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By Keith Weiner
The Root of the Problem Is Debt
Worldwide, an incredible tower of debt has been
under construction since President Nixon's 1971 default 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 on. 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 happen because 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 December 2008. One could have earned
a 2.5% (annualized) profit by selling physical gold and simultaneously buying
a February 2009 future. Gold was $750 on December 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 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.
Once the gold owners have lost confidence, no amount
of price change will bring back trust in paper currencies. Gold will not have
a "high enough" price that will discourage buying or encourage
selling. Thus gold backwardation will not only recur, but at some point, it
will stay in 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. However, the fact that it has happened and keeps
happening means that it is inevitable and 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. At that point, paper's bid on gold will be unlimited, and this
is why paper will inevitably collapse without gold.
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 bond 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.
Keith Weiner is a technology entrepreneur who
founded DiamondWare, a VoIP software company, which
he sold to Nortel in 2008. Keith is an adherent of Ayn
Rand's philosophy of Objectivism and a student at the New Austrian School of
economics, working on his Ph.D. under Professor Antal
Fekete, with a focus on monetary science. Keith is
now a trader and market analyst in precious metals and commodities. Now that
central planning has failed, he would like the world to return to a proper
gold standard and laissez-faire capitalism.
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