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The Gold Standard Issue #34 ● 15 October 2013 The Gold Standard Institute 1 Editorial We have explained and extolled the virtues of an unadulterated gold standard for almost four years now. For those many who have recently signed up for our monthly journal, it may be time to again state our position, and perhaps clarify it. The Gold Standard The journal of The Gold Standard Institute Editor Regular contributors Philip Barton Rudy Fritsch Keith Weiner Sebastian Younan Thomas Bachheimer Ronald Stoeferle Publius John Butler Charles Vollum Occasional contributors The Gold Standard Institute The purpose of the Institute is to promote an unadulterated Gold Standard The Gold Standard Institute supports free markets. While history unequivocally validates this stance, we base it on moral principles as well as on the practical fact that free markets create wealth, while all ‘systems’ destroy it. Most proponents of free markets understand the practical and moral benefits of allowing people the freedom to produce and exchange, but fail to realize, or point out, that for a market to be truly free, money and credit must also be free – free from government control. www.goldstandardinstitute.net Money is the foundation of every single commercial exchange. How can there be a free market if each exchange is distorted by a government monopoly? President President – Europe President – USA President – Australia Editor-in-Chief While it is unlikely that governments will ever voluntarily relinquish monetary control, this does not mean that the effort should not be made; nor does it mean that the effort cannot succeed. Philip Barton Thomas Bachheimer Keith Weiner Sebastian Younan Rudy Fritsch Membership Levels Annual Member Lifetime Member Gold Member Gold Knight Annual Corporate Member US$100 per year US$3,500 US$15,000 US$350,000 US$2,000 Contents Editorial ........................................................................... 1 News ................................................................................. 2 Cognitive Dollar Dissonance: Why a Global Deleveraging and Reblancing Requires the DeRating of the Dollar and the Remonetisation of Gold ........................................................................................... 2 An election, a banking symposium – and a frightening parallel.......................................................... 6 Trust Your Neighbor; Tie Your Camel ...................... 7 The Theory of Interest and Prices in Practice ........... 9 We are on the threshold of a unique circumstance. Our globalised world and towering debt means that when one major paper money collapses, all collapse. The Gold Standard Institute does not believe that this is an improbable outcome; on the contrary, without a major change in direction we are certain that this is the unavoidable outcome. The dawn of this reality will reignite a one thousand year long argument; one that disappeared into the shadows of history upon the death of the mediaeval economist Nicole Oresme – that control of the money rightfully belongs to market participants. By not only reintroducing this argument, but by more fully fleshing out the intellectual case for a free market in money, the Gold Standard Institute staked an early claim to being a part of that discussion. The Gold Standard The Gold Standard Institute 2 Issue #34 ● 15 October 2013 Our intention is that this latest in a long line of monetary disasters brought about by government monopolisation of money is the last. have been ordered in to wipe up the mess by taking over the factory of the largest manufacturer. No matter, they will be able to use their currency soon. Since Croesus of Lydia and Darius the Persian, the world has laboured under the yoke of governmentmonopolised money. Always, without exception, the money has ended up degraded and the society collapsed. While coin has reliably been adulterated, in no other age has the crass swindle of a worldwide irredeemable paper money been attempted. ≈≈≈ Our job at the Institute is to make the case for the unadulterated gold standard. It may not have been obvious, so let me make it so; the unadulterated gold standard is not feasible without a free market – including, and most importantly, in money. Forbes: American wages in gold ≈≈≈ Gold smuggling in India is booming. These would be just the tip of the iceberg: 2-kg gold seized at goa airport Smuggling along nepal border Gold smuggling from dubai customs Gold biscuits seized from two passengers at airport Gold biscuits seized from passenger Kochi airport gold haul Philip Barton ≈≈≈ News Amazon: Beyond Mises by Rudy Fritsch – now for sale on Amazon (Kindle edition) ≈≈≈ Seeking Alpha: I would be genuinely interested in how many of our readers can spot the primary confusion in this piece ≈≈≈ Business-standard: Gold flavoured tea ≈≈≈ Cornwall Standard Freeholder: Money to burn ≈≈≈ Yahoo: Super rare gold coin sells for $2.75 million ≈≈≈ Daily Mail: Just in the last 13 years the UK has spent 1.4 trillion pounds on welfare ≈≈≈ BBC: Venezuelan central planners form a central committee to overcome the shortage of toilet paper that their central price controls created. The military And now for something completely different… The Song of the Golden Dragon – pretty good guitar! Estas Tonne Cognitive Dollar Dissonance: Why a Global Deleveraging and Reblancing Requires the De-Rating of the Dollar and the Remonetisation of Gold For most of the 1990s and 2000s, the economic academic and policy mainstream essentially ignored gold. No longer. Notwithstanding a decline in price over the past two years, the longer-term secular bull market has returned gold to a subject of active debate. Moreover, following 2008, monetary debasement by most central banks has been far greater and has continued far longer than the mainstream originally thought at all likely or even possible. As some have recently claimed, referring to Japan’s lost decades amidst perennial quantitative easing, “we are all turning Japanese.” However, to the extent that the mainstream acknowledges gold, the debate remains relegated primarily to its role as an alternative store of value, rather than as a monetary alternative to the fiat currencies that provide the bulk of the global monetary reserve base, including most importantly the US dollar. The Gold Standard Issue #34 ● 15 October 2013 To bifurcate the debate around the gold in this way, however, is to demonstrate cognitive monetary dissonance. This is because, as Kopernick, Gresham, Carl Menger and others have demonstrated, money must be both a medium of exchange and a store of value. It cannot be just one or the other, or it will be abandoned over time in favour of something else. The economic academic and policy mainstream, therefore, cannot claim on the one hand that a global deleveraging and rebalancing requires a much weaker dollar, as is generally acknowledged, and then claim on the other that the dollar can remain indefinitely a reserve currency. Yet this is what many appear to believe. As we know, cognitive dissonance is not uncommon, but when such dissonance dissipates, it tends to do so abruptly, in an ‘awakening’ of sorts. Hence the international remonetisation of gold, while an inevitable consequence of the global debt crisis in my opinion, is likely to occur in spontaneous, unpredictable fashion, rather than being driven in any conscious way by economic or monetary officials. In a previous article I wrote in this Journal about how a reallocation of global monetary reserves away from the dollar and into gold is already well underway. Recent data suggest that, if anything, this process has accelerated over the past year. China and Russia, among others, appear to be growing their gold reserves at an elevated rate. In both cases, it is impossible to know exactly how much is being accumulated, but available mining and import data are supportive of this view. Many other countries also continue to accumulate gold reserves. Accumulation of dollar reserves, conversely, has clearly slowed over the past year and, far more importantly, is increasingly concentrated in a few hands. The fewer the countries still accumulating dollar reserves, the more unstable the current global monetary equilibrium becomes. This is because, according to game theory, stable systems require that one or more players can adjust their strategies to address changes in their own specific internal circumstances without forcing a change in other players’ strategies. Yet if only a few countries are still willingly accumulating dollar reserves, then if just one of them changes policy in favour of building up gold reserves, the other players must take up the remaining slack or the value of dollar reserves will The Gold Standard Institute 3 fall. And each time another player does so, the process accelerates non-linearly, as ever fewer players accumulate a comparable amount of dollar reserves. The last player in the game, of course, will be left holding the entire bag of sharply devalued dollars. As with many such games, while there is only a small ‘first-mover advantage’ in this game, there is a disproportionately large ‘last-mover penalty’, hence the fundamental instability of the equilibrium, regardless of the number of players involved. By corollary, as the move away from dollar to gold reserves accelerates, so does the requirement that future cross-border balance of payments are settled not in depreciating dollars but in gold, as reserves will be increasingly so comprised. This process can and is occurring spontaneously as the system evolves away from the essentially 100% dollar-centricity of Bretton Woods, the legacy that explains why a purely fiat dollar, rather than one backed by gold, has been able to remain a reserve currency at all. That said, it does appear that certain players in this evolving game, in particular the BRICS, are beginning to coordinate their strategies in ways that might include certain pro-active initiatives in future. Various bilateral currency arrangements are now in place between the BRICS and also many of their various trading partners, contributing to a reduced role for the dollar. This process could easily accelerate, especially if US monetary, economic or foreign policies are perceived to impinge upon one or more vital BRIC national interests. The recent showdown over Syria is but one obvious case in point. The process could also accelerate if it were perceived that the US Fed remained unconcerned about maintaining a stable dollar, as the recent flipflop regarding the so-called ‘taper’ could have done. Notwithstanding the evidence above that the game is changing, the economic academic and policy mainstream in the developed economies, in particular the US, nevertheless continues to embrace the cognitively dissonant narrative that, while gold may well be a superior store of value in a world with excessive debts and need to rebalance and deleverage, it has no business being remonetised, internationally or otherwise. Back in November 2010, Robert Zoellick, President of the World Bank, The Gold Standard Issue #34 ● 15 October 2013 let the golden genie out of the mainstream’s bottle with the publication of an opinion piece in the venerable Financial Times, in which he observed that gold should henceforth “serve as an international reference point of market expectations about inflation, deflation and future currency values.” He also noted that, “markets are using gold as an alternative monetary asset today.” At the time, considering of course the source, this came across as something of a bombshell. “Why on earth is the president of the World Bank talking about gold?” many must have asked, scratching their heads. Well, one must consider to whom Mr Zoellick was speaking at the time. With the western banking systems having stared into the abyss in 2008 and early 2009, and with their economies having received vital assistance via stimulus from the developing economies, including from the BRICS, perhaps he was acknowledging a certain pressure emanating from those quarters, that is, that there were limits to which the US dollar could be devalued without triggering a BRIC Treasury buyers’ strike. Perhaps he was also trying to control the terms of international debate, to ‘ring-fence’ gold into a purely nonmonetary role. This effort, however, will ultimately fail. A look at what has happened recently in India helps to illustrate why. India is a country where gold has always been part and parcel of the culture. Gold is wealth. Rupees are nothing more than a medium of exchange. Among Indians, it is considered complete nonsense to ‘save’ in rupees, and, thus, the rupee only has economic meaning to the extent that it is the enforced legal tender of the land, required for use in legal (and taxable) exchange. This bifurcation between these two roles of money is arguably greater in India than in any other country in the world. It is thus instructive to see how the Indian authorities are responding to a surge in private demand for gold alongside clear evidence that the economy is slowing, government finances are deteriorating and the risks of monetary debasement commensurately growing. Among other measures to shore up a weakening rupee, Indian economic officials recently imposed large taxes on gold imports. Prior to their enactment, there was a huge rush to import gold, accelerating The Gold Standard Institute 4 the rupee’s slide. Now that the taxes are in place, gold smuggling has apparently soared as Indians try to avoid the tax, something that is seen by most as illegitimate anyway. Moreover, Indian officials have sought to learn more about the gold holdings at various temples and belonging to various religious groups and sects. These actions have not gone over well, meeting with stiff public resistance. Arguably they have backfired, fuelling a surge in distrust of the government, which is not exactly held in particularly high esteem by Indians in the good times, much less when the economic going gets rough. The toxic combination of slowing growth, a dependence on imports and nervousness that the government might seek to arrogate to itself greater control of the country’s quasi-religious gold stocks have all contributed to a sharp decline in the external value of the rupee and a scramble for gold. Gresham’s Law is playing itself out, as indeed it always will do in such circumstances. The plunging rupee recently resulted in the central bank surprising the financial markets with a rise in interest rates which, in short order, caused a sharp decline in the stock market. Spooked by this reaction, the central bank then reversed the hike and explained that it stood by to maintain financial market stability. Well, which is it then? Is the central bank committed primarily to maintaining the stability of the rupee, which has plunged in the gold terms in which it is measured by Indians; or is it committed to propping up the stock market, which no doubt has imparted a large wealth effect on the Indian economy in recent years, contributing, however unsustainably, to growth? The uncertainty so created is only going to contribute to an ever-greater propensity for Indians to accumulate gold at the expense of rupees, placing upward pressure on interest rates. Returning to our primary topic of international monetary dynamics, what is playing out in India with gold and the rupee today is but of microcosm of what is happening in the world as a whole vis-à-vis gold and the US dollar. The Fed has explicitly sought to support the US economy with higher asset prices in recent years. The dollar has been at times weak and at times strong versus other currencies. With the The Gold Standard The Gold Standard Institute 5 Issue #34 ● 15 October 2013 Fed’s recent decision to extend Treasury purchases indefinitely, the dollar has weakened yet again. As with India, the uncertainty created by a Federal Reserve that is demonstrably failing to deliver on its promises to get the US economy on a sustainable growth path is only going to increase the propensity for international economic agents of all stripes to accumulate gold at the expense of dollars, placing upward pressure on interest rates. As higher interest rates naturally threaten the Fed’s goals and methods of supporting US economic growth via asset price inflation, they are likely to be resisted. Should Treasury yields continue to rise, the Fed might well accelerate their rate of purchases rather than scale them back. Trapped as they now are in a vicious circle of their own making, it is unknown just how many iterations of this process will occur before the dollar reserve game collapses entirely, to be replaced by a general remobilisation of gold reserves to settle those international balance of payments transactions. As with any iterative process, at each stage certain global investors or other actors will see the future endgame that little bit more clearly and, in my opinion, each stage will be accompanied by a renewed and quite possibly sudden rise in the price of gold. Eventually, the gold price will rise to a level sufficient to allow existing gold stocks to settle existing global trade imbalances. These imbalances are huge; themselves a legacy of the dollar’s longheld reserve currency status. The gold price sufficient to imply sufficient cover for these imbalances is thus many multiples of where it is today. The cognitive dissonance of the mainstream nevertheless continues. Professor Barry Eichengreen has long predicted a weaker dollar as a necessary requirement of a general global economic rebalancing, yet he does not see any likelihood or purpose of an international remonetisation of gold. More recently, at a US gold mining and investment conference, Walter Russell Mead, formerly the Henry A. Kissinger Fellow for US foreign policy at the esteemed Council on Foreign Relations, pointed out that, “There are some very grim facts out there about the dollar at home. There are also signs of serious opposition to the dollar abroad.” He then added that the outlook for gold was positive, because “There will always be a desire by a significant number of people to have that one kind of asset they feel would hold its value against the worst of catastrophes.” Yet although he acknowledged the challenges faced by the dollar and the likelihood that it will continue to decline in value, he nevertheless concluded his remarks by observing that the dollar is in no danger of losing its reserve currency status. These comments, in effect, echo those of Mr Zoellick from 2010. Notwithstanding the accumulating evidence from China, Russia, India and elsewhere that the game is changing rapidly, the academic and economic policy mainstream refuses to acknowledge that a “game” is being played at all. Gold IS being de facto remonetised, because it is simply not possible to artificially and sustainably bifurcate money’s essential roles as both a store of value and medium of exchange. One look at India today illustrates the point; but stepping back and looking at the bigger picture of the broad history of international monetary relations does the same. Superior money has, always and everywhere, ultimately replaced inferior. And the verdict has always and everywhere been the same: gold and silver, or high-grade alloys thereof, provide the superior money. Thus gold and perhaps silver will provide the monetary foundation for the global economic rebalancing and deleveraging that all agree is both necessary and inevitable. John Butler John Butler is a founding partner and the CIO of Amphora, a commodity-focused hedge fund. He has 19 years' experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to founding his independent investment firm, he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, systematic trading strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is the author of The Golden Revolution (John Wiley and Sons, 2012), and author and publisher of the popular Amphora Report investment newsletter. His research has been cited in the Financial Times, the Wall Street Journal and other major financial publications, and he has appeared on CNN, CNBC, ReutersTV, RT and BBC programmes. The Gold Standard Issue #34 ● 15 October 2013 An election, a banking symposium – and a frightening parallel The German general election, the main political roadblock of the year 2013, has come and gone. Many pressing problems have not been tackled because no politician dared to touch them before the elections. A resounding victory for „Mutti“ – as the German chancellor is called part lovingly and part disdainfully – has turned into a very tricky situation. She has conquered the socialists in a very convincing manner but still finds herself in a cul-de-sac since all parties remaining in the Bundestag have hurried to announce they intend to sell their skins dearly. The choice of coalition partner is a foregone conclusion and the SPD will demand heavy concessions for their cooperation. The situation becomes ominous when looked at from the currency point-of-view because all eurocritical parties have not made the mark. The traditionally Europe-skeptical FDP has not been elected to the Bundestag for the first time since the Second World War and has missed clearing the 5 per cent hurdle by only 0.3 per cent. Equally close was the result for AfD (Alternative for Germany). This party was founded on a euro-exit ticket but has softened their goals of late to include only mild alterations to the euro in their election programme. They had to contend themselves with 4.8 per cent and have thus missed entering the Bundestag. Two euro-skeptical parties, both failed by a tiny margin. A coincidence – or does it relate to last summer’s new motion in Brussels, home of uncounted hordes of bureaucrats, suggesting a future ban of Europe-critical parties? Yes, you have read correctly. The EU organization did not shy away from using heavy-handed gestures reminiscent of the Stalin regime. True to the motto of anti-democrat Jean-Claude Juncker: first we try some measures, and when the people do not resist we continue. Should there be a public outcry, we rescind the suggestion and after a two or three year The Gold Standard Institute 6 wait we suggest the same in a slightly different form. In any case, after the German elections there is NOT ONE truly Brussels-sceptical party in power, but several losers instead: on the one hand the euro/EUcritical parts of the population, who still believe in the democratic achievements of the past, on the other hand the seeming election winner Merkel, who is being hounded by the leftist parties and will be plucked like a goose in coalition talks. A Pyrrhic victory, indeed! But political variety and democracy also count among the losers of this Sunday that is so eminently important for Europe. The winners are the EU organization and their political proponents that have managed to shed a number of adversaries and need no longer suffer any troublemakers in the parliament of the European economic powerhouse. Yet another frontier where the EU bureaucracy has made headway is in banking. I had the chance to witness the biggest Austrian banking symposium in Alpbach/Tyrol. Here, too, one could observe an unsettling scene. This event has taken place for almost 30 years now and is a popular meeting point for bankers and their corporate customers. In various panel discussions and seminars, participants could pick up valuable knowledge. For the last two years now, EU banks and their regulations have gained more and more importance. This year, bankers were being prepared for the fact that in the future, SME (small and medium sized enterprises) financing will be available almost exclusively via the European Investment Bank and other so-called promotional banks. It was obvious that the EU wants to concentrate funding and liquidity provision (the most essential banking service) in their hands – with commercial banks being reduced to sidekicks. The current crisis (that has been going on for 5 years now) helps these concentration attempts because pesky commercial banks can be beaten about the brow if not outright killed with cumbersome and enormously expensive regulations as well as insane equity requirements. The Gold Standard Issue #34 ● 15 October 2013 Next to EU representatives there were still some prominent bankers on the panel who duly criticized the current and proposed rules and regulations in an unusually candid manner. Many banks would fail to jump the hurdle of these new regulations due to excessive compliance costs, according to these veteran bankers. These warnings sounded a bit like a swan song. Any politically interested person could only listen in astonishment at how clearly and vehemently these plans were presented to the attending bankers, corporate CFOs and members of the press and at the sheer pace with which the concentration of the banking and money world unfolds in front of our eyes. Even a long-standing critic of the banking industry has to acknowledge that the currently implemented measures do not serve to protect the savings of the small bank customer. Rather, the crisis is used by the eurocrats to concentrate the banking business and thus power in their own hands. It does not take a clairvoyant to recognise: at the end of this path lie banks controlled by eurocrats that runs the entire show and rule over today’s banking industry. Commercial banks will lose their independence and become mere servants. The death of (banking) variety, competition and hence the citizen’s right to choose is preordained. What happened this September in Europe was a real eye opener. We remain hopeful that many people will realize soon that this is the road to perdition, that is, a dictatorship. All measures now being announced and implemented serve to solidify the power of the EU. The fundamental principle of politics with the people as principle and politicians as their agents has been perverted and turned on its head. It remains to be hoped that the people of Europe will soon put an end to these disgraceful goings-on. Ideally by questioning and maybe abolishing the main tool of this new dictatorship: the euro! Thomas Bachheimer President – The Gold Standard Institute Europe The Gold Standard Institute 7 Trust Your Neighbor; Tie Your Camel In my last article, I introduced the topic of trust based credit… or how to make money without money. In today’s G’man dominated world, only fringe economic activities like street vending of umbrellas escape the all-smothering regulatory blanket. But imagine if the whole world economy could run on ‘trust based credit’… and escape the ‘vampire squid’ actions of the Bankster and the G’man… impossible you say? Just a pipe dream? Well, the historic reality is that prior to the madness of WWI… the ‘War to End All Wars’… the world economy did indeed run on such a credit system, with the reality check of ‘trust your neighbor but tie your camel’ in full effect. So effective and efficient was this system of credit, that world trade volume seen before WWI was not matched till the nineteen seventies; almost three quarters of a century later, despite huge growth in population and wealth. To fully understand the trust based credit system and the enormous and deadly ramifications of its destruction during WWI, we need to understand how the principles employed by the street vendor and umbrella wholesaler apply in the whole world economy. We all know what a bill is; a paper record of what we purchase… in restaurants the bill is called a check, in bars a tab… but the idea is always the same. We buy some merchandise; a meal, an umbrella (in a retail store) or a pint of brew, get presented with the bill or check or tab, verify the bill… by confirming that what it claims we bought is true… then we accept the bill, and pay it. The only difference between a retail bill and a commercial bill is the term; retail bills are COD… to be paid immediately. Commercial bills are almost never COD, but give terms; time to pay. Terms are like 30 days net, 60 days, 90 days etc. Thus, while a retail bill is paid immediately, and is ‘retired’… i.e. paid in full and only kept for bookkeeping purposes… the commercial bill stays ‘open’ or in effect until the due date, when it is paid... and only then retired. The Gold Standard Issue #34 ● 15 October 2013 A big trailer truck carrying 30,000 Liters of gasoline backs up to the gas station, fills the underground storage tank… and the driver heads to the gas station office to complete the paperwork. Suppose gasoline costs $1 per Liter... do you imagine the station attendant will pay $30,000 in cash? Not likely! Nor can the attendant write a check… he simply signs (accepts) the bill or commercial invoice. The invoice specifies that 30,000 L of gasoline have been delivered, and that payment will be due in say 60 days from the signing date. Until paid in full, this bill represents value; the value of the 30,000 L of gasoline delivered, and the value of the payment that will be made in not more than 60 days. The holder of the bill, the gasoline wholesaler, may simply hold the bill till it is paid… in his ‘accounts receivable’… or may use it to pay the refinery that produced the gasoline. If he does this, he will assign the bill to the refinery, so that when the gasoline retailer makes payment, the payment will be made to the refinery, not the wholesaler. This is the crux of the commercial credit system; goods are placed on consignment, a bill written and accepted, and payment made as per the terms of the contract… the bill. Notice credit is granted, goods change hands, but there is no borrowing involved. No borrowing, no interest charges, no collateral… simply trust that the retail gas station will indeed sell the gasoline delivered, and use the proceeds of retail gas sales to pay the bill when due. The bill thus created can circulate, that is clear credit... make payments. Such a bill, one that circulates, is called a Bill of Exchange. Suppose the retail gas-bar makes a profit of 8% on gasoline sales, and the prevailing interest rates are 4%... reasonable enough assumptions under normal economic circumstances. The retail gas-bar owner has three choices to fund inventory; use bank credit i.e. borrow the funds; use his own capital; or work with ‘trust based’ credit. Today, most retailers except fringe operations like street vendors, and ‘vertical’ transactions within one industry like petroleum products, have only the first two choices available to them. To make an 8% annualized profit, the gas bar owner will make a 2% profit by re-selling the gasoline in The Gold Standard Institute 8 ninety days; he then buys another batch of 30,000 L... makes another 2% profit in the next 90 days... and repeats this four times a year. Four times 2% is 8%, the annualized profit. Now consider this; if the interest rate is 4% per annum that translates to 1% per quarter... the 90 day period that the 30,000 L must be funded. Isn’t this incredible; net profit is 2%, and cost of interest is 1%... half the profits go to pay the Bankster! The second alternative is to fund the purchase with cash, the retailer’s own capital; this plays up the ‘you need money to make money’ rule spread by the Bankster... and yes, if the retailer has the cash, he can indeed fund the purchase... but then he falls prey to opportunity costs. The cash invested in gasoline inventory could have been invested in a bond that pays 4% annual interest income; so, the retailer is still hit. With borrowed funds, he pays 1/2 his profit to the Bankster. With cash payment, the retailer loses 1/3 of the profit he could have made using the third option, trust based credit to fund the gasoline... and investing his own capital in something else. If he makes 8% on gas sales, and 4% on interest earned on his capital, that is a 12% per annum income on the $30,000; not bad at all, is it? Now we start to see the benefit of ‘trust based credit’... cost of doing business drops drastically. Indeed, there are many enterprises... and job opportunities... that remain ‘in potentia’; they never materialize because the cost of doing business on a cash or borrowed funds basis is too high. These ‘phantom’ enterprises actually did exist under Gold, when all retail business not just the fringe ones took advantage of trust based credit. This is one major reason there was no structural unemployment under the Classical Gold Standard. But really, we have just scratched the surface of the magical benefits of ‘trust based credit’, often called the Bills of Exchange system... or the Real Bills Doctrine of Adam Smith. The full vertical and horizontal circulation of Bills, the international BiIl market, the discount rate... these all depend on the free circulation of Gold and Silver coin. Much G’man and Bankster effort goes into suppressing Gold and Silver money, in order to suppress the Bill The Gold Standard The Gold Standard Institute 9 Issue #34 ● 15 October 2013 market... and to keep the world economy hooked up to the ‘vampire squid’. have been the peak (it has subsided a little since then). Once the Fiat paper regime collapses and real money makes its comeback, circulation of Real Bills will again arise. Monetary debasement will be replaced by constantly increasing purchasing power of money. Structural unemployment and the dole will be replaced by full employment. Financial speculation will be replaced by real wealth generation. Several readers asked me if I thought this was the beginning of a new rising cycle, or if I thought this was the End (of the dollar). As I expressed in Part VI, the End will be driven by the withdrawal of the gold bid on the dollar. Since early August, gold has become more and more abundant in the market.3 I think it is safe to say that this is not the end of the dollar, just yet. The hyperinflationists’ stopped clock will have to remain wrong a while longer. I said that the rising rate was a correction. I can hardly wait. Rudy J. Fritsch Editor in Chief The Theory of Interest and Prices in Practice Medieval thinkers were tempted to believe that if you throw a rock it flies straight until it runs out of force, and then it falls straight down. Economists are tempted to think of prices as a linear function of the “money supply”, and interest rates to be based on “inflation expectations”, which is to say expectations of rising prices. The medieval thinkers, and the economists are “not even wrong”, to borrow a phrase often attributed to physicist Wolfgang Pauli. Science has to begin by going out to reality and observing what happens. Anyone can see that in reality, these tempting assumptions do not fit what occurs. Over five months, I wrote about 12,000 words (half the length of my dissertation1 not including appendices!) presenting my theory of how interest rates and prices actually operate in our paper monetary system.2 I argued that the system has positive feedback and resonance, and cannot be understood in terms of a linear model. When I began this series of papers, the rate of interest was still falling to hit a new all-time low. Then on May 5,2013, it began to shoot up. It rose 83% over a period of exactly four months. That may or may not A Free Market in Goods, Services, and Money The Theory of Interest and Prices in Paper Currency Part VI (The End) contains links to the other five parts. I am quite confident of this prediction, for all the reasons I presented in the discussion of the falling cycle in Part V. But let’s look at the question from a different perspective, to see if we end up with the same conclusion. In the gold standard, the rate of interest is the spread between the gold coin and the gold bond. If the rate is higher, that is equivalent to saying that the spread is wider. If the rate is lower, then this spread is narrower. A wider spread offers more incentive for people to straddle it, an act that I define as arbitrage. Another way of saying this is that a higher rate offers more incentive for people to dishoard gold and lend it. If the rate falls, which is the same as saying if the spread narrows, then there is less incentive and people will revert to hoarding to avoid the risks and capital lock-up of lending. Savers who take the bid on the interest rate (which is equivalent to taking the ask on the bond) press the rate lower, which compresses the spread. It goes almost without saying, that the spread could never be compressed to zero (by the way, this is true for all arbitrage in all free markets). There are forces tending to compress the spread, such as the desire to earn interest by savers. But the lower the rate of interest, the stronger the forces tending to widen the spread become. These include entrepreneurial demand for credit, and most importantly time preference. There is no lending at zero interest and nearly zero lending at near-zero interest. 1 2 3 See the Monetary Metals Supply and Demand Report The Gold Standard Issue #34 ● 15 October 2013 I emphasize that interest is a spread to put the focus on a universal principle of free markets. As I stated in my dissertation: “All actions of all men in the markets are various forms of arbitrage.” Arbitrage compresses the spread that is being straddled. It lifts up the price of the long leg, and pushes down the price of the short leg. If one buys eggs in the farm town, then the price of eggs there will rise. If one sells eggs in the city center, then the price there will fall. In the gold standard, hoarding tends to lift the value of the gold coin and depress the value of the bond. Lending tends to depress the value of the coin and lift the value of the bond. The value of gold itself is the closest thing to constant in the market, so in effect these two arbitrages move the value of the bond. How is the value of the bond measured— against what is it compared? Gold is the unit of account, the numeraire. The value of the bond can move much farther than the value of gold. But in this context it is important to be aware that gold is not fixed, like some kind of intrinsic value. An analogy would be that if you jump up, you push the Earth in the opposite direction. Its mass is so heavy that in most contexts you can safely ignore the fact that the Earth experiences an equal but opposite force. But this is not the same thing as saying the Earth is fixed in position in its orbit. The regime of irredeemable money behaves quite differently than the gold standard (notwithstanding frivolous assertions by some economists that the euro “works like” the gold standard). The interest rate is still a spread. But what is it a spread between? Does arbitrage act on this spread? Is there an essential difference between this and the arbitrage in gold? Analogous to gold, the rate of interest in paper currency is the spread between the dollar and the bond. There are a number of differences from gold. Most notably, there is little reason to hold the dollar in preference to the government bond. Think about that. The Gold Standard Institute 10 In the gold standard, if you don’t like the risk or interest of a bond, you can happily hold gold coins. But in irredeemable paper currency, the dollar is itself a credit instrument backed by said government bond. The dollar is the liability side of the Fed’s balance sheet, with the bond being the asset. Why would anyone hold a zero-yield paper credit instrument in preference to a non-zero-yield paper credit instrument (except as speculation—see below)? And that leads to the key identification. The Fed is the arbitrager of this spread! The Fed is buying bonds, which lifts up the value of the bond and pushes down the interest rate. Against these new assets, the Fed is issuing more dollars. This tends to depress the value of the dollar. The dollar has a lot of inertia, like gold. It has extremely high stocks to flows, like gold. But unlike gold, the dollar’s value does fall with its quantity (if not in the way that the quantity theory of money predicts). Whatever one might say about the marginal utility of gold, the dollar’s marginal utility certainly falls. The Fed is involved in another arbitrage with the bond and the dollar. The Fed lends dollars to banks, so that they can buy the government bond (and other bonds). This lifts the value of the bond, just like the Fed’s own bond purchases. Astute readers will note that when the Fed lends to banks to buy bonds, this is equivalent to stating that banks borrow from the Fed to buy bonds. The banks are borrowing short to lend long, also called duration mismatch. This is not precisely an arbitrage between the dollar and the bond. It is an arbitrage between the shortterm lending and long-term bond market. It is the spread between short- and long-term interest rates that is compressed in this trade. One difference between gold and paper is that, in paper, there is a central planner who sets the shortterm rate by diktat. Since 2008, Fed policy has pegged it to practically zero. This makes for a lopsided “arbitrage”, which is not really an arbitrage. One side is not free to move, even the slight amount of a massive object. It is fixed The Gold Standard The Gold Standard Institute 11 Issue #34 ● 15 October 2013 by law, which is to say, force. The economy ought to allow free movement of all prices, and now one point is bolted down. All sorts of distortions will occur around it as tension builds. I put “arbitrage” in scare quotes because it is not really arbitrage. The Fed uses force to hand money to those cronies who have access to this privilege. It is not arbitrage in the same way that a fence who sells stolen goods is not a trader. In any case, the rate on the short end of the yield curve is fixed near zero today, while there is a pull on the long bond closer to it. Is there any wonder that the rate on the long bond has a propensity to fall? monetary economists are to bellow from the rooftops that this practice is destructive). Today, duration mismatch is part of the official means of executing the Fed’s monetary policy. I have already covered how duration mismatch misallocates the savers’ capital and when savers eventually pull it back, the result is that the bank fails. I want to focus here on another facet. Pseudoarbitrage between short and long bonds destabilizes the yield curve. Under the gold standard, borrowing short to lend long is certainly not necessary.4 However, in our paper system, it is an integral part of the system, by its very design. By its very nature, borrowing short to lend long is a brittle business model. One is committed to a longterm investment, but this is at the mercy of the short-term funding market. If short-term rates rise, or if borrowing is temporarily not possible, then the practitioner of this financial voodoo may be forced to sell the long bond. The government offers antiseptic terms for egregious acts. For example, they use the pseudoacademic term “quantitative easing” to refer to the dishonest practice of monetizing the debt. Similarly, they use the dry euphemism “maturity transformation” to refer to borrowing short to lend long, i.e. duration mismatch. Perhaps the term “transmogrification” would be more appropriate, as this is nothing short of magic. The original act of borrowing short to lend long causes the interest rate on the long bond to fall. If the Fed wants to tighten (not their policy post-2008!) and forces the short-term rate higher, then players of the duration mismatch game may get caught off guard. They may be reluctant to sell their long bonds at a loss, and hold on for a while. Or for any number of other proximate causes, the yield curve can become inverted. The saver is the owner of the money being lent out. It is his preference that the bank must respect, and it is for his benefit that the bank lends. When the saver says he may want his money back on demand, and the bank presumes to lend it for 30 years, the bank is not “transforming” anything except its fiduciary duty, its integrity, and its own soundness. Depositors would not entrust their savings to such reckless banks, without the soporific of deposit insurance to protect them from the consequences. Side note: an inverted yield curve is widely considered a harbinger of recession. The simple explanation is that the marginal source of credit in the economy is suddenly more expensive. This causes investment in everything to slow. Under the gold standard, this irrational practice would exist on the fringe on the line between what is legal and what is not (except for the yield curve specialist, a topic I will treat in another paper), a getrich-quick scheme—if it existed at all (our jobs as I argue that it always fails in the end in Duration Mismatch Always Fails At times there is selling of the short bond, at times aggressive buying. Sometimes there is a steady buying ramp of the long bond. Sometimes there is a slow selling slide that turns into an avalanche. The yield curve moves and changes shape. As with the rate of interest, the economy does best when the curve is stable. Sudden balance sheet stress, selloffs, and volatility may benefit the speculators of the world5, but of course, it can only hurt productive businesses that are financing factories, farms, mines, and hotels with credit. 4 5 Theory of Interest and Prices, Part III The Gold Standard Issue #34 ● 15 October 2013 Earlier, I referred to the only reason why someone would choose to own the Fed’s liability—the dollar—in preference to its asset. Unlike with gold, hoarding paper dollar bills serves no real purpose and incurs needless risk of loss by theft. The holder of dollars is no safer. He avoids no credit risk; he is exposed to the same risk as is the bondholder is exposed. The sole reason to prefer the dollar is speculation. As I described in Theory of Interest and Prices in Paper Currency, the Fed destabilizes the rate of interest by its very existence, its very nature, and its purpose. Per the above discussion, the Fed and the speculators induce volatility in the yield curve, which can easily feed back into volatility in the underlying rate of interest. The reason to sell the bond is to avoid losses if interest rates will rise. Speculators seek to front-run the Fed, duration mismatchers, and other speculators. If the Fed will “taper” its purchase of bonds, then that might lead to higher interest rates. Or at least, it might make other speculators sell. Every speculator wants to sell first. Consider the case of large banks borrowing short to lend long. Let’s say that you have some information that their short-term funding is either going to become much harder to obtain, or at least significantly more expensive. What do you do? You sell the bond. You, and many other speculators. Everyone sells the bond. Or, what if you have information that you think will cause other speculators to sell bonds? It may not even be a legitimate factor, either because the rumor is untrue (e.g. “the world is selling Treasury bonds”) or because there is no valid economic reason to sell bonds based on it. You sell the bond before they do, or you all try to sell first. I have been documenting numerous cases in the gold market where traders use leverage to buy gold futures based on an announcement or nonannouncement by the Fed. These moves reverse themselves quickly. But no one, especially if they are The Gold Standard Institute 12 using leverage, wants to be on the wrong side of a $50 move in gold. You sell ahead of the crowd, and you buy ahead of the crowd. And they try to do it to you. I think it is likely that one of these phenomena, or something similar, has driven the rate on the 10-year Treasury up by 80%. I would like to leave you with one take-away from this paper and one from my series on the theory of interest and prices. In this paper, I want everyone to think about the difference between the following two statements: 1. The dollar is falling in value 2. The rate of interest in dollars must rise It is tempting to assume that they are equivalent, but the rate of interest is purely internal to the “closed loop” dollar system. Unlike a free market, it does not operate under the forces of arbitrage. It operates by government diktats, and hordes of speculators feed on the spoils that fall like rotten food to the floor. From my entire series, I would like the reader to check and challenge the sacred-cow premises of macroeconomics, the aggregates, the assumptions, the equations, and above all else, the linear thinking. I encourage you to think about what incentives are offered under each scenario to the market participants. No one even knows the true value of the monetary aggregate and there is endless debate even among economists. The shopkeeper, miner, farmer, warehouseman, manufacturer, or banker is not impelled to act based on such abstractions. They react to the incentives of profit and loss. Even the consumer reacts to prices being lower in one particular store, or apples being cheaper than pears. If you can think through how a particular market event or change in government policy will remove old incentives and offer new incentives, then you can understand the likely first-order effects in the market. Of course each of these effects changes still other incentives. It is not easy, but this is the approach that makes economics a proper science. The Gold Standard Issue #34 ● 15 October 2013 P.S. As I do my final edits on this paper (October 4, 2013), there is a selloff in short US T-Bills, leading to an inversion at the short end of the yield curve. This is due, of course, to the possible effect of the partial government shutdown. The government is not going to default. If this danger were real, then there would be much greater turmoil in every market (and much more buying of gold as the only way to avoid catastrophic losses). The selloff has two drivers. First, some holders of TBills need the cash on the maturity date. They would prefer to liquidate now and hold “cash” rather than incur the risk that they will not be paid on the maturity date. Second, of course speculators want to front-run this trade. I put “cash” in scare quotes because dollars in a bank account are the bank’s liability. The bank will not be able to honor this liability if its asset—the US Treasury bond—defaults. The “cash” will be worthless in the very scenario that bond sellers are hoping to avoid by their very sales. When the scare and the shutdown end, then the 30-day T-Bill will snap back to its typical rate near zero. Some clever speculators will make a killing on this move. Dr. Keith Weiner Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals where he write on the basis and related topics. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona. The Gold Standard Institute 13