Wednesday, May 10, 2017

Money or Wealth?


"Gold is not money, not currency, not an investment, it is wealth."
-Another

_________

This is a repost from the Speakeasy:

There's been a lot in the news about money lately—negative interest rates, the war on cash, the dollar shortage, Venezuela's collapsing currency—and we use that word, money, to mean so many different things that it can be confusing, so I thought it was a good time for another post on the subject. What is money, really? And what should we do to fix it?

Back in 2014, I wrote a series of three very long posts, Fiat 33, Dirty Float and Global Stagnation, which explained, at length, my view of the future monetary system I call Freegold, which, ironically I think, has almost nothing to do with gold. Two weeks ago, FoNoah emailed me about the series:

"Hello FOFOA - Happy New Year again to you and Mrs. FOFOA

I have just finished RRTFB Trilogy - Fiat 33, Dirty Float, and Global Stagnation. This time around I kicked the wife out of the house and sat in a quiet corner for three days straight. I made sure I understood each sentence before going on to the next.


"So now my question to you is whether or not the beginning of Fiat 33 finally makes sense to you. I hope it does."

Yes it does, and it only took me 2-and-a-half years to get there! The Trilogy is a bloody MASTERPIECE."

That line he quoted was from the end of Global Stagnation, where I asked the reader if I accomplished what I set out to do six months earlier. When I started writing the first one in June, I knew what I wanted to say and accomplish from the very beginning, but I also knew it would be difficult, and take time and more than one post, though I didn't know how many. So I actually ended Global Stagnation in December with a long quote from the beginning of Fiat 33 from June. Here's an abbreviated excerpt of it:

"From Fiat 33:

I know I haven't written a post in a while, but my plan right now is to write a series of posts, this being the first, that will hopefully paint a nice big picture for you of what Freegold is all about. I've had the idea for a while now to write a post about what, precisely, constitutes the overvaluation of the dollar today, as that relates directly to the deflation versus currency collapse/hyperinflation debate.

[…]

I know that some of you are skeptical about what I am saying. You're probably thinking that Freegold relies somehow on gold and whether or not it is embraced by the masses. But here's another thing that will probably surprise you in the end. Gold has little to do with "Freegold the monetary system"! Gold is not a key part of the monetary adjustment mechanisms in Freegold. The price and physical movements of gold won't even matter to the monetary system. Any movements of gold in price, ownership or location will be irrelevant to the monetary system of the future.

Freegold is the true unshackling of gold from the monetary system. In Freegold, a properly functioning monetary system requires nothing of gold. In Freegold, the international monetary system won't require gold to change price or location in order for it (the new IMFS) to function. That's why it's called Freegold. Gold is finally and truly set free from its shackles to the monetary system."

It's kind of like how hyperinflation has almost nothing to do with "inflation" except that it's part of its name, and in fact has more in common with deflation. Freegold in terms of money and the future monetary system has almost nothing to do with "gold" except that it's part of its name.

But you'll notice from the title of this post that it's not only about money. It's also about wealth. And you'll have hopefully caught in the Another quote at the top that gold is not money, it's wealth. So this post is indeed about both, money and gold (wealth). Did I catch your interest yet? ;D

In my last post, How Gold is Different, I asked you to put yourself back in time…

"Put yourself back in time, back when gold was base money, circulating coin, and monetary reserves. Now picture the banks as the gold middlemen, and the bank vaults as their warehouses of gold. Money was gold. That's not to say all money was pieces of gold, but money, which is mostly credit, was denominated in weights of gold. So it is fair to say that, while all gold was money, not all money was gold, and gold was only a small subset of money.

I know that gold bugs like to say "gold is the real money, and all else is credit," roughly paraphrasing JP Morgan once upon a time. But FOA proved, beyond a shadow of a doubt in my mind, that money of the mind, an association of values held in our heads, and therefore credit, was the pure concept of money as it grew out of antiquity, and that gold was something different. Gold was tradable wealth, while money was just a useful concept, and trying to combine the two turned out not to be the best use of gold. Please see Moneyness and Moneyness 2: Money is Credit for more on this subject.

I'm sure that most of you are familiar with the parable of the Goldsmith, but here it is again:



I called it a parable because it's not totally true. While it does a good job illustrating the concepts of credit money and fractional reserve banking for the purpose of this post, it is way too simplistic in the way it characterizes them as a duplicitous scheme. The pure concept of money has always been, basically, credit. Gold, the most tradable wealth item, ended up as the reserve in fractional reserve banking, which, as I said, was not the best use of gold. But I'll get more into that concept in a future post…"

This is that post, so welcome to the future! ;D

Now let's take a journey of the mind even farther back in time, all the way back to antiquity. In the course of this journey, I will rely on what I learned from FOA, not what I learned elsewhere, when thinking about gold and money in antiquity. The reason I think this is necessary is in order to separate "the money concept" from "gold as tradable wealth" which, as far as I have seen, no one else has done.

In antiquity, gold was used as a medium of exchange, another term for tradable wealth. The pure money concept as explained by FOA is human credit, which is essentially "money of the mind". Both existed in antiquity, as did many other mediums of exchange or tradable wealth items.

Building upon FOA, I tend to think of three spheres of trade in which the ancients would have engaged each other. The three could be described as distant, local, and "among trusted acquaintances" or what we could call "super-local". As FOA explained, gold was best suited for distant trade, and, therefore, gold was always "On the Road," a phrase used 15 times by FOA in Gold Trail 3.

Credit would have been mostly used on a "super-local" basis, or "among trusted acquaintances," and other media of exchange, other forms of tradable wealth, would have been used "locally", like at the town marketplace. Credit is scalable, both in quantity and duration, or length of time required for clearing, and it would have been scaled in proportion to the level of trust between trading counterparties.


As an example of the "super-local", I like to imagine a bar like Cheers in ancient times, where everyone knows your name and, therefore, everyone drinks on credit. Everyone runs a bar tab. The bar tab is a handy device because it is generally one-way credit. The bar owner extends credit to all of his patrons each night, and they settle up on a regular basis rather than having to barter for each and every drink. It's merely a convenient device for a mental exercise.

The point of this exercise is many-fold. It is to understand how money (credit) and barter (settled or completed trades) coexisted at the same time, not that money emerged from barter. It is to retrain your brain to be able to separate the money concept from barter, even where gold coins or other tradable wealth items were traded. And it is to be able to visualize the process, over time, whereby gold became the focal point tradable wealth item.

In order to run a super-local credit system, you need a unit of account. It could be anything. It could even be different for each patron. Perhaps our ancient bartender simply kept track of the number of drinks for each patron, and then settled up later depending on their trade. Or perhaps he kept track using each patron's trade. Like the egg farmer owes so many eggs. Or perhaps he used some other unit of account, like pieces of silver or gold. It doesn't really matter, and it could have varied from bar to bar, and community to community.

Over time, of course, a standard unit of account would be easier and would therefore spread from town to town until everyone used the same unit of account. Perhaps it was pieces of silver. One of FOA's points was that it is more common to find hoards of silver coins in ancient digs than gold. That's because, as FOA said, silver would have been a common item of trade, and it would make for a good unit of account in ancient credit.


In terms of local (but not super-local) trade, barter would be the order of the day. You can imagine a bustling marketplace where trade consists of haggling over relative values and goods on offer. Over time, gold and silver would emerge as good media of exchange, but still that would not entail the money concept as explained by FOA. Eventually a system of scrip would emerge, as in Fekete's 'Fairy' Tale (found in this post), and in that case, the scrip would represent the expansion of the money concept from the super-local sphere into the local sphere.

A scrip system is a system of short-term credit amongst a limited group of relative strangers. The scrip itself becomes a medium of exchange, but only for the limited scope of the fair itself. The clearing of the scrip would entail the return from the monetary plane to the physical, from money back to barter. You don't want to go home carrying a credit slip from a stranger. You want to go home carrying either a good or a tradable wealth item.


Beyond the super-local and local was distant trade. This was where gold was used. As FOA explained, a very small amount of gold in the world carried a tremendous value in antiquity because of the way it was used.

"All throughout these early times, prior to BC and into some AD, people didn't see these gold coins as we think of money today. These various gold coins had tremendous value, but they were just gold pieces. They were wealth for trade like everything else was.. That's simple logic, I know, but the vessel of oil, for instance was just as tradable as a gold coin. In fact, within most of the medium sizes city states of that era, barter of like goods was just as good or better than gold coin. One's life was better if he owned wealth he used."

Gold's highest value in antiquity was to be, as FOA would say, "On the Road." Imagine you are a trader in antiquity, heading out to distant lands in search of fine silk or whatever it is you are after. You will need to bring something of value with you to trade for those things you hope to obtain. So, whatever wealth you have before you hit the road, you will want to trade it for the item that carries the greatest value in the smallest package and lightest weight. That was gold.


If a stranger rolls into your town wanting to obtain a cart full of your fine oil or furs, you will engage him in barter, not credit, because he is an out-of-town stranger. He will offer you gold and you will take it. You will take it because you know how valuable gold is to "on the road" traders, and you know that when the next one leaves your town he will trade all of his wealth items for gold, because that's what you take on the road. That's what gives gold its tremendous value—the way it is used.


There were a number of points that FOA was making in Gold Trail 3:

1. Gold was not money, in fact it was practically the antithesis of money in ancient times. If you understand that money was credit, and that credit was used proportionately at the local and super-local levels, gold was the tradable wealth item used where money (credit) couldn't be used, over long distances between strangers.

2. Gold had a far higher value in ancient times than we tend to imagine. Too high, in fact, to be used as "savings" by normal people. Too high to be hoarded! Lifetimes were shorter, wealth scarcer, and he who underconsumed to save for later would save, as FOA said, "wealth he used."

"Humans of that period didn't live all that long a time span. Even though some accounts prove otherwise, the majority of life went by rather quickly. If you were a regular part of society in general, your wealth was what you had and consumed during those short days. There were no banks or investment houses and the average person's return on a wealth unit was his length of use and its quality of life enhancement. More to the point, this logic made these guys spenders of gold, rather than savers! If you had gained gold in trade, for your services or goods supplied, you had no reason to save it. There was no other money that needed to be hedged against value loss…

For longer savings, even for those of above average means that had all they wanted, people tended to spend their most valuable gold coins first, while saving the least valuable (bronze, silver, iron) for emergencies and later use. To us, today this sounds strange, but place yourself in that time. It was better to build your most useful and needed store of things while times were good."

3. A much smaller quantity of gold existed (and sufficed) in antiquity than we tend to imagine.

"It's becoming more and more apparent that average people of that time quickly traded (spent) their gold for something useful of value, for both them and their family. They didn't have the excess we know today. In modern nomenclature; this logic dictates that a much smaller amount of gold money circulated and circulated faster than many supposed. All forms of jewlery and art objects were in the same situation."

This last point was, I think, what sparked the discussion about ancient gold in Gold Trail 3 in the first place. Just prior, at the end of Gold Trail 2, the subject of vast hoards of "black gold" had come up in the discussion forum, and this was how FOA chose to address it.

My point in revisiting this discussion here is that gold's true value comes from the way it is used, which is not necessarily the way it is described by the hard money/gold bug camp.

Now jump ahead, in your mind, from antiquity to the Renaissance period, and think about the differences. Witness the emergence of international banking families and the beginnings of an international monetary system. Yes, coins, both gold and otherwise, were a big part of the system's development. But as we earlier witnessed the expansion of the money concept from the super-local to the local with the use of scrip at the fair, here we can see the expansion from the local to the distant with the addition of international clearing organizations in the form of these big "evil" banking families.

A busy scene in a 15th century Medici bank.

Also remember that, in terms of FOA's pure money concept, it was the numbers stamped on the coins, and not the metal itself, that was money. The fact that gold was used in this way was probably an essential step, or at least a helpful one, in the expansion of the money concept from super-local to local to distant. But, as FOA said, it was not the best use of gold:

"To understand gold we must understand money in its purest form; apart from its manmade convoluted function of being something you save. Money in its purest form is a mental association of values in trade; a concept in memory not a real item. In proper vernacular; a 1930s style US gold coin was stamped in the act of applying the money concept to a real piece of tradable wealth. Not the best way to use gold, considering our human nature."

So, in antiquity, gold was tradable wealth just as it is today. But, in antiquity it was "on the road," which is not necessary today, because we now have a functioning international monetary system enabling money to be used in distant trade. Also, today, we have the need to save for retirement, which was a little different in antiquity for the reasons FOA explained.


Let's take a quick look at gold's unique set of physical properties:

Scarcity: It's not all that scarce relative to other things, but it also doesn't grow on trees, which is actually what is meant by scarcity as one of gold's properties. It takes considerable effort and luck to find it directly in nature.
Fungibility: This is what sets gold apart from, say, diamonds. An ounce of 24K gold is the same anywhere, they are mutually interchangeable, and we can specify an amount of gold without having to be specific about which actual piece of gold is being referenced.
Recognizable: Gold is easily recognizable and relatively easy to authenticate.
Divisibility: This is what sets gold apart from, say, the Mona Lisa. Gold can be divided almost infinitely without losing its value.
Portability: This is really a function of gold's high value, but it was very important in antiquity. It's a little bit circular and self-referential in that gold was portable because it was very valuable, and it was so valuable (back then) because it was so portable, because it was so valuable, because it was so portable, and so on.
Malleability: Gold is easily shaped, which is how and why it traded in many different forms, like jewelry, art and coins.
Durability: This is the big one. It's very hard to destroy gold. Easy to lose, but difficult to destroy.
It's pretty: And shiny. I imagine its shine was always more alluring than its yellow color, but that's just my personal bias. Gold has high reflectivity, but silver is even more reflective than gold.

I think these properties offer a good explanation for the beginning of gold's journey through history, but not its true value. Value comes from how we use it. To explain what I mean, let's look at which of the properties were most important to its "on the road" use in distant trade, before we had an international monetary system. I think the facts that it was both portable and recognizable were of the greatest importance. And remember that portability is a circular, self-referential property based on value. So, in essence, I think the fact that it was recognizable anywhere you traveled was probably the singular physical property that led to its highest value use, a value that was imparted on all gold, even that which wasn't "on the road," simply because it potentially could be.


Now let's think about the way gold is used by Giants today, including CBs and governments. It is being used primarily in large bar form, buried and secured out of sight in underground vaults for decades on end. Gold's beauty doesn't factor in at all, since the vast majority is hidden and unseen. It's just lying still and not circulating, so the facts that it is portable, easily recognizable and fungible hardly matter at the moment. Divisibility doesn't matter much, although some of the larger bars are being divided into smaller kilo bars and coins, and malleability only really matters to those who are making gold jewelry for the Indian wedding season. Scarcity is not a big deal since we have literally doubled the above-ground supply in the last 45 years, so I'd say the most relevant physical property today is gold's durability.

Those are just the relevant physical properties though. In antiquity, it was that gold was universally recognizable. And for the Giants of the last few hundred years, it was that gold is durable, because what else matters when all you are going to do is bury it for the long haul?

It is probably true that in recent decades a massive portion of formerly-Western gold disappeared into Eastern "jewellery demand", but don't let that distract you from the point I am trying to make. That large "jewellery demand" is both an artifact of the $IMFS (from what I understand, the gold jewelry was, how shall I put it, smaller(?) 60 years ago), and evidence that "so many people worldwide [still] think of it as [store-of-value] money." My point is that gold's true value comes from its best and highest use, and jewelry is not it. Neither is currency, base money or monetary specie.


Indian gold earring

I have even speculated in the past that, in Freegold, other "lesser" uses for gold will disappear, falling victim to the substitution effect, like jewelry, dental and consumer electronics. It will probably still be used in some industrial electronic applications, but that's only because technology today makes it possible to use gold at the atomic level of thickness where, even at Freegold prices, the cost will be negligible.

Why We Hoard Gold

I was having a discussion with Edwardo a few years ago, maybe he'll remember, about why we hoard gold. It started with me suggesting that we buy and hoard gold due to a kind of recursive regression that's not too unlike a Ponzi scheme, except that this one has lasted for thousands of years and can continue indefinitely. In other words, we buy and hoard gold because of the expectation that other people in the future will buy and hoard gold because of the expectation that other people in their future will buy and hoard gold, and so on, ad infinitum.

Edwardo came back with a clever reply, in perfect Edwardouan style:

"I suspect this line of thought was precisely what informed Bernanke's now (in)famous "tradition" response to the query, "Why do CBs hold gold?" It may be correct for some, but I actually think that, in the main, it is an errant notion.

Let's start with what stands behind the impulse to hoard. There are, by my runes, three reasons for hoarding, mental illness, speculation, and saving for retirement and/or a rainy day. The three reasons are by no means entirely exclusive of one another, but I believe that, generally, only one of the three motives, madness, speculative fervor, or the proverbial "saving for a rainy day" informs anyone's desire to hoard.

The mental illness thesis requires little to no explanation. Nor does the motive of the hoarder who does so with speculation in mind. Let's call him person A., Person A hoards with the devout hope that someone, let's call him person B., will pay more for the item than person A. originally paid for it. The prospective retiree hoards for that time when, for whatever reason, disability, old age, etc. they can no longer support themselves through work. At such times one must have something in the cupboard with which to sustain oneself.

Only the last of the three types of hoarders actually needs to hoard. The compulsive hoarder and the hoarder who does so for profit, don't need to hoard, however passionately they may feel about it.

And while one can certainly quibble about the level of hoarding required by, for example, a retiree, I don't think one can dispute the imperative to hoard. It is a fact of life for many creatures, not just man, that the drive to store key items, food being the most common one, is probably as close to coded into the DNA of animals as something can be. We humans certainly have enough self-awareness to understand that we all diminish past a certain age and that necessitates hoarding.

So, now that we have established that evolutionary forces have likely programmed into us the drive to hoard, one is then tasked with finding those items, or that item, which hoards best. To make a long story less long, gold has its fantastic six thousand year track record because it hoards better than anything else, at least in what passes for the monetary plane broadly defined. Humanity would have stopped hoarding gold a long, long time ago if it wasn't fungible, divisible, portable, malleable, with the right stock to flow profile, etc. etc. If, somehow, mankind had discovered something else (I can't even imagine what that other thing would look like) that exceeded gold's unique profile, well it would now have all the allure of wampum or tally sticks. The only thing that is likely to stop gold from carrying on as it has is if mankind itself doesn't need to save. And that will only happen if mankind ceases to be a going concern, or if the fabled horn of plenty somehow shows up making saving obsolete."

My immediate response was, what about Giants? Where do they fit into those three categories? They buy and hoard gold not because they need to save for retirement or a rainy day (they have enough wealth to last for generations), nor for speculative purposes, and hopefully not due to mental illness. I don't think any of Edwardo's three motives apply to the Giants, from whom, as I have said in the past, I think gold gets its true value today.

Let me repeat, to be perfectly clear. I think that gold gets its value today, its real value, which will be apparent come Freegold, from the way the Giants use it. Not from the way we shrimps use it, or jewelers, or dentists, or the solar cell industry, or the bullion banks, or the financial industry, or India or China, or even the central banks, but the Giants. I'll try to explain what I mean.

Since Another first said, and I quote, caps, punctuation and all, "The PHYSICAL GOLD MARKET HAS BEEN CORNERED!", since he first wrote that in April of 1997, roughly 52,000 tonnes have been dug out of the ground and added to the above-ground supply, and have disappeared into a black hole of demand. Where to? We don't really know.


To put a little perspective on this, the total of all gold bullion coins in existence may be roughly on the order of only 5,000 tonnes or so. With an estimated 189,000 tonnes in existence, that should give you an idea of how much of it is held by shrimps like us, who tend to hold bullion coins. Roughly another 2,200 tonnes is in ETFs, and roughly 33,000 tonnes is held by central banks. That's about the same amount in central banks as when Another started writing, so we can ignore CB demand when wondering where the 52,000 tonnes went.

That 52,000 tonnes of new gold, by the way, doesn't include supply from recycling, which is roughly 35% as much as new mine production on average, and which is therefore enough to account for a good portion of what we see flowing into Asia. So, subtracting what we know is in the central banks (33,000t) from the estimate of all existing gold (189,000t) leaves us with about 156,000 tonnes in private ownership, a full third of which (52,000t) was mined in the last 20 years. That gold went somewhere, and as I said, recycling (which is in addition to the 52,000) is enough to account for most of the eastward flow. We know where 2,200 tonnes went… into the ETFs, which means there's still almost 50,000 tonnes basically unaccounted for since Another first said the physical gold market was cornered. That's roughly 2,500 tonnes per year that someone bought.

Of course, gold demand is different from other commodities in that it's currency-denominated demand. Industrial commodities have weight-denominated demand, because they are used in specific quantities for whatever industry they serve. Understand this point! The demand for industrial commodities like copper is pretty stable in terms of weight. The amount of copper needed by industry is roughly the same by weight, regardless of price. Gold, on the other hand, is simply locked up in underground vaults, so its demand should be pretty stable in currency terms, and in fact, in some senses it is. We see this effect to some degree in the eastward flow of gold. As the price declines, we see more gold by weight flowing east, and vice versa. That's partly because, with a lower price, the same amount of currency buys more gold by weight.

This, however, leaves us with the question of those 2,500 tonnes of new gold per year for the last 20 years that someone bought. For the most part, that was steady by weight, so all things being equal, we should have seen the price of gold decline over the last 20 years as a massive amount of new supply was added. But instead we saw the opposite.

Year
World Production (in metric tons)
Avg. POG/oz. that year
Avg. Cost of all newly-mined Gold that year
1997
2,450
$330.98
$26.0B
1998
2,500
$294.24
$23.6B
1999
2,570
$278.88
$23.0B
2000
2,590
$279.11
$23.2B
2001
2,600
$271.04
$22.6B
2002
2,550
$309.73
$25.4B
2003
2,540
$363.38
$29.6B
2004
2,420
$409.72
$31.8B
2005
2,470
$444.74
$35.3B
2006
2,370
$603.46
$45.9B
2007
2,360
$695.39
$52.7B
2008
2,290
$871.96
$64.1B
2009
2,450
$972.35
$76.5B
2010
2,500
$1,224.53
$98.3B
2011
2,700
$1,571.52
$136.2B
2012
2,864
$1,668.98
$153.5B
2013
3,018
$1,411.23
$137.7B
2014
3,153
$1,266.40
$128.2B
2015
3,226
$1,160.06
$120.2B
2016
3,191
$1,250.74
$128.1B

Here's what the above means to me. There is a hidden level of demand for physical gold which is virtually infinite. This is counterintuitive, because gold demand should be relatively steady in dollar/currency terms. And we can see this expected effect on one level, our level, which is the level of shrimp demand and physical gold market flows. But on another level, as seen above, new physical gold added to the global above-ground supply disappears into a black hole of demand that appears infinite in dollar terms, and steady in weight terms only to the extent that new gold being added to the supply is steady in weight terms.

Please take a moment to let the implications of this sink in.

Again, the table above represents new supply added to the global above-ground total, which doesn’t get used up. It just circulates like poker chips on a poker table, or lies very still in an underground vault. The second column is the new supply each year by weight. So the fourth column represents the seemingly-infinite demand in currency terms, but because supply and demand must meet, consider that fourth column as new supply each year in currency terms.

With this slightly different view, the new supply being added each year, in currency terms, grew 667% (6 2/3rds times larger) from 1999 to its peak in 2012. That's an average new supply increase of 16% per year, compounded for 13 straight years, and with no negative effect on demand. In total, adding up all twenty years in the table above, that's $1.38 trillion that bought up the new supply coming out of the mines, and I'm suggesting that money (actually around 95% of it) did not come from one of the known sources, like industrial demand, jewelers, dentists, the bullion banks, the financial industry, ETFs, India, China, or even the central banks. And that's what I mean when I say that gold gets its value today, its real value, from the way the Giants use it.

It's not out in the open. It's not something you can point to and say there, that's where the 50,000 tonnes went. It's opaque. It's secret. It's hidden from public view and from the Forbes bean counters. I know that some of you will be tempted to dismiss this notion out of hand, but just give it some thought. Look at the WGC annual demand trend reports, and then think about the 52,000 tonnes that have been mined since Another first wrote, "The PHYSICAL GOLD MARKET HAS BEEN CORNERED!", and quietly ask yourself if those reports sufficiently explain where it went. I have given it some thought, and I say they don't.

So, to recap, gold derives its value from its utility, which is the same today as it was in antiquity: tradeable wealth. But because of a few differences between today and antiquity, like longer life spans and an international monetary system to name just two, we do use it a little differently. Back then, we took it on the road, and today we just bury it. And this next part is of course merely academic, but I think gold's key or most important property is different today than it was in antiquity. I think, back then the key property was its recognizability and easy authentication, while today it's simply its near-infinite durability. Other than secure storage, unlike paintings, castles and yachts, gold requires no upkeep or maintenance.

"So, with the Athens, Macedon, Tarentum and Antiochus to name a few, began the worlds first coins. Gold coins? Yes they were, but money as we know it? Our view of how these people viewed and used this gold money is, we believe, far different from what gold scholars teach. And its impact on estimates of existing modern gold supply and use is enormous.

[…]

Walk up to any citizen living during 335BC, in the latest town where Troy once was, show them a “Head of Zeus” (Saracuse 3 stater) coin. Then show him a vessel of oil and ask which he would take in equal trade for anything? Odds are, even though your two items were of equal value, he would take the vessel. Why?

All throughout these early times, prior to BC and into some AD, people didn’t see these gold coins as we think of money today. These various gold coins had tremendous value, but they were just gold pieces. They were wealth for trade like everything else was. That’s simple logic, I know, but the vessel of oil, for instance was just as tradable as a gold coin. In fact, within most of the medium sizes city states of that era, barter of like goods was just as good or better than gold coin. One’s life was better if he owned wealth he used.” – FOA

Money

That picture at the top of this post is 90-year-old Stephen Ivičinec, posing with a good portion of his life's savings of one million, two hundred thousand Yugoslavian dinars. He and his wife, Kate, hoarded them for a rainy day, hidden away for years in cushions and pillows, right there in their home. And then, in 2014, that rainy day finally arrived.

As they sat listening to their son and his wife explain the dire situation they were in, desperate for even enough money for seeds to plant their fields, Stephen looked over at his wife with a smile, and said, "Come now, Kate, bring a cushion and the scissors. See? They have come to the dark days we always feared, but were spared. Now you can finally see that it was good to listen to me and to save, and not spend the money like you wanted."

Stunned and in disbelief, his son and daughter-in-law held their breath as they watched him rip open his favorite cushion and pull out a bunch of the old Yugoslavian dinars. "What's wrong?" Stephen asked. "Not enough? If you need more, we'll just open another cushion! Don't worry, we'll never go hungry. We'll have enough seeds for the rest of our lives!"

Stephen and Kate had no idea that the dinars were now worthless, which was why they didn't understand the stunned look their generous offering brought. Their cash stash had once been worth about $50K (DM 93,000). Of course, Yugoslavia broke up in 1991, and, in ‘92 and ‘93 went through one of the worst bouts of hyperinflation in history, with a peak inflation rate of 313 million percent. Here is the original Croatian article.


Money is essentially the antithesis of wealth. A balance in the monetary plane represents an unsettled imbalance in the physical plane. You've probably seen me write that before.

“I have seen one sure sign that Westerners don’t really know what has happened to their wealth. This is demonstrated when one “bemoans the loss of good times” if gold goes very high. It comes across the same every time; ””“if gold goes to $30,000, we won’t have a dime and everything will fall apart””“. Well, Another made his point that the dollar said your wealth was worth more than it really was. Let me demonstrate.

Like this:

Ever been to a high priced auction. They bring out the “Strad” violin and start bidding at $500,000. After a while it goes for $1 million flat and it’s over. After that we listen to the perceptions around the room.


One guy in the back, who has 10 million cash, thinks the Strad was cheap at one mill and will pick one up next year. In fact he may get ten if they are offered. Some rich woman has 3 million and she figures her wealth is equal to three “violins” if she ever wanted them.

All around the room the feelings are the same, as perhaps 100 million in assets are represented. They all equate their buying power to this one auction. Even though only one walked away with physical, everyone knows they are “strad rich” in wealth. Each goes home for the evening cognac and relishes in this knowledge. Their lifelong effort of hard work and shrewd investing has positioned them to own the wealth of many rare violins. Life is good, very good.

The one problem with all of this is that they based their “wealth holdings” on the outcome of just one auction. Truly, had they all bid, the violin would have gone for much more and their wealth would seem “not so much”.

In much the same way, our world of dollar assets carries the same risk. All of us stand in the same world auction room and watch the daily bidding for goods and services. We watch the prices of cars, gas, houses, clothes, etc. and conclude our wealth balances based on what we could acquire at this auction should we choose to bid. We see our economy in a light of infinite goods and services but fail to balance this with the potential of others to bid, “in mass”. In this light, few have a valid perception of just how many dollar assets are out there. Indeed, without this grasp of “dollar inflation”, we blindly consider our wealth and position in life using the present price structure of “things”. A system in which we trade paper IOUs of infinite number for real things of finite number.

So, our belief that life is good, largely rests not on the confidence in the dollar. Nor is it in the confidence that others will value and accept our dollars. Life is good, because all of us do not “bid” at the same time! If we did, our life would not be as good as our dollar wealth says it is!

This is the deception in our Western grasp of what wealth is. Our life savings are valued at what they can buy today, even though, in reality it is based on an unknown purchase price in the future. Just as all of the wealth at the violin auction was a phantom in self delusion, so too is our present good life and bank account numbers. The evolution of a people that once gripped gold for the real wealth money it was, has proceeded to the hoarding of bookkeeping entries of account credits. History has proven that once humans begin to question the value of this dollar “wealth owed them at a future unknown price”, they run a race to outspend their loved brothers. Buying goods now at the “known” price quickly balances the books so no one is any longer fooled. The currency equivalents remain as a trading medium, even as real things are held in the background for value proof.

No, a high price of gold will not rob us of our wealth. It will rob us of this perception of money value that was but an illusion in the clouds. Wealth for tomorrow is found in this context for today; one cannot lose something they never owned. Buying physical gold at today’s prices will not help you maintain this modern illusion of wealth we never had. But will allow us to later spend the true value of gold that presently exists today. A value few will accept or believe.” – FOA

It's starting to fit together like a puzzle, isn't it?


Money and the monetary plane have their place in our lives, as does wealth. They're just different places. Having wealth means you settled those unsettled imbalances in the monetary plane. But I need to make it clear that such settlement is only necessary at the individual or family level. At the national and international level, it is perfectly appropriate to remain “unsettled” in the monetary plane, as long as it is constantly and gradually making adjustments in the background, passively and subconsciously (i.e., the clean float). The old Bretton Woods gold exchange standard, on the other hand, was active and conscious adjustments, that often went against the natural inclination of a currency and actually made economic imbalances worse.

Free Trade?

"We have got to stop sending jobs overseas.
It's pretty simple: If you're paying $12, $13, $14 an hour
for factory workers and you can move your factory
south of the border, pay a dollar an hour
for labor,… have no health care
—that's the most expensive single element in making a car—
have no environmental controls, no pollution controls
and no retirement, and you don't care
about anything but making money,
there will be a giant sucking sound going south.
...when [Mexico's] jobs come up from a dollar an hour
to six dollars an hour, and ours go down to six dollars an hour,
then it's leveled again. But in the meantime,
you've wrecked the country with these kinds of deals."

-Ross Perot talking about NAFTA in 1992

There has been some discussion lately about what effect possible import tariffs might have on the $IMFS. On the surface, it's pretty simple. Import tariffs make imports less competitive. There is indeed a problematic differential between the competitiveness of local versus foreign production, but overpricing cheap imports will not directly fix the problem. It could, however, fix it indirectly by collapsing the dollar system.

You see, while there are adjustments needed on both sides, the problem is more about us being uncompetitive than about foreign products being too competitive. Imagine that the low price of cheap imports is actually the correct price of those goods in real terms, and that locally produced goods today are incorrectly overpriced due to bloated wage and entitlement expectations, along with excessive bureaucratic meddling.

With this slightly different perspective, you can see that what actually needs to be fixed is that we need to become more competitive, not make them less competitive like us. But there's an underlying level to this problem, and that's the overvalued dollar that brought us here to this place of bloated expectations and excessive bureaucracy. It's because of this underlying level that import tariffs, or maybe even just protectionist rhetoric, may indirectly cause us to become competitive once again.

The basic idea behind the import tariffs is, if we'd only produce more at home of what we consume anyway, well then there'd be higher employment and more people would have money to afford the stuff we're now making domestically, and all these great positive feedback loops would jumpstart themselves, and the economy would roar back to life. Said another way, a lower trade deficit, or even balanced trade, theoretically correlates with higher employment and a stronger economy. The objective is respectable; the problem is the dollar.

We can theoretically have balanced trade without being an island of self-sufficiency. It feels odd including the word "theoretically", but we haven't had balance in so long, it almost seems necessary. Again, this is the basic idea, to head toward balanced trade. The problem is that the 40 straight years of trade deficit need to be settled before we can have balanced trade.

Trump isn't the only one who has called the Chinese currency manipulators. Remember back in 2014? Obama's Treasury told the Chinese to stop buying dollars, stop strengthening the dollar, and let their currency float. That was around the same time that the PBOC Treasury holdings peaked. It was basically the same misguided strategy as today. Obama wanted a weaker dollar to boost exports, and today we're talking about cutting imports through tariffs. Increasing exports and decreasing imports are two sides of the same coin that is trying to decrease the trade deficit in order to cause economic growth. Correlation is all too often mistaken for causation. Anyone remember the caption contest? ;D

Lew: "Did you know it took them hundreds and hundreds
of years to build this wall and they almost bankrupted
the whole country? But by manipulating the exchange rate
it only took a few decades to rebuild the whole country
from its previously medieval infrastructure."
Kerry: "Oooooo0O ! That's it, we gotta make sure we make
them stop that Jack."
(Caption submitted by Aquilus)

We have run a trade deficit every year since 1975, and just like coins have two sides, there's a flipside to a trade deficit too. That flipside is that we've been exporting dollars every year since 1975, net-exporting that is. And as I mentioned above, money is essentially the antithesis of wealth, a balance in the monetary plane represents an unsettled imbalance in the physical plane, and for 40+ years, the rest of the world has accumulated a huge balance of dollars which represents an unsettled imbalance between us and them.

Of course, we can never pay it back. We'd actually have to run a trade surplus for the next 40 years or so to pay it back, and that ain't happening. But there's another way it can (and will) be settled, and that way is dollar hyperinflation.

Remember these quotes from FOA?

"Why promote a digital currency such as the dollar or the Euro? The answer lies with the modern world, it's the only way we can trade globally in an efficient manner. Then we further ask, why promote the Euro over the dollar. Ironically, the very prospect of free world trade, so fought for by the American Administration, is the condition that the IMF/dollar system cannot handle! The debt built up from all of the past, unfree, protectionist old world trade is killing the transition. The policy is to sell free trade and the narrow margins it produces as they shut down entire economies because the low profits cannot service the old debt. Do you follow the logic and the problem? This brilliant, modern free trade system and all of its benefits cannot be implemented using the US dollar as a reserve currency. It shuts off commerce that in turn limits the use of commodities such as oil, metals, food and the like. Many hail the low price inflation in the US as a victory and ignore the intent other nations had in following "free trade". That being to promote a world economy, not just a US economy.

[…]

Some would have you believe that third world people are enriched by saving US treasury bonds, not true! The only way to increase world trade, with an eye on building new consumers in all countries, is to remove the overhang of "dollar settlement".

The US started the free trade movement but quickly backed away when it was realized that the US currency, backed by debt through the fractional reserve system, would suffer severe inflation in the transition. Government guarantees would require the treasury (and Fed) to print unbelievable amounts of new currency to cover the unserviceable debt that Free Trade would create! Now, Europe is going to finish the job using a new currency to supplant "dollar settlement".

[…]

It was understood some time ago that the $US would indeed become "debted out" as digital currencies go. It was the logical conclusion to the world reserve money being removed from the gold exchange standard… We arrive at the final result today, with the dollar so expanded that it is failing the "free trade conversion" the world so craves. Entire countries are economically impaired in an effort to maintain the fictional valuations of "US assets"!

[…]

The strategy to counter this outcome started with the formation of the ECU (European Economic Unit). It was started in the early eighties as a precursor to the now existing EURO. As Another said before, it took at least ten years longer than anyone thought, but it's here. In no small way has this been responsible for the 18 year (gold bear market, as some would call it) upward revaluation of the dollar by the BIS. It was the longest "stop gap measure" I have ever known to exist! A tremendous success by any standard, to keep the dollar stable for such a time. Many think it was "good old American know how" that did it… As it is, this is created through BIS manipulations of foreign exchange (dirty float)… this is not a "New York day trade", but rather a world money transformation… history usually documents that the most earth moving events were obvious, all along, but no one believed them!"
-FOA (3/14/99-3/20/99)

He was basically talking about the same thing I'm talking about here. If the term "free trade" is tripping you up, just replace it with "free float", because exchange rate manipulation (the dirty float) can have the same effect as a tariff. Just like import tariffs make imports less competitive, so does raising your trading partner's currency exchange rate by buying it up.

This is what the rest of the world has done with the dollar for the past 40 years, bought it up, which made US exports uncompetitive, which caused us to run a perpetual trade deficit that whole time. It's what FOA called the longest "stop gap measure" ever, and "a tremendous success by any standard, to keep the dollar stable" for such a long time, thanks to the "upward revaluation of the dollar by the BIS."

As I have said many times, you can substitute "the ECB" for "the BIS" as it was written by A/FOA, because they were referring to the core European central banks whenever they talked about "the BIS." FOA wrote that in 1999, and up to that time, it had been the European central banks (the BIS) who had supported the dollar by buying it up. Then it was China, the PBOC, up through 2013.

This is what my aforementioned 2014 series, Fiat 33, Dirty Float and Global Stagnation, was all about. Fiat 33 was about the exchange rate procedure pre-71. Dirty Float was about 1971 through 2013, and Global Stagnation picked up in 2014. And that's where we are still today, living in the global economic stagnation caused by using the dollar as the global reserve currency (FOA's "dollar settlement"), even as we are entering the "free trade (free float) conversion" that FOA described, "a most earth moving event… a world money transformation" that history will, in the end, document as being "obvious all along."

We could theoretically do as Ross Perot suggested, bring up foreign (Chinese, Mexican, etc.) wages and crash our own lifestyle and expectations down so they match—so that we were suddenly and miraculously competitive once again—but it wouldn't work. It wouldn't work within the $IMFS as it currently stands. And by that, I mean with the dollar exchange rate and dollar financial asset values as they currently stand.

Here's a diagram I made for Global Stagnation to illustrate how our perpetual trade deficit feeds and supports dollar financial asset prices:


Now imagine that we suddenly had Ross Perot's theoretical and miraculous balanced trade. And again, this is what both Obama and Trump want, Obama through a weaker dollar to boost exports, and Trump through import tariffs to cut imports, both in order to decrease the trade deficit based on the belief that it will cause economic growth. To decrease our trade deficit means to decrease our net financial inflow, circled below in red, which is really juicing the stock market right now:


That's your trade deficit that tariffs would cut. Now imagine it just disappeared… POOF:


What do you think that would do to this?


Now, to be fair, I'm not really waiting for import tariffs to hobble the rally. The stock market is looking rather toppy on its own. What I actually expect is a chain reaction, beginning with a dramatic "correction" in the markets, and ending with balanced trade. Would you like a playbook for how it plays out? Here are a few more quotes from FOA that could have been written today:

"Years of deficit spending, over borrowing, debt expansion have created an illusion that the dollar was immune to price inflation. This illusion is evident in our massive trade deficit as it carries on with no negative effects on dollar exchange rates. Clearly other investors, outside the Central Banks were helping in the dollar support process without knowing they were buying into a dying currency system."

- "Other investors, outside the Central Banks" = foreign private sector
- Foreign CBs = foreign public sector = "For. Official" (on the TIC)

From my post, Global Stagnation: "The foreign private sector loves all kinds of US investments, and it buys lots of dollars because of this love affair with Wall Street and the various US markets. This overvalues the dollar and causes the US trade deficit. But the foreign private sector isn't a constant source of dollar support because it acts only from the profit motive. Every once in a while, US markets come down and the foreign private sector flees out of the dollar. That's when the dollar exchange rate declines.

For the past 40+ years, certain foreign CBs have kept their currencies more or less pegged to the dollar. This meant buying dollars whenever the dollar's exchange rate declined. In effect, this acted as a "stop gap measure" for the dollar, and prevented its overvaluation from ever correcting. In effect, this exchange rate pegging with the dollar was the structural support that I write about. The foreign public sector bought dollars not with a profit motive, but for quite opposite reasons which translated into buying dollars whenever the rest of the foreign sector was fleeing from the dollar and its markets. This was structural support."


Back to FOA:

"The only thing that kept this process from showing up in the prices of everyday goods was the support other Central Banks showed for our currency through exchange intervention. As I pointed out in my other writings, this support was convoluted at best and done over 15 to 20 years. Still, it's been done with a purpose all this time. That purpose was to maintain the dollar for world economic trade, without which we would all sink into depression…

The first signs that official dollar support is winding down is seen in real world pricing and official policy. The most obvious "first" price sensitive arena to reflect a "real coming inflation" is not gold as so many think, it's the stock markets… we can see where equity markets are telegraphing a transition into dollar expansion "without world support". … Many stock markets have headed straight up in reflection of this."

Why do you think he would say that a rising stock market "telegraphs" a lack of "world support"? Look at the $500B financial inflow in my diagram above. It shows that it comes from "Investors & CBs". CBs are the foreign public sector (what I think FOA meant by "world support"), and investors are the profit-driven foreign private sector. When the dollar is being supported by the CBs, it is because it is in need of support. And foreign CBs generally don't plow the dollars they buy into the stock market. They tend to buy US debt.

If, however, the dollar exchange rate is rising, then it is probably the foreign private sector that is driving it up, and that's who plows dollars into the stock market. So while a strong dollar simultaneous with a strong stock market obviously doesn't mean official support won't return when needed in the future (obviously, because support did return, in 2001 and again in 2008), it does indicate what FOA said, which is $IMFS expansion "without world (CB) support."

Of course, I argue (in Global Stagnation among other places) that the "dirty float" is now dead, meaning unlike on previous occasions, foreign official support won't step in next time, or if it does, it'll do so too late. For that, we'll have to wait and see.

Back to FOA:

"Prior to EMU the dollar was expanded (thru debt creation) at levels never before thought allowable or possible. But all of that debt creation in conjunction with its demands for that future debt service is spiking the dollar "exchange rate" as Euro financing competes with Dollar financing. In other words, on the world stage converting dollar debt into more favorable Euro debt shrinks the dollar liquidity pie…

Again; it's the dollar that's caught in a vice because its exchange value is rising while its native buying power is somewhat the same. In order to balance the dollar's strength, native goods prices should be falling. By staying the same, its effects on our exchange rate process makes the local price of US goods ever more noncompetitive to sell to world markets

This very dynamic creates a massive demand for Euro priced goods from outside their borders. Left on its own, such a process would expose the dollar structure to the bankrupt / hyper inflated position it has been in for many years. The US trade deficit would grow until the flow of dollars destroys our dollar reserve system."

What he's talking about here is a vicious circle or feedback loop in which the dollar is stuck. In the first line, he's talking about Eurodollars, the lending into existence of credit dollars outside of the US, and the demand that creates for more dollars for future debt service. I'm sure you've all read about the "dollar shortage" which I mentioned at the top of this post. That's what he's talking about.

So, there is this financial (monetary plane) demand for our dollars which is driving up the dollar exchange rate. In a true clean float, a rising exchange rate would translate to an increase in purchasing power, but as FOA notes, our "buying power" is not rising with the exchange rate. That's because the giant sucking sound you hear coming from the rest of the world is demand for our dollars, not our goods.

US goods are uncompetitive, which, in conjunction with the financial demand for dollars, keeps the US trade deficit going. In a true clean float, your exchange rate might rise if your goods were too competitive. The foreign sector would go nuts for your underpriced goods which would bid up your currency until your goods were no longer considered underpriced when the prices were converted to other currencies. The monetary/financial plane should not drive exchange rates in this same way, but for the dollar it does. Think about it.

Imagine you were an island whose only industry was the financial industry, and whose only output was financial products. If that were the case, you would not have your own currency. You would need to import everything in the physical plane, like food, shelter, clothing, energy, transportation, etc., etc., so you would create financial products in someone else's currency who had those necessary goods to trade. If there were a large neighboring currency, or a global reserve currency, you would use that. It would actually be absurd for you to have your own currency.

This hypothetical financial industry island which absurdly uses its own currency is a good analogy for the US today. Not because the US only produces financial products, obviously it doesn't. But because its goods production is uncompetitive while its currency is driven even higher due to financial demand alone, it might as well be a financial products island.

We got here, of course, because the dollar was used globally for many decades, so it wasn't exactly like using our own currency. It was the world's currency, so it was okay in a way that we became "Financial Island" for the dollar. The problem is the vicious circle that created, leaving us with no escape other than currency collapse.

How do you transition from global currency to national currency in this situation, without currency collapse? As a global currency, this debt denominated in your currency but outside of your borders grew out of control, and today its very existence drives up your exchange rate, even as your aggregate goods production is already uncompetitive. You need to get competitive again (both Obama and Trump get this), but you can't until all this debt is either settled or wiped out through currency collapse (this is the part they don't get), and there's no chance it will ever be settled in real terms at today's prices. So you're stuck, or as FOA put it, "it's the dollar that's caught in a vice."

Meanwhile, this flow of dollars circulates round and round, even as it expands, because of course no one holds actual dollars, they hold dollar assets. So this never-ending, ever-expanding, circular flow of dollars keeps coming back into (or passing through) dollar assets, driving interest rates to zero, Wall Street bonuses to the moon, and stock prices up, up and away. Starting to see the problem yet?

Now imagine you suddenly choke that flow of dollars with import tariffs. The reason for import tariffs is to make foreign goods uncompetitive inside the US, so that companies will choose to produce goods here. But even if they do produce the goods here, they will still be uncompetitive out in the rest of the world. So we'll only be producing goods for ourselves, we'll further island-ify ourselves, and the foreign private sector financial demand for dollars will only get worse, because there'll be fewer flowing out to buy imports, and therefore fewer flowing back into dollar assets like the stock market. We'll probably see the dollar exchange rate spike really high at first, even while the stock market bubble is collapsing.

"Once the ball starts rolling, it's good bye dollar overvaluation,,, and hello US hyper inflation. Especially if we want to keep our DOW and financial structure away from bookkeeping failure. Roaring prices for goods, yes, but bookkeeping failure, no! This is how a real inflation plays out!

[…]

Our currency will be lowered to non-reserve status no matter what route we take. Just as in many other historic examples and present examples around the world, nation states always choose hyperinflation when no other way out is offered.

[…]

In our time and for the first time in the modern US dollar history, the US will embark into a classic hyperinflation for the sake of retaining its own lessened dollar for trade use. As destructive as that might be to players in this financial house, it is better than immediate total economic failure. It will evolve in a form much like the course of any other third world country, if its currency too was suddenly deprived of world reserve status. We will, like people the world over, learn to live with it and live in it. Truly, our dollar and economy will not go away, but its function, use and value will change dramatically.

[…]

I know that far too many think the system is healthy enough to go on forever maintaining their lifestyle. It won't. Currency systems come and go with time and our dollar is being phased out. Eventually, as the next reserve system unfolds, our US inflation rate will spike into hyper status. Not because the dollar or our economy is suddenly nonfunctional, but because all the past "inflation tax deficits" that we built up over decades will come due. Then, not only the price of using our fiat system will be exposed,,,,, the price of all the political bailouts and American lifestyle enhancements will come due also. It will require a huge devaluation of the dollar to cover this debt.

[…]

The debts and the dollars would remain; only 90% of their current illusion of value would vanish."
-FOA (3/17/00-7/27/01)

You see, right now, almost literally everyone wants and needs a lower dollar. I already mentioned Obama's call to the Chinese to let the dollar weaken, and just yesterday, the head of President Trump's new National Trade Council called the euro "grossly undervalued", the obvious implication being that we want a weaker dollar. Everyone wants a weaker dollar. It's not just the US economy that’s suffering under the strong dollar right now, it's the whole world. And that's why, when it does start falling, foreign official support will just let it go. Or as FOA put it, "Once the ball starts rolling, it’s good bye dollar overvaluation,,,,, and hello US hyper inflation."

By the way, the National Trade Council is a brand new office created by Donald Trump, which only opened on January 20 when he took office. Its Director is economics professor and Trump's campaign advisor on US trade policy Peter Navarro, who is the one who called the euro "grossly undervalued" yesterday. Navarro also wrote a book called Death by China, which was then made into a documentary, also titled "Death by China", and here it is:



I cannot overstate how remarkable this is. It is a documentary that perfectly encapsulates the current US administration's view on international trade policy, and what they plan to do about it. If you disagree with the views in the film, as many do, or even if you think he uses "dodgy economics," as The Economist does, that's simply beside the point. This is what the Trump administration thinks, it's a good part of what he was elected to "fix", and it is therefore a must-see documentary.

There's a great analogy at the end of the film, by Patrick Mulloy of the US-China Economic and Security Review Commission. He says: "I think the number one thing that the United States has to do is to say, 'we're gonna balance our trade.' Now, people say, 'how do you do that?' Well, when President Kennedy said, 'we're going to the moon,' he didn't have a clue how to get to the moon. But we set it as a national goal, and we figured out how to do it."

That's it right there in a nutshell! When we elected Trump, we elected this policy, these goals, and Trump is to jobs and renegotiating our trade deals as Kennedy was to the moon. Oh we'll get there alright, the only part that might surprise a lot of people, President Trump included, is that 40+ years of debt will be wiped out through currency collapse along the way. But get there we will! ;D


Money and Gold

Up at the top, I said this post was about both money and gold. And I think I kept that promise; I have written about both money and gold in this post so far. Also at the top, I think I made it clear that gold has no place in the monetary system, that gold has little to do with the future monetary system I call "Freegold", and that whenever gold ended up in the monetary systems of the past, that was not the best use of gold. And, I started the post with a quote from Another saying that "gold is not money."

For the most part, I think I have kept the two separated in this post, while including them both, at least that's what I tried to do. I tried to do that as kind of a practical demonstration of something I said around the middle of the post, that both money and wealth have a place in our lives, they're just different places.

To get that, I think you need to understand what I mean when I say that money is the antithesis of wealth. You can convert one into the other, and vice versa, but they aren't the same thing. They are opposites. They're like matter and antimatter.

You might think it makes more sense to say that debt is the antithesis of wealth, but debt is just a negative monetary balance. It exists only in the monetary plane, and can be extinguished or wiped out all within that single plane. The difference, as I said, is that a balance in the monetary plane is an imbalance in the physical plane. You could theoretically obtain the same physical plane items through debt that constitute wealth, so in that way, perhaps you can see how it doesn't make more sense.

The story of Stephen Ivičinec above is a lesson about mistaking money for wealth. Imagine Stephen had a neighbor named Kanye who, rather than stuffing cushions full of money in 1991, ran up a bunch of dinar-denominated debt that same year. Which story is sadder? Both Stephen and Kanye would have had monetary balances, one negative, one positive, both of which would be wiped out by the subsequent hyperinflation. We can certainly look down on Kanye more than Stephen if we want to, but who in this hypothetical scenario was the bigger fool?

I think it was all the talk recently about open letters to Trump, WSJ editorials, Trump advisors, etc., all pitching this idea that a return to some kind of a gold standard should be put on the table, that got me thinking about writing a post to really drive home the error in that kind of thinking… that bringing gold back into the money is not the solution to anything, nor is it even a good idea. I don't view those kinds of pitches as "not quite Freegold, but better than the mainstream financial view." No, they are worse.

If something needs repair, it's the modern concept of wealth, not money. While almost everyone seems to misunderstand the concept of wealth today, it's really only the gold bugs who don't understand money. Modern money is fine. Repair the concept of wealth at the personal level, and everything will be fine.

You know, this reminds me of something from my Trump post:

"Someone on FNC a few days ago, who had worked with Richard Nixon on the Nixon Library during the early 90s, had asked him why he thought the liberals owned the media, and I thought Nixon’s answer was interesting. He said that smart conservatives come out of college and go into business to make money, while smart liberals come out of college and join the media to change the world. It’s that old (but true) stereotype that conservatives tend to better themselves to do well in the world as it is, whereas liberals tend to prefer to change the world rather than work on themselves."

I think the fact that I'm a conservative and that I'm not an activist are more than related, they are one and the same. What does this have to do with money and wealth? Well, changing wealth is something personal, something you do to better yourself. Trying to change money, a concept as old as antiquity, is a fool's errand—the folly of the activist, trying to change the world to fit his own misconceptions of it, rather than looking inward.

This applies at the macro level too. The clean float (Freegold) is passive, subconscious, gradually making adjustments in the background, making active settlement between currency zones unnecessary. This is the key as to why gold is not needed at the macro level. Gold is active, activist, activism, which is needed at the personal (wealth) level.

Regardless of any impression my early posts may have given you about gold being important for settlement at the national level, I want you to understand that anytime a CB/country buys gold to increase its reserves, it manipulates its currency. And while having an initial CB gold reserve is needed, Freegold is the antithesis of countries settling imbalances through gold. Countries correct (not settle) imbalances though floating monetary exchange rates, private entities settle imbalances (monetary balances) by buying wealth (gold, or any other physical-plane item). Having wealth means you settled unsettled imbalances, i.e., monetary plane balances.

We all need money. Money is a good thing, and having an efficient international monetary system is a huge improvement over not having one. Money and the monetary plane have their place in our lives, as does wealth. They're just different places. So beware of anyone pitching a gold standard or trying to fix money.

For more on this subject, you can do what FoNoah did and "RRTFB Trilogy - Fiat 33, Dirty Float, and Global Stagnation" (which, combined, are 3.5 times as long as this post, FYI). If you have a similar result, especially after reading this post, please let me know. :D

And if you would like to join the discussion, you can click here to join the Speakeasy.

Sincerely,
FOFOA


Thursday, May 4, 2017

How Gold is Different


"The present world gold market negates the true value of gold
by removing the “real demand” that “gold settlement” creates!
Break the mechanics of this market and you will find that
gold is the most valuable currency in today’s currency arena.
Many investors, today think that the answer to this dilemma
is for traders to take delivery and cause a short squeeze.
My friend, in this arena, taking delivery means settling in cash!
No, this market will not be destroyed by anyone but itself.

...just as ten people can’t physically possess the same ounce
of gold, nine of them are going to court to make the others
perform what physics will not allow!

...1. the current gold price is mostly a paper contract fabrication
2. it’s easily controlled as long as the “current price setting
system” is functioning 3. this gold price everyone uses, could fall
through the floor if the contract system comes into question
4. physical gold prices could skyrocket in the future as no one
accepts the credibility of any contract for derivative gold.
Effectively destroying the paper equity of gold banking.
Most of the people in the gold industry do not want to hear this.
For them, a break-up of the London gold market would destroy
their financial partners and spike the physical gold price
into uncontrolled levels.

…It seems every Gold bug sees only half the trade
and has great faith that contract law will favor a short squeeze.
Yet, none of them see where it’s the longs that will be dumping
and forcing the discount!"
-FOA

_________

This is a repost from the Speakeasy:

In a recent comment, I wrote:

"...it is one of the key differences between a Freegold understanding and the rest of the gold bug sphere. They all believe that the paper market is ultimately subservient to the physical side..."

I want to explain this in a little more detail.

Commodity markets work like this, hypothetically. You essentially have four parties. You have producers, consumers, middlemen, and speculators. The middlemen operate the physical side, buying from producers and selling to consumers, and they hedge their price risk on the paper side, buying and selling paper claims to and from the speculators who assume the risk.

With this basic setup, supply and demand are always equal on the physical side, because gradual price movements make it so. This is important in commodities. Producers, middlemen and consumers are not in it for the risk of price speculation. Producers and middlemen are in it to make a steady and predictable income, and consumers are in it because they need the commodity, to consume or for some other practical purpose. So speculators are like the shock absorbers that make the ride smooth for everyone else.

To explain what I mean when I say the paper market is (or is not) ultimately subservient to the physical side, let's take a quick look at the mechanics of a "short squeeze".

First, we have a middleman who fills his warehouse with goods purchased in bulk at a wholesale price from the producer, and his plan is to mark them up to a retail price and sell them one at a time to consumers. The difference between the wholesale and retail prices is called his spread, it's the middleman's income, and it's the reason he's doing this. His risk, however, is if the base price of those goods drops while they're filling his warehouse. If that happens, he could go out of business.

So to insure against this risk, the middleman sells paper claims to speculators at the same wholesale price at which he purchased the goods. This is called a hedge, and it transfers the price risk to the speculators. If the price falls, he still makes his expected spread, and if the price rises, he also makes his expected spread and the excess profit goes to the speculators. So by selling these paper claims, the middleman offloads price risk (and reward) to financial speculators.

The number of paper claims in the paper market will equal the amount of goods stored in the middleman's warehouse. If he expands his inventory, he'll also sell more paper, and if he runs down his inventory selling it off to consumers, he'll buy back the paper. He is hedging against the price dropping, so unless he becomes a gambler (like Hannes Tulving), he's always essentially betting on the price falling.

The speculators are the gamblers. They are placing bets on whether the price of the goods in the middleman's warehouse will go up or down. Because the middleman is essentially betting on the price falling, we'd expect to see most of the speculators taking the other side, betting on the price rising. But there are some speculators who will bet with the middleman on the price falling, and those are called the shorts, or the "spec" shorts, to distinguish them from the middlemen who are the "commercial" shorts.

Of course, if there is more money betting on the price falling than on it rising, the price will fall, and that's how the paper market drives the price in the short run. But how do spec shorts sell the same paper claims as the commercial shorts, you ask? Good question. Because they don't have a warehouse of real goods to back newly issued claims, they borrow illusory-goods-on-paper from a spec long and sell more paper claims against them. This creates the effect of extra (synthetic, i.e., not physical) supply, and thereby puts downward pressure on the price.

A short squeeze is when the price rises unexpectedly, catching the spec shorts by surprise. The middleman (commercial) shorts don't care, because they were just hedging actual inventory, so they were going to make the same spread no matter which way the price went. But the spec shorts were just betting, not hedging actual inventory, so they have to take a loss. Long positions have a limited downside and, potentially, an unlimited upside, but shorts have a limited upside and an unlimited downside, so they must cut their losses.

The way spec shorts cut their losses is the same way they book profits, by "covering" their shorts. This means buying back the very paper claims they borrowed and then sold, which can start a feedback loop of buying (rising demand-diminishing supply) which can drive the price up spectacularly. All of a sudden everyone's a buyer, even the shorts!

Supply and Demand

What I just explained was a supply and demand event on the paper side, but the physical side has its own supply and demand dynamics, so now I need to explain briefly how supply and demand works on either side. Very simply, supply and demand should probably be stated as three variables of equilibrium (or disequilibrium), instead of two.

Supply, demand and price are the three variables. If one of the three changes due to exogenous factors, some combination of the other two will change in response. Say demand increases, then either price will rise until demand subsides, or supply will ramp up until it meets demand, or some combination of the two. If price rises due to an exogenous factor, then either demand will decline in response, or supply will ramp up in response, or more likely both will happen simultaneously until supply and demand meet at the exogenously-caused price. (This is a very complex dynamic, so please don't take my reductive explanation too literally. Take it for what it's worth, which is to help you understand, in the context of this post, why gold is different.)

As I said, the short squeeze above was a supply and demand event on the paper side, but what made it an "event" at all was that it caught the shorts by surprise, forcing them to react. And it caught the shorts by surprise because the supply and demand dynamic on the physical side was different than on the paper side, and, except for gold which I'll get to in a moment, the paper market is ultimately subservient to the physical side.

In the short squeeze example above, there was more money betting on the price falling than on it rising, so the price fell, because as I said, the paper market drives the price in the short run. It works basically like this. As I said, the supply of paper provided by the middlemen will be fully backed. In other words, it'll match their physical inventory. So absent short sellers, paper supply would be the same as physical supply, and the long bettors (paper demand) would drive the price up or down and win or lose accordingly.

It would be a simple matter of paper demand trying to guess and match physical demand. In the short run, paper demand would drive the price and be self-fulfilling in terms of winning or losing. If it drove the price up, it would see profits. But if it was insufficient compared to supply at a given price, the price would fall and paper demand would take the loss.

In this hypothetical example with no spec short sellers, paper demand could only potentially levitate the price above where it would be in a physical-only market, it could not suppress it. If paper demand was consistently lower than physical demand, the paper market would cease to exist because the specs would all be perpetual losers. If, on the other hand, paper demand was consistently higher than physical demand, it would become a bubble and would eventually pop as all bubbles do, when the participants, all of whom would be potential winners, tried to lock in their profits by cashing out. The point being that, even in this hypothetical example with no speculative shorts, the paper market is still ultimately subservient to the physical side.

With speculative shorts, as we have in the real world, of course, we have a much more complex dynamic, with a variable supply differential between the paper and physical sides, as well as the potential for the paper side to also suppress the price, at least for the short run. This is because, as I already mentioned, speculative short selling creates a greater supply on the paper side than exists on the physical side, thereby putting downward pressure on the price.

So, with short selling creating this paper supply that surpasses physical supply, the price will have to fall unless paper demand also surpasses physical demand. So while we still have the possibility of levitation and a bubble as in the previous hypothetical, we now seem to have a bias toward the opposite, price suppression. If your head feels like it's spinning, bear with me, because this is where it starts getting interesting.

This apparent bias toward price suppression is simple to see. On the supply side, we have this structural short which is the middlemen, aka the "commercial short", which must be at least matched by a speculative (paper) demand in order for a paper market to even exist. But only a minimal short interest, even a single speculative short, creates this paper supply that surpasses physical supply. I say "apparent" bias, because there are some other factors to consider in the long run.

For one thing, as I mentioned earlier, in order to lock in their profits, the shorts must eventually become buyers. They must buy back, at a lower price, what they sold at a higher price, in order to book a profit, which, if they all did it at the same time, could raise demand enough to eliminate their profit, and in the worst case, if there are too many shorts, could cause massive losses by running up a spectacular spike in price known as the short squeeze.

One of the most dramatic short squeezes in recent history happened in 2008, on the German stock exchange. Basically, Porsche wanted to take over Volkswagen by acquiring 75% of its shares, a key amount. At the beginning of 2008, Porsche owned 31% of Volkswagen, and the German state of Lower Saxony owned 20%. From March through October, Porsche secretly acquired another 43%, and on Oct. 26, 2008, announced that it owned a total of 74%, and intended to make it 75% and take over the company.


The problem was, Volkswagen had a short interest of 13%. In other words, 13% of the shares were out on loan to short sellers, and the simple math caused a short squeeze which spiked its price from $200 to over $1,000 in two days, making Volkswagen the most valuable company in the world, if only for a day.

Neither Porsche nor Lower Saxony was about to sell any of its shares, for fear of losing control of its stake, and the math was clear. 74%+20%+13%(short interest)=107%, and on top of that, the 6% not held by either Porsche or Lower Saxony was in index funds, which could not legally sell. This was right at the height of the global financial crisis, and a lot of big money was shorting the markets. Volkswagen itself had plunged 50% in October alone. But, again, to lock in a profit, the shorts had to buy back their borrowed shares, and with Porsche's announcement, it was clear that there were no more shares for sale, and so it was off to the races.


The shorts lost "tens of billions" that day. One of them was a German billionaire named Adolf Merckle. According to Forbes, he was worth $12.8B in 2007, but on January 5, 2009, he committed suicide by train. Those who knew him said it wasn't because of the short squeeze, since he only lost about half a billion on Volkswagen, and would have still been worth some $6B, but it probably played at least a part in his decision to jump in front of a train.

Of course Volkswagen is not a commodity, but the point is that the "paper market" with its fake supply of borrowed shares was ultimately subservient to the "physical side" of actual shares. And of course the price spike didn't last long, as short squeezes tend not to. In the end, Porsche made 5% of the stock available to desperate short sellers, but for them, the damage was already done.

One could say that Porsche caused the short squeeze, whether intentionally or not. In fact, you can probably imagine a bunch of activist longs in one commodity or another trying to cause a short squeeze (and, say, crash JP Morgan, for example), either by buying physical or buying paper and taking delivery, even while the price is dropping, simply to diminish the supply in hopes that the price will go up turbo charged the next time it goes up. In the case of Volkswagen, Porsche enormously diminished the supply of shares without the market being fully aware of what they were doing, and once their actual off-take became known, the price went up turbo charged.

A massive short squeeze is what most of the gold bug sphere expects in the end, because they believe the price of gold is suppressed by the synthetic (paper) supply created by the shorts. In fact, they are so close to the truth, it's really a shame they can't see it. And because they can't see it, they imagine the price of gold as it is today—the paper price—is what will go up turbo charged (and stay up). And if that's what you believe, then it is perfectly reasonable to buy silver, mining shares, paper gold and so on, to gain a little extra leverage on the move.

The problem is, they understand everything in this post above this line, but they don't understand how gold is different. They are correct that the price of gold is suppressed by synthetic supply. They are also correct that the tightening of physical reserves will ultimately result in a dramatic jump in the price of gold, and that (unlike other commodity price spikes) it will stay up. What they are wrong about is that it won't be the price of gold as it is today—the paper price—that will go up in a turbo charged bull market run, and that the rest of those things that are leveraged to the price of gold as it is today won't go along for the ride.

They are so close, yet so far away. There are even some who will, on the surface, acknowledge the physical-gold-only line, but who don't understand why, and so they personally have a large percentage of their holdings in things like silver, GLD and mining shares. Believe me. I know a few.

So now I'm going to once and for all (hopefully) explain how gold is different.

As I explained above, in our hypothetical commodity market, we have this "structural" short position put out by the middlemen, which is at least equaled by a contingent of speculative longs in order for a paper market to even exist. Then comes the spec shorts who must borrow on paper in order to place their bets, which expands the effective paper supply.

Now, the ratio of spec shorts to paper claims outstanding (what I'm calling "structural" shorts) is known as the "short interest". In the real world, if the short interest is too high, the price is thought to be too low. So, contrary to the apparent bias I mentioned above, a short squeeze price spike is expected to be more likely when the short interest is higher than when it is lower. So how high is high?

Well, in the case of Volkswagen, the short interest was 13%. I'm no expert, but from what I've found in my research, 13% is verging on high. Investopedia implies that around 3% is normal, 25% is high, and a 40% short interest makes a company very vulnerable. I found this site called shortsqueeze.com where you can check a stock's short interest. Here is GLD's:

http://shortsqueeze.com/?symbol=GLD


It says the short interest in GLD is 8,853,600 shares. Total shares of GLD right now are 270.7 million, so the short interest is about 3.3%. Pretty normal.

Another metric is the "short interest ratio", which is the short interest as a percentage of the average daily trading volume. This is important because, during a short squeeze, the shorts are all trying to cover (buy) at once, so the short interest ratio is often stated as "days to cover". In GLD, the average daily trading volume is 6,362,100 shares, and the short interest is 8,853,600 shares, so the "days to cover" is 1.4 (8,853,600/6,362,100=1.4). (BTW, I'm only using GLD as a convenient (and perhaps ironic) example of anything and everything except gold. I could have used SLV which has a "days to cover" of 1.6, or even Google (1.9) or Facebook (1.3). Try it yourself!)

My point here is to give you an idea of the range of normal to very high in short interest for everything except gold. Under 5% is normal, and 40% is very high, and in days to cover, somewhere between 1 and 2 appears to be pretty normal. So what if I told you that the effective equivalent of short interest in gold is probably somewhere between 200% and 20,000%, depending on how you choose to figure it, and that gold's equivalent of "days to cover" is effectively infinite, or at least it would be better stated as "decades to cover"?

While I'm at it, I should also mention that back when gold was base money, all credit and all other forms of currency, like paper money, were the effective equivalent of short interest in gold, and so it was much higher than it is today. In fact, whatever it is today (one can only guess) is probably an historic low, when taking all of history into account.

I make these fantastic statements and give you incredible numbers not to establish some technical comparison between gold and everything else, but to make the point that there is no technical comparison between gold and anything else. It makes no difference if the short interest in gold is 100% or 100,000%, because it is so far past the tipping point for anything else that it is irrelevant. There is no technical comparison between gold and anything else, including silver, even including fiat currencies. Gold is quite literally unique, and quite simply different.

If you can set aside the notion of trying to make technical comparisons, even if only temporarily while reading this post, then I can start to explain how gold is different.

Put yourself back in time, back when gold was base money, circulating coin, and monetary reserves. Now picture the banks as the gold middlemen, and the bank vaults as their warehouses of gold. Money was gold. That's not to say all money was pieces of gold, but money, which is mostly credit, was denominated in weights of gold. So it is fair to say that, while all gold was money, not all money was gold, and gold was only a small subset of money.

I know that gold bugs like to say "gold is the real money, and all else is credit," roughly paraphrasing JP Morgan once upon a time. But FOA proved, beyond a shadow of a doubt in my mind, that money of the mind, an association of values held in our heads, and therefore credit, was the pure concept of money as it grew out of antiquity, and that gold was something different. Gold was tradable wealth, while money was just a useful concept, and trying to combine the two turned out not to be the best use of gold. Please see Moneyness and Moneyness 2: Money is Credit for more on this subject.

I'm sure that most of you are familiar with the parable of the Goldsmith, but here it is again:



I called it a parable because it's not totally true. While it does a good job illustrating the concepts of credit money and fractional reserve banking for the purpose of this post, it is way too simplistic in the way it characterizes them as a duplicitous scheme. The pure concept of money has always been, basically, credit. Gold, the most tradable wealth item, ended up as the reserve in fractional reserve banking, which, as I said, was not the best use of gold. But I'll get more into that concept in a future post. For now, I just want you to picture the banker as the middleman, the bank vault as his warehouse, and all forms of money and credit as the short interest on gold.

Over centuries, banks became quite adept at the business of gold, and London emerged as the global center of that business. Then, in 1971, the last vestige of a gold standard monetary system ended, but not the business of gold, nor the banks in London that ran it. Those same banks continued on as the gold middlemen of the world, the same vaults as the warehouses, and over the next twenty to thirty years, they evolved into the gold market as we know it today.

What was once just known as banking, when money was denominated in a weight of gold, became known as bullion banking. As I have written in many posts, modern bullion banking is simply a carryover from regular London commercial banking during the gold standard. And to understand bullion banking, and to thereby understand the modern gold market in which the price of "gold" is derived, you must understand regular commercial banking, because they work basically the same.

Ari was the one who helped me understand how bullion banking is simply banking, but using bullion as its base/denomination instead of dollars. The following is an email exchange we had on the subject back in January of 2011. I hope it helps drive this home for you the way it did for me, because this simple concept really is the key to understanding how gold is different from everything else. I have posted pieces of this before, but I think this is the first time I've ever shared the whole thing with anyone:

Me: > > I must admit I am struggling a bit with how I want to
> > present the Bullion Banks in my piece. Seems to me that
> > understanding that gold is still treated as a fractionally
> > reserved currency by a portion of the banking industry is
> > key to understanding the "free" in "Freegold."

Ari: Yes, it has long been my impression, too, that the key to helping people understand/embrace the freegold paradigm is to help them see how gold is fractionalized in the old variations of conventional gold standard banking and in the modern extension of the same old same old (and which we now refer to almost quaintly/unnecessarily as "bullion banking" as if it were as uniquely apart from commercial banking as is a "blood bank" or "sperm bank". To be sure, we haven't taken similar pains to differentiate dollar banking from yen banking, so to suggest a distinction for bullion banking is almost a disservice to the truth -- frankly, that it's all just variation on the same banking principles and practices.)

Me: > > Paper markets, schmaper markets, it's all about gold
> > being a fractional reserve in banks. It's much less important
> > that the investing public believes gold is a commodity. Those
> > that really matter know it's not. And the paper markets and
> > the public misunderstanding of gold simply help the banks
> > manage their fractional reserves to keep everyone happy.
> > Would you agree with this?

Ari: Yes! In fact, I wrote my above paragraph prior to reading onward.

Me: > > This is what gold will be freed from: the fractional
> > reserve banking practice, which is a carryover from the gold
> > standard years.

Ari: Yes yes yes! (But delivered not quite with Meg Ryan's degree of zeal in the cafe scene with Billy Crystal -- "When Harry Met Sally".)

Now I'll move on to your older e-mail...

Before addressing the specifics of your questions, a little background may prove helpful -- at a minimum it will ensure that we are continuing our discourse in the dear context of a shared frame of reference. It is here that I offer the eurodollar market as a very good parallel to the bullion sector of banking. While not a perfect parallel (for all the most obvious reasons) it provides a remarkably good bridge to help anyone who has a good footing on modern commercial banking to successfully cross over to that seemingly unfamiliar territory of "bullion banking". In fact, they need do little more to successfully cross over than to simply think of bullion banking ops as though they were eurodollar banking ops -- the difference being that whereas eurodollar banking makes extra-sovereign use of the U.S. dollar as its accounting basis in international banking activities (thus outflanking New York's purview and restrictions), bullion banking engages in similar "extra-sovereign" use of gold ounces within its operational/accounting basis (thus outflanking and overrunning Mother Earth's domain and tangible restrictions).

And just to be sure we're on the same page, the eurodollar is not to be in any way confused with the euro, but rather stands to mean the artificial supply of "U.S. dollars" that "exist" as accounting units in off-shore banks, having originally been authentic deposits of New York's finest export, but which were then subsequently lent on -- fractionalized and derivatized into a vast amorphous mass as only a network of cooperating banks can do best.

Me: > > Let's say a bullion bank that is not the administrator of a
> > gold ETF has 10 million ounces of unallocated gold. I was
> > trying to think of what would be the incentive that bank has
> > to participate in the Trust. And what I came up with was that
> > the bank allocates this gold to the ETF Trust in exchange for
> > shares that it sells into the market for dollars which it then
> > uses to churn an ROI (since its former gold lending operations
> > are now dead thanks to rising gold price and the end of CB
> > backing for fractional reserve gold lending thanks to the
> > CBGA). Is this correct?

Ari: Exactly right. As mutually reinforcing factors of rising prices and termination of mine company hedging and waning carry trade activities in the wake of the 1999 CBGA left bullion banks with their full store of unallocated gold deposits but a shrinking base of usual customers for their gold lending services, the ETF mechanism provided the ideal means to relatively safely put these deposits back into play -- delivering them into allocated account with the ETF in exchange for shares that can be lent or sold in any combination for cash that can subsequently chase other pet schemes.

Me: > > And then, as the BB gets redemption notices from its gold
> > depositors (or allocation requests as the case may be) it must
> > then buy back those ETF shares from the marketplace before
> > withdrawing gold from the trust. Is this correct?

Ari: That's right, except for the term "must". Upon getting requests from its own assortment of unallocated depositors for either outright withdrawal or more simply for transfer into allocated accounts, the BB has options. Yes, it can seek to acquire (through borrowing or purchase) the requisite ETF shares for redemption of a standard basket in its special capacity as an Authorized Participant of the Fund, or it can pursue alternate avenues such as buying gold on the open market or better still, borrowing it from either its own unallocated pool of deposits (if still available in adequate in size) or turning to other members in the fraternity to borrow the adequate quantity to cover the immediate needs. Whatever combo is deemed most efficient or cost-effective is what the bank will do.

Me: > > Back to that 10 million ounces of unallocated gold; Do
> > you think the bank has gold liabilities in great excess of this
> > gold, to depositors that actually deposited physical? I'm not
> > talking about "claimants" that may have bought paper claims
> > from the bank for gold, but actual depositors of physical. In
> > other words, I'm wondering how deep these BBs are into this
> > game. It's one thing if you bought paper gold only to find out
> > later that paper gold wasn't the same thing as physical. But
> > it's something entirely different if you put your family's
> > precious nest egg in the bank only to find out it was sold to
> > someone else by the bank.

Ari: A bank can be "populated" with unallocated gold accounts in two primary ways. It can either be done as a physical deposit by a silly person or by another corporate entity, or else it can occur completely in the non-physical realm as a cashflow event whereby a customer with a surplus account of forex calls up and requests to exchange some or all of it for gold, whereupon the bank acts as a broker/dealer to cover the deal -- occurring and residing on the books as an accounting event among counterparties rather than as any sort of physical purchase. No bread, no breadcrumbs, only a paper trail and metal of the mind. This is how the LBMA can report its mere subset of clearing volumes averaging in the neighborhood of 20 million ounces PER DAY. Just a whole lot of "unallocated gold" digital activity as an ongoing counterparty-squaring exercise. [Me: It needs to be noted here that Ari's comment was on 1/19/11, so it was during 2011Q1, the subject period of the LBMA survey which wasn't released until seven months later. As it turned out, the average clearing volume for Q1 was actually 18.8 million ounces per day, so Ari's "in the neighborhood of 20 million ounces PER DAY" was correct, but what the survey revealed which had never been published before was the turnover volume that 18.8 million ounces cleared. And that turnover for 2011Q1 was actually 173.7 million ounces PER DAY.]

Me: > > I could see the system defaulting on paper sales but at
> > least trying to make good on physical deposits. But am I
> > being too optimistic here?

Ari: Does the person who established his unallocated account with a physical gold payment rank any higher in the pecking order than the earlier or later fellow who established his similarly sized unallocated position at the same bank with a cash payment? And in this light now you see your original optimism fly out the window. Whereas an Allocated account sets you more securely above the fray, an UNallocated account puts you in the same large sea of unsecured creditors bobbing in the wake of any Titanic failure.

It was also Ari who helped me come up with a way to explain commercial banking through a simple balance sheet exercise, which I used in Peak Exorbitant Privilege. Remember, in order to understand how gold is different, you need to understand today's gold market, and to understand today's gold market (which is ~90% LBMA), you need to understand bullion banking, and to understand bullion banking, you need to understand basic balance sheet commercial banking. Here's a short excerpt from that post, just to refresh your memory:

"Now let's say that one of our depositors at COMMBANK5 withdrew his deposit in cash. And let's also say that another depositor at the same bank spent his money and his deposit was therefore transferred to COMMBANK4 and that transaction cleared. Here's what it would look like:

COMMBANK1
AAACC|DDDDD

COMMBANK2
AAACC|DDDDD

COMMBANK3
AAACC|DDDDD

COMMBANK4
AAACCC|DDDDDD

COMMBANK5
AAA|DDD
________________________________________
CB
AAAAAAAAAR|CCCCCCCCCC


A few quick observations. There are now only 9 Cs in the commercial banking system even though there are still 10 Cs outstanding on the CB's balance sheet. That's because one of them is now outside of the banking system as cash in the wallet.

Also, notice that… COMMBANK5 is now out of reserves.

In this little scenario, COMMBANK4 is now extra-capable of expanding its balance sheet, while COMMBANK5 needs to forget about expanding and try to find some reserves. To obtain reserves, COMMBANK5 can call in a loan, sell an asset for cash, borrow cash temporarily while posting an asset as collateral, or simply hope that some deposits come his way very soon. But in any case, COMMBANK5's next action is, to some extent, influenced by its lack of reserve."

As we translate this exercise into bullion banking, there are a few differences we need to note. I think the most significant and obvious one is that, in bullion banking, there is no lender of last resort, no central bank that can print new cash reserves on demand. Another difference is that, while COMMBANK5 with only assets and no cash reserves in the example above is an outlier, only THREE (3!) out of the LBMA's dozens and dozens of bullion banks, 13 of which are the LBMA's main market makers, only 3 are LBMA physical gold custodians. And in the LBMA, physical gold is the equivalent of the cash (C) reserves in the example above.

So if I were to do a similar exercise for, say, the 13 LBMA market makers, 10 of them would have only A's on the asset side. Their "reserves" would actually be liabilities of the three custodians. Those "reserves" could, of course, be allocated or unallocated, but for clearing purposes, it makes sense that most if not all of them are unallocated (which of course implies that even the LBMA's "reserves" are fractionally reserved!). Also, I would change the C's (standing for "cash" reserves) to G's (standing for physical "gold"), and I would change the D's (standing for "deposits") to L's (standing for "liabilities"). The number of L's in excess of the number of G's would be the effective equivalent of short interest in gold. It might look something like this:

The 13 LBMA Market Making Bullion Banks
Assets|Liabilities

HSBC
(Custodian)
AAAAAAAAGGGG|L L L L L L L L L L

ICBC Standard Bank
(Custodian)
AAAAAAAAGGG|L L L L L L L L L L

JP Morgan Chase
(Custodian)
AAAAAAAAGGG|L L L L L L L L L L

Citibank
(Non-custodian)
AAAAAAAAAAA|L L L L L L L L L L

Goldman Sachs
(Non-custodian)
AAAAAAAAAAAAA|L L L L L L L L L L L L

UBS
(Non-custodian)
AAAAAAAAAAAA|L L L L L L L L L L L

Bank of Nova Scotia -ScotiaMocatta
(Non-custodian)
AAAAAAAAAA|L L L L L L L L L

BNP Paribas SA
(Non-custodian)
AAAAAAAAAAA|L L L L L L L L L L

Merrill Lynch International
(Non-custodian)
AAAAAAAAAAAAA|L L L L L L L L L L L L

Morgan Stanley & Co International Plc
(Non-custodian)
AAAAAAAAAAAAA|L L L L L L L L L L L L

Societe Generale
(Non-custodian)
AAAAAAAAAAA|L L L L L L L L L L

Standard Chartered Bank
(Non-custodian)
AAAAAAAAA|L L L L L L L L

Toronto-Dominion Bank
(Non-custodian)
AAAAAAAAAA|L L L L L L L L L



In the above example, the effective short interest is 1330% (ratio of synthetic to real supply of 133:10), which is completely meaningless. It's not even a guess; it's only an example of how it works. But let me give you some real numbers with real meaning. Today the LBMA has 81 "Full Members". Back in 2011, it had 56 "Full Members", of which 36 responded to the LBMA Gold Turnover Survey for Q1 2011. What those 36 LBMA members (65% of the membership) reported was a daily turnover of $240.8B.


That number is useful in a couple of ways. It is useful in comparison to the clearing volume during the same period, because we have average daily clearing volumes for each month going back to October of 1996, and it is useful in comparing to other markets, because the survey methodology is basically the same. Here I'm going to cut to the chase, because $240.8B compares to only one market in the world, which happens to also be the largest market by volume in the world, and that is the FOREX or foreign exchange currency market.

For comparison to other markets, here are some of the most active stocks by volume right now, like Apple, Facebook and Microsoft:


If you add up the daily volume and prices of all of those top five stocks and multiply them, it totals to only 15% ($37B) of the daily volume in gold as reported by 36 LBMA members. For further comparison, the average daily trading volume in GLD shares is less than $1B, for COMEX, the average is around $21B per day, and on the Shanghai Gold Exchange (SGE) it's $4.2B per day (calculated from the SGE's own Daily Volume Report for 1/16/17, adding up all AU categories, and converting yuan to dollars). That puts SGE daily volume at about 1.7% of the LBMA by comparison (note that the LBMA's daily clearing volume is roughly the same right now as it was in Q1 2011, both by weight and value, so it's fair to also assume similar daily turnover). In fact, if we add up the daily volumes in gold from these four markets, which are indeed the four largest gold markets (SGE, COMEX, GLD and LBMA, I'll even throw in another $4B for TOCOM and MCX combined), it comes to about $271B per day, which makes the LBMA roughly 89% of the gold market, and remember, only 65% of the LBMA membership participated in that survey. So that's where I got my ~90% number above.

"At Royal Bank of Canada [which is an LBMA Full Member
and a GLD Authorized Participant], we trade gold bullion
off our foreign exchange desks rather than our commodity desks,"
says Anthony S. Fell, chairman of RBC Capital Markets,
"because that’s what it is – a global currency."
(Source)

Gold as a FOREX Currency

As I already stated above, there's only one market that compares to the turnover volume reported by the LBMA, and therefore only one plausible explanation for those numbers. And that explanation was clear even back in 1997 when the LBMA first began releasing its clearing statistics. These are from The Red Baron series in 1997:


And that was based on only the clearing volumes the LBMA had just begun reporting in January of 1997. Comparing the turnover reported in 2011 to mine supply in 2011, instead of 100 times, you'd have to say more than 500 times the annual world's gold production rate is traded annually at the LBMA. Or if you included scrap recycling in the production numbers you'd say more than 300 times, just FYI.


Again, that was 1997, and they were only looking at the LBMA's average daily clearing numbers, which as we now know are only about 10.8% of the total loco London daily turnover. So you can multiply them by 9.25 to get a rough idea of turnover, and you can find all the average daily clearing numbers from 1996-2016 here.

Oh, and the FOREX market which was a $1.2T market in 1997, today is a $5.1 trillion per day market according to the BIS's Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2016. This would make the LBMA's $240.8B per day equal to roughly 5% of the market, smaller than the volume of trading in the euro, pound or yen, about equal to the Aussie dollar, but more than the volume of the Canadian dollar, the Chinese yuan, and the Swiss franc.


Back in October of 2013, another gold writer was emailing with me, and in one of his emails he asked me to explain this concept. He wrote, "The area where I’m still hazy is the gold as a FOREX currency," and my reply turned into my post titled, Gold as a FOREX Currency. Following that post, he decided to email the LBMA and ask them straight out if the 2011 survey included gold trading as a FOREX currency. He wrote, "I emailed LBMA this morning asking for some more info on what actually constitutes the large spot trading volume (as it couldn’t possibly be physical) so I’ll let you know whether they come back with anything useful." Here was his actual email to the LBMA:

Sent: Friday, 18 October 2013
To: mail@lbma.org.uk
Subject: Some information please

Hi there,
I am conducting some research into the gold market.

I am trying to gain a little more understanding about LMBA turnover.

According to your 2011 survey, average daily trading volume in the London market in this period was 5,400 tonnes, equivalent to US$240.8 billion at the time.

Given that most of this is ‘spot’ gold trading (and its understated given the lack of full responses from members) and it’s clearly not that much physical changing hands/ownership (more than annual scrap and mine supply trading per day would be impossible, despite the large outstanding stock of gold) can you provide some information as to what accounts for this huge level of trade?

The only thing I can come up with is that it’s related to currency trading. As you probably know, you can trade gold on a computer screen in the same way you can trade global currencies. Its currency code is XAU. I’d imagine XAU/USD long or short is a pretty popular pair trade. Is it this ‘gold as a FX currency' trade that accounts for the huge amount of daily spot volume?

Would gold as FX trade be reported to you as part of the survey?

Any info you could provide to clear this up would be much appreciated.

Cheers,

It took more than five months of pestering the LBMA to get an answer. The email was passed around the office, and ended up with LBMA Public Relations Officer, Aelred Connelly, who wrote in January that he'd have to do some research in order to answer the question:

From: Aelred Connelly
Sent: Thursday, 30 January 2014 1:32 AM
To: XXXX
Cc: LBMA Mail
Subject: RE: Some information please

Dear Mr. XXXX,

I refer to your questions below which have been passed to me. First of all, I would like to take the opportunity to apologise for the delay in our response.

This was a one-off survey which was conducted before I joined the LBMA with 36 of the 56 full members involved in gold trading. As I was not directly involved in the survey I will need to some research to find answers to your questions. I will come back to you as soon as I can with a response.

Kind regards,
Aelred



A bit more pestering, and he finally came back with an answer in March:

From: Aelred Connelly
Sent: Monday, 24 March 2014
To: XXXX
Cc: LBMA Mail
Subject: RE: Some information please

Hi XXXX

Apologies for the delay, but I thought that my colleague had already responded to your questions. The Survey included all forms of gold trading so certainly included gold currency trading which would have contributed to the significant numbers that came out of the Survey. We are in the process of discussing with market participants running more regular surveys. I will keep you posted on developments. I am not sure if you have seen the article that accompanied the results of the 2011 Survey, see below. Once again apologies for the delay in responding to your questions.

http://www.lbma.org.uk/assets/Loco_London_Liquidity_Surveyrv.pdf

Kind regards,
Aelred

Of course, I didn't personally need official confirmation for something that was so obvious, but it is interesting nonetheless. This does, however, raise a puzzling question. What was not so obvious was what assets the bullion banks could possibly be using to balance their books against a trading volume that was clearly much larger than the physical side of the gold market.

LBMA BULLION BANKS
Assets|Liabilities
????????????????????AAAAAAGG | L L L L L L L L L L L L L L L L L L L L L

Not surprisingly, the answer came to me from FOREX Trader, who, just in case you were wondering, actually is a large scale professional FOREX trader. He explained that they are synthetic gold assets, complex derivatives based on other commodities and currencies that tend to have a price correlation with gold, probably in combination with OTC gold options as well. The price correlations are never exact, but over long periods of time they can be relatively stable and predictable, so using complex math, derivatives with a delta of 1, meaning a 1 to 1 price correlation with gold, can be created. Or they can get close to 1.00 and make up the difference with OTC gold options.

He wrote:

"Hi FOFOA,

Re correlated assets:

All the big IBs [Investment Banks] have delta-1 desks. Do you remember the UBS trader that blew up and was big in the news last year? He worked the UBS delta-1 desk.

What is delta-1 trading? It's exactly what's described:

"The only answer I can think of is that they hedge it by going long correlated (but not identical) assets. What's correlated with paper gold? Silver, copper, euros, crude oil, interest rates, yield curve spreads, whatever."

The job of the trader is to use quantitative methods to build a synthetic instrument with a delta as close as possible to the desired underlying.

I made a quick delta-0.7 using some regression and eyeballing, with AUDUSD+(0.5*CADUSD)+(0.2*10YNotePrice) providing a good starting 'kernel'. Good enough that you could make up the other 0.3 deltas dynamically in the OTC/FOREX gold options market. Obviously any quants who want can build their own synthetic too. If they have access to OTC markets, it will be very very simple. Obviously the goal would be to 'long' this synthetic, to hedge the underlying short, to reduce deltas to 0 or near 0…

If you are long/short the underlying and don't want the directional risk you can hedge your deltas relatively cheaply by trading around your position using options. If you are a big player in the market, you can actually make money doing this, using the options to get better prices for your underlying position that the market wouldn't be able to otherwise cope with."

I need to include a disclaimer here that we don't know for a fact that this is precisely what all of the bullion banks are doing all of the time to balance their books. But it is the best explanation I have encountered, and it opens up a world of possibilities and combinations of possibilities outside the physical gold market, which is necessary to plausibly explain such overwhelmingly large volumes.


What I can tell you, is that this topic was under debate for a year and a half, from June of 2012 when I first posted FOREX Trader's email above, until November of 2013 when Bron and I agreed to disagree on the subject. Most of what was considered debatable is now considered settled. For example, some argued that "delta-one" was as narrow a field as some of the news articles made it seem.

For example, Bron argued that "Delta One desks are no more than speculative trading, gambling," based on a Reuters article about rogue trading at the UBS Delta One desk. And Texan argued that "Delta one is equity derivatives, primarily equity repo. They do not touch commodities," based on the Delta One Wikipedia page.

As it turns out, however, "delta-one" is not as narrow a field as that. As Izabella Kaminska wrote here (linked through web archive because otherwise a subscription is required):

"Ask someone from outside the industry to define Delta one, and you’ll struggle to get a cohesive answer. Ask the industry to define it, meanwhile, and you’ll get a multiple of different explanations. And that’s because Delta one means different things to different people. Every financial institution seems deeply involved — all the usual big-name suspects, and many smaller names you might not have heard of too."

And as to whether Delta One is only equities, here's the answer to that:

"Delta One desks at banks can cover a range of asset classes – everything from currencies to equities and commodities."

And, of course, in 2014, the LBMA itself confirmed that the 2011 survey "certainly included gold currency trading which would have contributed to the significant numbers that came out of the Survey," putting to bed once and for all any notion that the volume could be explained by the physical gold wholesale market. As if that wasn't obvious from the moment the survey was released. Yet some gold analysts today still apparently think that way.

Of course none of these large trading volume numbers, in the range of $271B per day for "gold", include your and my small shrimp purchases and sales, nor do they even attempt to aggregate them. And neither do they count the millions of small trades made by small FOREX traders every day around the world. We can tell by the number and size of the (quote-unquote) "trades" that were counted.

In the case of the LBMA survey, the $240.8B per day in turnover came from 6,125 individual trades per day. So we can simply divide $240.8B by 6,125, and we see that the average trade reported was $39 million. That's $39 million per trade, and an average of 170 of these $39M-trades reported by each of the 36 reporting LBMA members, every day.

So these trades were likely the net result of many smaller trades, by clients of clients of clients of the banks. I don't know this, but I think it makes sense. Who, other than the LBMA, could make 6,125 different trades each day, each one averaging $39M? And this is "gold" (in quotes) they're trading. So the average trade was the equivalent of 28,361 ounces, or 9/10ths of a tonne. 6,125 of those trades each day, representing (6,125x28361=) 173.7 million ounces, or 5,400 tonnes… per day. I really don't think I can overstate this. As big as that number is, I think it makes sense that it's actually net of a much larger number. It's called tiered settlement, or settlement hierarchy, if you want to look it up. But that's beside the point here, because like I said above, even with just the numbers we have, we are so far beyond comparison to other markets that, whether the volume was halved or two orders of magnitude larger is irrelevant.

Now that I've hopefully established in your minds the sheer magnitude of the paper side of the gold market, I want you to understand that this is the effective equivalent of short interest in physical gold:


This is what I was talking about in my comment to Aaron the other day:

"As FOFOA once said, GLD is just a huge short position on physical gold."

Hello Aaron,

Actually, that's not what I said, and I never would say that. What I said is that bullion banking, the LBMA's massive (5,400 "tonne" per day/$240 billion per day turnover, according to its own 2011 survey) system of spot unallocated credit gold, is essentially a huge short position on physical gold. The word physical there is important, because it's not an unhedged position. The banks' position is flat, or neutral, but it has a lot more --- A LOT MORE --- gold-ounce-denominated liabilities than it has in physical reserves as assets. The balance of (non-physical) assets are paper assets, complex derivatives mathematically based on price correlations with other commodities and currencies, notes, someone else's gold-ounce-denominated liability, maybe a mine, a mint, a refinery, a hedge fund, or even another bank, etc…

I want you to notice, too, that this is a "structural short" as I called it above, because it is put out by the middlemen, whose price exposure is flat, or neutral, so they don't really care which way the price moves. The difference, of course, from the middlemen in other markets as I explained above, is that the "structural short" of the bullion bank middlemen is not fully backed by goods in the warehouse. It is backed by synthetic supply, just like your balance at your local bank is not backed by physical dollars in its vault. Only, your neighborhood bank has a central bank that can print more "goods" if necessary, but no one can print physical gold.

Yes, there are, of course, speculative shorts in the gold market too. These are the ones we hear most gold bugs whining about. But the volume of spec shorts pales in comparison to the volume of the LBMA bullion banks, which I'm calling the effective equivalent of short interest in physical gold.

Another thing is that the spec shorts, like the gold shorting hedge funds, and even some of the non-bank commercial shorts, like the hedging miners, mostly disappeared from 2002-2011, during the run-up from $256 to $1,896. It doesn't make much sense to be short gold when the price is obviously rising, but the bullion banks' "short position" never went away. Notice that? It's because, like I said, they're flat, neutral, so they don't care which way the price goes, and, in fact, they can control the price to some extent by actively expanding or contracting their balance sheets.

These banks are the market makers. They are quoting bid and offer prices to sellers and buyers, and if they wanted to exert some control over the price, all they'd have to do was expand or contract their gold-ounce-denominated balance sheet. If the price was rising faster than they wanted, they could simply issue more paper gold, increasing the effective supply, while balancing their books with derivatives. They could theoretically make the price decline in the same way. Remember when Another said this?

"Someone once said, "noone wants gold, that's why the US$ price keeps falling". Many thinking ones laugh at such foolish chatter. They know that the price of gold is dropping precisely because "too many people are buying it"!"

And:

"Some say, "gold fall because noone was buying it". I say, "gold fall because many were buying it"! They buy as the "trading market" was made "much fat" with added paper! Understand this: The US$ price of gold could only fall if a market existed for paper gold priced lower each time of offer! If the price did not fall, this paper market "could not function" as "it would not be profitable to the writer"! It was, for many years, in the good interest of all, for the dollar to find a gold price close to production cost. That time has now much passed!"

Let's see if I can help you understand these confusing quotes, now, in the context of this post!

Those quotes were both from 1998, and at that time, the price of gold had been steadily declining since December of 1987, from $500 down to about $280, a steady decline for ten straight years. That was also the decade when the CBs got the mines to hedge, to sell their gold forward through the LBMA (which had also just been established in 1987). So, we've got gold mine hedging and the LBMA being established at about the same time, followed by a decade straight of a declining price.

"The writer" in second quote was the miners who constituted the short interest, and as I just explained above, it was only profitable for them to hedge like that while the price was declining. Once it started rising in 2001, they stopped hedging and eventually even bought back their hedges at a loss, just to get out of them. So that's what he meant when he wrote, "If the price did not fall, this paper market "could not function" as "it would not be profitable to the writer"!" If the price wasn't falling, the mines wouldn't be hedging, and there wouldn't be paper gold for the longs to even buy.

On the other hand, as I explained at the very top of this post, the "commercial short" paper supply, which from 1987-1998 came from the miners, must be at least matched by a speculative (paper) demand, the "longs", in order for a paper market to even exist. This is what Another meant by saying that it wasn't a matter of nobody buying gold, there were in fact plenty of people buying gold… paper gold, that is. If there hadn't been demand for the paper the mines were selling, then they wouldn't have had a market to sell into, and if the price hadn't been declining, they wouldn't have been selling. So the trick was, to constantly meet the demand with more (paper) supply, and keep the price declining (but only until it reached production cost). It was in that way that Barrick made billions "mining money" rather than gold. From FOA:

"It truly started with Barrick, in Canada in the 80s…

All that happened was that Barrick could earn interest on its unmined reserves and call it "the higher price they were getting for gold"!

…You see, the mines motive was not to receive a higher than market price for gold, rather receive a stable price for gold so financing could be arranged. The fact that gold prices fell made Barrick (and many others) look real good and their staff stood for all the praise…

ABX [Barrick] has evolved into little more than a banker's extension. One that trades gold for their gain. On ABXs side,,,,, I see their massive paper short position as a financial tool that allows them to make a return on in place reserves without mining them in total,,, at once. That is all their program is really doing. It's a product of banker's games."

And from Peter Munk's own biography:

"Peter Munk was beginning to maximize the leverage that only ownership of the gold reserves of producing mines could bring… Munk's involvement in pioneering gold-backed financings was emerging…

During the remainder of 1987, Munk focused on raising capital for American Barrick Resources. He left the mining development to Bob Smith and his professionals. Munk and Gilmour, with their expert number-cruncher partner, Bill Birchall, would orchestrate the money mining…

Munk had successfully completed, in September, a deal with Merrill Lynch Canada Inc. for the sale of C$43 million worth of units of American Barrick's common shares and gold purchase warrants. Each unit offered consisted of one common share and two warrants to purchase gold at US$460 an ounce. For those who had faith (or were prepared to bet) that the price of gold would rise beyond US$460 by September four years later [which of course it didn't], the enticement was complete. Merrill Lynch had no trouble selling them."

Another's comments should make sense now! Of course the miners are no longer "the writers", and it's no longer their gold in the ground backing the short interest on physical gold. Today "the writers" are the bullion banks, and they don't care if the price goes down or up, because they are effectively neutral to the price. Which brings us back to the main question in this post: how could a short squeeze in physical gold force up the price of paper gold?

The story gold bugs tell themselves goes something like this: The LBMA bullion banks are suppressing the price of gold (or at least somebody evil is), but when the wholesale physical market (driven by Asia) demands physical delivery that they can't supply, they'll have to go out into the world's physical market to buy that physical in order to deliver it. This will start the standard short squeeze feedback loop of buying (rising physical demand and even further diminishing supply) which will drive the price up, "turbo charged"! All of a sudden, as in past short squeezes in other markets, everyone will be a buyer, even the shorts (who are, in this case, the bullion banks). Of course all of the gold ever mined is still out there somewhere, so the theory is that they'll run up the price of gold as everyone knows it today—the paper gold price—to $5,000, or $10,000, or even Jim Sinclair's $50,000, whatever it takes to shake enough physical loose from those stingy old evil gold hoarders to cover the shorts and cut their (in this case, the bullion banks') losses.

Here's the problem with that (and note that it is unique to gold). The paper gold market is probably 90% of the paper and physical markets combined, at least the parts where price is determined. So the paper market does indeed drive the price as we know it today, and the LBMA bullion banks are not only 90% of that market, they are also almost the entire short side of the market, similar to how the miners were almost the entire short side back in the early 90s.

So let's say the physical does run out. Let's say I'm right and what's left in GLD is almost all of what the LBMA has left, and most of that is already spoken for anyway. And let's say China and the SGE is what drained the LBMA of all of its gold. And let's even say that the spread explodes as the premium on physical skyrockets.

What then? Paper longs start demanding delivery from the LBMA bullion banks? Arbs buy paper gold while simultaneously selling physical? Yeah, right. As FOA said, at that point taking delivery will mean settling in cash and running with it as fast as possible over to the physical dealers, and it'll be the longs that will be dumping their paper and forcing the discount. No one will be buying paper at that point, and even if they did, the banks could just expand their balance sheets to meet the paper demand.

You see, it won't matter what the physical price is elsewhere, because the LBMA bullion banks are their own market. So what, if the physical price is running away elsewhere? Their price (today's paper gold price) is all that matters to them. There is no law anywhere that will force the biggest banks in the world to commit suicide by going broke in order to preserve the LBMA. Instead, just like GLD, the LBMA will be terminated, its assets liquidated, and its unsecured creditors settled in cash (and all unallocated bank depositors are unsecured creditors—you can't force a bank to give you "cash reserves" it doesn't have; just try withdrawing $100K in cash from your bank without notice and see what happens) at the low $POG from the moment of termination.

How low could it be? Well, I'd say zero, but that would make them look pretty bad. So maybe some nominal amount like $10 an ounce (which is a number Another once suggested), but probably much lower than where GLD terminates. You see, a very low gold price at termination will be a HUGE windfall for these banks, while any attempt to chase the physical price would have been suicide. So they'll just shut down the LBMA and call it a day. But then it gets interesting for any entities elsewhere with "gold" liabilities and unsecured creditors.

This is where I say that physical in your possession is the only way to be sure that someone else doesn't claim your windfall, because it will be tempting. If such an entity outside of the LBMA (I won't name names here) is even a tiny bit fractionally reserved, the explosion in the physical price could make that tiny bit huge, even bankruptingly huge. And here is where I once suggested that it's best not to even trust one's own sister with a dilemma like financial windfall versus financial devastation.

"The paper market" is the LBMA, for all intents and purposes. It is not COMEX as is a common misconception. And the LBMA, while it must manage its physical side as long as it wants to be a going concern, is not ultimately subservient to that side. It can simply pull the plug when the time comes, and the time will come.

It's not about people owning paper who think they own physical, or even think they might have a right to take delivery. Gold is different because its price is driven by bullion banking, which is an unfortunate carryover from the monetary gold standard of the past, unfortunate because denominating money, and thereby becoming monetary reserves, was never the best use of gold. And with a daily trading turnover volume on par with major currencies, and another $5.5T-worth of physical (at today's prices) in private ownership (more than three times the market cap of Apple, Microsoft, Facebook, Cisco Systems and Volkswagen… combined!), it is clear that gold, or at least the idea of gold, is anything but a relic from the past.

The gold price tracks or correlates with other commodities like copper and silver, and other currencies like AUD or CAD, because paper traders make it so. As I wrote in my Candid View series:

"Today gold is chained to both commodities and foreign currencies like the AUD through the paper markets. This is why we see gold moving in lockstep with either other commodities or as the inverse of the dollar. And what this means is that it would be virtually impossible to control the price of gold in isolation. If you even attempted such a feat, you'd have a world full of paper traders working against you no matter which direction you were trying to move the POG…

Now think about this in terms of the "gold thesis" of almost every gold bug in the world. They all have it basically right. They all think that gold should be much higher. But how can gold get there when it is chained to all of these other commodities through the regressive expectations of a massive Superorganism of traders that far outnumbers the gold bugs? It can't!

So in this case, all of the publicly traded commodities in the world constitute a weight around gold's neck holding it under water. If the gold bugs try to drive gold higher in isolation, the rest of the trading world will see a profit opportunity in selling gold and buying whatever their favorite correlated commodity is. This will keep gold correlated with all of the commodities it was correlated with yesterday. And if those commodities are not ready to explode in price, then neither will gold. The only way we get $3,500 gold is with $230 oil and $70 silver. And that's not a revaluation. That's either a commodity bull run or inflation."

Paper traders essentially perform a paper arbitrage between different commodities and currencies based on expectations which are in turn based on past performance. It's not perfect, but it's why things we expect to rise together, like gold and silver for example, usually do. But when the paper gold market is suddenly terminated, there will be no way to arb the physical market with the rest of the paper trading arena, and that's why nothing else will go along for the ride. I'll just leave it at that for now. Some topics are just too big for one post, and this is almost one of them.
The Free in Freegold

Okay, here it is. What you've been waiting for patiently, I presume. This is what gold will be freed from: The fractional reserve banking practice, which is a carryover from the gold standard.

This is the free in Freegold.
-From Freegold Foundations
Apologies to anyone who jumped down here to the last paragraph hoping to gain the wisdom of a post in just a few lines; I must admit that I ended this one purposely trying to avoid that. But for those who made it here the long way, I hope you'll agree it was worth the trip. Understanding how gold is different is key to understanding Freegold, and understanding Freegold is key to peace of mind, which is priceless. At least that's been my experience so far. :D

If you would like to join the discussion, you can click here to join the Speakeasy.

Sincerely,
FOFOA