coax some
gold out of various hoards, jewelry, etc. Gold went into backwardation
for the first time in Dec 2008. One could have earned a 2.5%
(annualized) profit by selling physical gold and simultaneously buying a Feb
2009 future. Gold was $750 on Dec 5 but it rocketed to $920—a
gain of 23%--by the end of January.
But
when backwardation becomes permanent, then trust in the gold futures market
will have collapsed. Unlike with wheat, millions of people and many
institutions have plenty of gold they can sell in the physical market and buy
back via futures contracts. When they choose not to, that is the
beginning of the end of the current financial system.
Why?
Think
about the similarities between the following three statements:
- “My
paper gold future contract will be honored by delivery of gold.”
- “If
I trade my gold for paper now, I will be able to get gold back in the
future.”
- “I
will be able to exchange paper money for gold in the future.”
The
reason why there was a significant backwardation (smaller backwardations have
occurred intermittently since then) is that people did not believe the first
statement. They did not trust that the gold future would be honored in
gold.
And
if they don’t believe that paper futures will be honored in gold, then
they have no reason to believe that they can get gold in the future at all.
If
some gold owners still trust the system at that point, then they can sell
their gold (at much higher prices, probably). But sooner or later, there
will not be any sellers of gold in the physical market.
Higher Prices
Can’t Cure Permanent Gold Backwardation
With
an ordinary commodity, there is a limit to what buyers are willing to pay
based on the need satisfied by that commodity, the availability of
substitutes, and the buyers’ other needs that also must be satisfied
within the same budget. The higher the price, the more that holders and
producers are motivated to sell, and the less consumers are motivated (or
able) to buy. The cure for high prices is high prices.
But
gold is different. Unlike wheat, gold is not bought for
consumption. While some people hold it to speculate on increases in its
paper price, these speculators will be replaced by others, who hold it
because it is money.
Gold
does not have a “high enough” price that will discourage buying
or encourage selling. No amount of price change will bring back trust
in paper currencies once the gold owners have lost confidence . Thus
gold backwardation will not only recur, but at some point, it will not leave
its backwardated state.
In
looking at the bid and ask, one other observation is germane to this
discussion. In times of crisis, it is always the bid that is withdrawn
-there is never a lack of asks. Permanent gold backwardation can be
seen as the withdrawal of bids denominated in gold for irredeemable
government debt paper (e.g. dollar bills).
Backwardation
should not be able to happen at all as gold is so abundant. The fact
that it has happened and keeps happening means that it is inevitable that, at
some point, backwardation will become permanent. The erosion of faith
in paper money is a one-way process (with some zigs and zags). But
eventually, backwardation will become deeper and deeper (while the dollar
price of gold is rising, probably exponentially).
The
final step is when gold completely withdraws its bid on paper.
Paper’s bid on gold, however, is unlimited, and this is why paper will
inevitably collapse without gold.
The Mechanics of the
Collapse of Paper
Let’s
look at what will happen to non-monetary commodities when gold goes into permanent
backwardation.
People
who hold paper but who desire to own gold will discover gold-commodity
arbitrage. They can buy crude or wheat or copper for paper, and then
sell the commodity for gold. This will drive up the price of crude in
terms of paper, and drive down the price of crude in terms of gold. The
crude price in dollars will rise exponentially and its price in gold will
fall exponentially.
For
example, today the price of a barrel of crude in terms of paper is around
$100 and an ounce of gold priced in crude is 17 barrels. It is possible
to trade $1700 for one ounce of gold this way. Right now, there is no
gain to this trade. Anyone buy an ounce of gold directly for $1700.
But
when gold is no longer offered for dollars, this indirect way will be the
only way to buy gold. The more this trade is used, the more that both
the dollar and gold prices of a commodity will be moved, up and down
respectively. Let’s look at an example. If the price of
crude in paper rises to $2000 and the price of gold in crude rises to 150
barrels, then one would need $300,000 to trade for one ounce of gold this
way. There will always be a gold bid on crude, but it doesn’t
have to be high.
Of
course, this window will shut sooner or later. Producers and hoarders
of commodities will refuse to sell for dollars when they understand
gold-commodity arbitrage, not to mention once they see the dollar losing
value so quickly. And while this is happening, everyone is running to
the stores to trade paper for whatever goods they can get their hands
on. This is the “Crack Up Boom.” The currency will no
longer be acceptable in trade.
Conclusion
Permanent
gold backwardation leading to the withdrawal of the gold bid on the dollar is
the inevitable result of the debt collapse. Governments and other
borrowers have long since passed the point where they can amortize their
debts. Now they merely “roll” the debt and the interest as
they come due. This leaves them vulnerable to the market demand for
their bonds. When they have an auction that fails to attract bids, the
game will be over. Whether they formally default or whether they just
print the currency to pay, it won’t matter.
Gold
owners, like everyone else, will watch this happen. If government bonds
holders sell their securities in response to this crisis, they will only
receive paper backed by that same government and its bonds. But the gold
owner has the power to withdraw his bid on paper altogether. When that
happens, there will be an irreconcilable schism between gold and paper, with
real goods and services taking the side of gold. And in a process that should
play out within a few months once it gets started, paper money will no longer
have any value.
Gold
is not officially recognized as the foundation of the financial system.
Yet it is still a necessary component. When it is withdrawn, the
worldwide regime of irredeemable paper money will collapse.
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