Western economic commentary on China and Russia is usually coloured by monetarist assumptions not necessarily shared in Moscow and Beijing. For this reason, Russian and Chinese fiscal and monetary policies are misunderstood in financial markets, as well as the reasons their governments buy gold.
China has been notably relaxed about her own people acquiring gold, and the government itself appears to be absorbing all of China’s mine output. Russia is also building her official reserves from her own mine supply. The result over time has been the transfer of aboveground gold stocks towards these countries and their allies. The geo-political implications are highly important, but have been ignored by western governments.
China and Russia see themselves as having much in common: they are coordinating security, infrastructure projects and cross-border trade through the Shanghai Cooperation Organisation. Furthermore, those at the top have personal experience of the catastrophic failings of socialism, which have not yet been experienced in Western Europe and North America. Consequently neither government subscribes to the economic and monetary concepts prevalent in the West without serious reservations.
We saw evidence of this from Russia recently, with Putin’s appointment of his own personal economic adviser, Elvira Nabiullina, as the new head of Russia’s central bank. Ms Nabiullina is on record admiring, among others, the writings of Robert Higgs – a leading US economist of the Austrian School. She is therefore likely to take a strong line against the expansion of bank credit, which is confirmed by Russian commentators who believe she will prioritise reforms to strengthen bank balance sheets.
She is not alone. The People’s Bank of China recently let overnight money-market rates soar to over 20%. The message is clear for those prepared to look for it: they are not going to fuel an extended credit bubble. The two countries have learned how damaging a bank-credit-fuelled business cycle can be, and are determined to restrict bank lending. Western commentators find this hard to understand because it does not conform to the way western monetary policy works.
It seems that the leaders of both Russia and China are also painfully aware of the importance of currency stability in a way the West is not. The comparison with the West’s reckless monetary policies is stark. It follows that Russia and China are increasingly concerned about the major currencies, given both countries have substantial trade surpluses. Their exposure to this currency risk explains their keenness for gold. Furthermore, they know that if the renminbi and the rouble are to survive a western currency crisis, they must have the sound-money credibility provided by a combination of monetary restraint and gold backing. And the reason China is happy to let her citizens plough increasing amounts of their savings into gold is consistent with ensuring her people buy into sound money as well.
While the Chinese and Russian governments are authoritarian mercantilists, there are elements of the Austrian School’s economics in their approach. The tragedy for the West and Japan is they have embarked on the opposite weak-money course that can only end in the ultimate destruction of their currencies, leaving Russia and China as the dominant economic powers.
This article was previously published at GoldMoney.com.
Earlier this month, in an article for “Project Syndicate” famous American economist Nouriel Roubini joined the chorus of those who declare that the multi-year run up in the gold price was just an almighty bubble, that that bubble has now popped and that it will continue to deflate. Gold is now in a bear market, a multi-year bear market, and Roubini gives six reasons (he himself helpfully counts them down for us) for why gold is a bad investment. Roubini does not quite go so far as to tell his readers that there is no role whatsoever for the yellow metal. Investors should have a “very modest” share of gold in their portfolios, as a hedge against extreme risks, which, the good professor assures us, are almost so negligibly small that they are “irrational fears”, really, but beyond that there is little reason to bother with gold.
Interestingly, “very modest” is indeed a good description of gold’s share in the global asset mix. According to some studies gold accounts for only around 1 percent of global asset holdings. In terms of asset breakdown we already are where Roubini thinks we should be. So why bother? Those of us – such as yours truly – who hold a more pessimistic outlook as to the efficiency of current policies and the sustainability of the current monetary infrastructure, and who accordingly hold a bigger share of their wealth in gold, are evidently “paranoid”, and as they now reap the deserved reward for their dreadful negativity courtesy of a declining gold price, why not ignore them? It is, after all, a tiny minority. But it is evident from Roubini’s essay that he not only considers the gold bugs to be wrong and foolish, they also annoy him profoundly. They anger him. Why? – Because he thinks they also have a “political agenda”. Gold bugs are destructive. They are misguided and even dangerous people.
Roubini’s case against gold
But let’s first look at his arguments for a continued bear market in gold. They range, in my view, from the indisputably accurate to the questionable and contradictory to the simply false and outright bizarre. Here is the list (with some of my commentary. Apologies to Professor Roubini.):
1) Gold is only useful in extreme economic scenarios (such as 2008/2009) but even then its price is highly volatile (and so it was in 2008/2009).
2) Gold is only useful when there is risk of rising inflation. Despite unprecedented policy measures, such as multiple rounds of QE, there is no inflation, according to Roubini. – Why is there no inflation?- Because the newly created money is stuck in the banking system and the wider financial system where it finances a happy merry-go round of asset trading without boosting broader monetary aggregates. Outside finance (and government, I might add) nobody wants to take on more debt. The normal transmission mechanism is not working. – Additionally, Roubini makes some heroic assumptions about there being no pricing power and no wage inflation.
3) Gold produces no running income and will thus be at a disadvantage in a recovering economy when equities and bonds do better. – Wait a minute. Recovering economy? Where did that come from? I thought none of the monetary stimulus was getting through to the real economy and hence failed to ignite inflationary pressures? How can it then stimulate real activity? Or are the two somehow unrelated?
4) Gold does best when interest rates are low or negative but the present recovery – recovery, again! – will allow central banks to unwind their present easy monetary policy stance and to hike interest rates. –- OK. Good luck with that. But again we are asked to take the present talk of recovery at face value. On the one hand Roubini cites ubiquitous deleveraging pressures, “lack of pricing power” and “excess capacity” (these are his words!) as reasons for why the extraordinary expansion in base money supply is not translating into money growth in the wider aggregates that usually drive the wider economy, and why therefore standard inflation measures remain benign and, on the other hand, evidently sees none of this as an obstacle to the self-sustained recovery story. — And if the economy indeed does recover without the help from easy money then, maybe, monetary policy is easy for other reasons, such as keeping an overstretched banking system from collapsing. In that case, better growth momentum as such may not be sufficient to allow central bankers to exit their present policy program.
5) Fears of sovereign default have been driving people into gold but now the greater risk is that struggling sovereigns may sell their gold holdings. – This is potentially a risk but I would counter that while selling from official sources could affect the gold market in the short-term, liquidating the family silver (no pun intended!) and removing the remaining smidgeons of hard assets at the bottom of the inverted pyramid of the über-leveraged paper money economy and replacing it with government IOUs is not going to instil a lot of confidence on the part of the public. Gold liquidation is a further sign of stress, of a check-mated policy elite running out of options, and the public may end up scooping up willingly whatever desperate politicians sell. But I guess that reasonable people can disagree on this point. – But now it gets really interesting:
6) In large parts the gold bull market was the work of, wait for this, “extreme” political conservatives, of the “far-right fringe” and conspiracy theorists. That hype is now coming undone. According to Roubini gold is not simply another asset but an indicator of political extremism, of an unhealthy mistrust of the established order. Roubini: “These fanatics also believe that a return to the gold standard is inevitable as hyperinflation ensues from central banks’ ‘debasement’ of paper money.” – Well, I guess it is time for the IRS to conduct a couple of customized tax audits!
Monetary policy prevents economic healing
Roubini does not provide much explanation for his claim that we are now in a self-sustained recovery that will allow central bankers to exit the extreme policy positions they adopted in recent years. He seems to rely on the healing forces of the market. I am the first to agree that these forces do exist in a capitalist economy and that they are incredibly powerful. That is why the market should always be left to its own devices, be allowed to unwind and liquidate accumulated dislocations that are now barriers to renewed growth, and to bring the economy back into balance. But these are precisely the very processes that present monetary policy sabotages with all its might: zero interest rates and unlimited bank funding, plus ongoing asset price manipulations, numb the market’s power to cleanse and heal and re-adjust, and instead allow banks and other financial operators to continue in their policy of pretend and extend, to keep on their books underperforming, bad or even toxic assets at unrealistic prices. Policy makers have to decide whether they want the market to operate its healing powers (even if some of the healing imposes near-term pain on the patient), or whether they rather trust their own powers to continuously drive the economy, imbalances and all, to higher levels of performance with their money-printing, market manipulation and deficit spending. We know which path they have followed so far, and that is why placing your hope on self-healing market forces is naïve. Strangely, Roubini himself has on numerous occasions warned against a strategy of kicking the can down the road and has repeatedly warned of new credit bubbles. I wonder which Roubini wrote this article.
At the core of Roubini’s argument is a paradox: easy money – the monetary ‘stimulus’ – is stuck in the banking industry and the wider financial system, and that is his explanation – together with excess capacity, deleveraging and the absence of ‘pricing power’ – for why the standard measures of inflation – consumer price inflation in particular – have not risen more dramatically. Unless you are a derivatives trader or a hedge fund manager you have not seen any of the money. But when you will, finally, believe me, then the prices that matter to you will also go up. Roubini cannot have it both ways: easy money has no effect on inflation but a stimulating one on growth – not even his funny New Keynesianism can square that circle.
But the real criticism of present policies is not that they will lead to instant hyperinflation – I believe they will eventually lead to much higher inflation and probably hyperinflation – but that they don’t solve anything but make economic imbalances much worse. They do not have an exit, and this is why they will ultimately destroy money. Roubini is overstating the ‘healing’ argument considerably, and in the course makes some big blunders: “Ongoing private and public debt deleveraging has kept global demand growth below that of supply.” – This is evidently not supported by the facts. As I have argued before, private sector deleveraging is minor, and in most countries, governments are issuing massive amounts of new debt, certainly in the US, the UK (contrary to what the public debate there would make you believe), and Japan.
Are owners of gold ‘extremists’?
But what is most worrying, and most disturbing, is Roubini’s pathetic attempt to label gold bugs political extremists. Central banks run policies today that only a few years ago would have set the average middle-of-the-road central banker’s hair on fire. Of course, the public is worried, scared and skeptical. Because the political and monetary elite, the establishment of which Roubini – senior economist for the Council of Economic Advisors under Bill Clinton and senior economic advisor to Timothy Geithner when at the United States Treasury Department – is a member, has lost the plot. The paper money bureaucracy has painted itself into a corner. The public has very good reasons to be worried, skeptical and scared.
Early in his article, Roubini makes the following observation: “During the global financial crisis, even the safety of bank deposits and government bonds was in doubt for some investors.” [my emphasis.] – What does he mean, for some investors? Banks did fail and governments did go bankrupt in the crisis. Was that just a figment of the imagination of some investors? – The only reason that not more banks went under (yet) and more governments went bankrupt is unlimited money printing. Unless monetary policy changes meaningfully we won’t even know which entities are truly solvent and which are not. And then we might find out the hard way.
Of course, people who are already predisposed to skepticism towards the political elite and their ongoing meddling with the free market will be more inclined to buy gold. But that only makes them libertarians, or individualists, or simply people who are suspicious of power and politics. I have met many of them and have yet to meet anyone who deserves the label ‘far right’, with all the connotations that Roubini invokes here, deliberately, I assume. — I am the first to acknowledge that the pro-gold community – and it is not even a real community – has its fair share of eccentrics but the majority of those who piled into gold is simply worried about where our unhinged monetary system will take us next – and justifiably so.
Roubini simply resorts to smear tactics. The same approach has been shamelessly employed for many years by Paul Krugman. The idea is to unilaterally determine the acceptable parameters of enlightened economic debate. The high gospel of John Maynard Keynes is not to be questioned, and the wisdom of having highly-trained academicians running a central bureaucracy in charge of monetary policy, administratively setting interest rates, creating bank reserves at will, and manipulating the prices of a growing number of assets to the benefit of the greater good, a system that not only did not exist 50 years ago but that back then nobody even advocated, is not to be challenged under any circumstances. Those who do are not worthy of debate. They are evidently members of the Montana Militia. They are crackpots and dangerous subversives. As Roubini stated: advocates of a gold standard are fanatics.
This is, of course, utter gibberish. A well-articulated, rational and sophisticated theory exists for why paper money systems are unstable and why they fail, and why hard money systems work better. The Austrian School of economics explains this convincingly. Its leading intellectual light was Ludwig von Mises (1881 – 1973) – urbane, sophisticated, highly intelligent, and a man of principle, one of the greatest economists of the twentieth century, who lived and taught in Vienna, Geneva and New York. – Not your average backwoodsman.
Roubini may be right on one thing: maybe gold will go down to $1,000. So what? – It won’t stay there. For whatever happens next to the gold price, or whatever the Fed does next, Roubini’s over-geared paper money economy will not survive in its present form.
In the meantime, good luck with that ‘exit strategy’!
This article was previously published at DetlevSchlichter.com.
There has been a growing shift in favour of assets relative to bank deposits. This was initially encouraged by zero interest rates, but more recently there is little doubt that Cyprus’s bail-in has accelerated the trend. This explains the bull markets in bonds and equities, which conveniently underwrites the entire banking system. It is however too early to offer evidence of falling deposit balances held by non-banks and the general public because depositors as a whole have been remarkably complacent, but there is ample evidence that liquidity from monetary expansion is inflating financial assets faster than bank deposits.
This helps explain why, for example, Italian 10-year bonds are on a 4% yield. The reason, doubtless reaffirmed by the Cyprus bail-in, is that investors with cash balances think over-priced sovereign debt is less risky than adding to their euro deposits. However, the central banks are relaxed because weakness in deposits at any single bank is easily covered through the banking system, insulating individual banks from depositor-withdrawal systems. Presumably, banking counterparties are also complacent because they can be reasonably sure to be exempt from any bail-ins. They have the comfort of knowing the banking system is underwritten by all those complacent enough to leave money on deposit beyond the insured level.
However, some of depositors’ cash balances post-Cyprus will have gone into physical gold and silver, which explains why the bullion banks operating in the futures markets and the central banks behind them are so keen to dissuade us that gold and silver is a safe haven. I recently interviewed Ronnie Stoerferle, the Vienna-based analyst, who put his finger on it: since Cyprus, there has been a sharp rise in European demand for physical gold, with the pressure being felt by the bullion banks unable to deliver bullion.
At least one bank was recently reported to be only prepared to settle bullion liabilities in cash. Therefore the price knock-down in April was a logical response by the bullion banks, which had to defuse customer demand for physical delivery. But given that the driving factor was not speculation but a reluctance to add to deposits in the banking system, the jump in demand for bullion at lower prices was inevitable.
Where does this leave things? The crisis in bullion markets is worse than it was before. A good example of how little physical stock there is can be gained by tracking bullion deliveries on the Shanghai Gold Exchange. In the last few weeks they have dwindled to virtually nothing, having been a truncated 190 tonnes in April and 297 tonnes in March. Yet we know from reports that retail demand in China has taken off; so it is only a matter of time before prices are bid up on the Shanghai Gold Exchange enough to replace lost inventory.
It will be interesting to see how many more bullion banks are forced to admit the fiction behind their customer accounts in the coming weeks. For the moment the temporary solution amounts to rationing bullion supplies to the public.
This article was previously published at GoldMoney.com.
The Honorable Ron Paul says:
Why is gold good money? Because it possesses all the monetary properties that the market demands: it is divisible, portable, recognizable and, most importantly, scarce – making it a stable store of value.
True. Yet those properties are not the most relevant today. The most important characteristic that makes gold a good reference point for money today is its enormous stock to flow ratio as the recent gold report by Erste Bank points out.
By neglecting the stock to flow ratio argument and using other, less important ones, it is much easier for anti-gold economists to confuse the public. For instance, Paul Krugman and others mercilessly criticize gold by conflating deflation with contraction and inflation with expansion.
Gold is money not because it is scarce but because it is abundant (relative to its production and consumption). This factor makes for a huge buffer that stabilizes its value against other things.
The same can be said about water. Water is abundant on Earth. Water evaporates from the land and oceans, falls down as rain and snow, rivers bring it back to oceans – at widely volatile rates.
Approximately 505,000 km3 of water falls as precipitation each year. But the world’s water supply is estimated at 1,386,000,000 km3 (97 per cent of which is stored in oceans). A huge stock to flow ratio that makes for a useful reference point.
The Erste Bank’s Gold Report concludes:
We believe that gold is not precious because it is scarce, but because the opposite is true: gold is precious because the annual production is so low relative to the stock. The aggregate volume of all the gold ever produced comes to about 170,000 tonnes. This is the stock. Annual production was close to 2,600 tonnes in 2011. That is the flow. Dividing the former by the latter, we receive the stock-to-flow ratio of 65 years (which is far more than for any other good offered in the world economy).
Gold has acquired this feature over centuries, and cannot lose it anymore.
Most commodities are consumed, whereas gold stocks are augmented, gradually.
Let’s suppose then that production of gold increases twofold or is cut in half. No big deal. There is a huge reserve to make up for difference. This does not really apply to any other commodity.
It should be also noted that CPI is a sum of two different and separate things.
CPI has a monetary component and a component related to business cycle.
When too much money is created the prices rise – prices of gold first, then other commodities and liquid assets. The prices of goods that are included in CPI rise thereafter.
But there may be other reasons for a rise in CPI. Let us assume that monetary policy in a given country is OK, but the economy is growing really fast, as was Ireland and Estonia before the crisis. CPI had been rising there due to the (relatively) huge inflow of capital – there was more demand than supply for everything, especially immovable property. Symmetrically, one can get a drop of CPI in a recession.
This is how adjusting interest rates works. Interest rates are not a monetary instrument, but an instrument to effect business cycle. By raising interest rates central banks depress economic activity and force marginal firms out of business. This reduces CPI. Symmetrically, central banks try to revive growth by reducing interest rates in an attempt to bring about an increase in CPI.
Why was there no surge in CPI after such a huge injection of money after September 2008?
There appear two things working in opposite directions here: too much money pushing prices up and severe recession bringing them down. Taken together they made, and are making, for modest CPI increases. In 1970 monetary expansion was much stronger (23X rise in gold prices against 3 fold now) and real economic growth as weak as it was, was stronger than it has been.
This article was previously published at The Gold Standard Now.
Continued from part 2 …
Finally to China where the only thing to note is that the meme of credit exhaustion is starting to spread, given that every CNY100 of reported GDP in the first quarter required the addition of CNY52 in new credit – much of that flooding back in from abroad to play the property boom.
That this is likely to lead to an implosion in fairly short order seems to have been recognised by the new men in charge. Hence the unusual convening of an April session of the Politburo Standing Committee for a meeting dedicated to the economy. From this there emanated an official press release containing the following injunction:
China needs to cement its domestic economic growth momentum and guard against potential risks in financial sectors
It doesn’t sound as if another dash for growth is on the cards, now does it?
After the rout in the gold and silver market, all we can say is that though conspiracy theories inevitably abound, we have warned on numerous occasions that such a sell-off was always possible given the number of stale, trapped longs who have had no return for months while sitting at very elevated real and nominal valuations – and all in the face of ever-mounting equity rises, to boot. One may or may not care much for the idea of technicals as predictive tools, but, just once in a while, the break of an obvious trend line convinces those who do subscribe and gives rise to an avalanche of me-tooism and that was very much the case in gold and silver.
Since then everyone has come up with their own pet, Just So Story about what or who exactly triggered it. In all likelihood there was a multiplicity of overlapping causes, of which the two most important were probably:-
- the absence of a Risk Off spike on Cyprus (with added piquancy of possible forced reserve sale at the ECB’s behest)
- the absence of an immediate inflationary rally on the BOJ move
More fundamentally, we have to face up to the fact that the Sell Side has simply l-o-v-e-d the fact that commodities are weakening while equities and credit are storming ahead since this enables it to spin a new tale to customers about why they should now revert to type and stick with their traditional, fee-generating asset classes.
Much has been made of the recent raft of negative reports from those who were formerly the bull market’s greatest boosters, but in truth, as consummate salesmen, these worthies are only telling their disappointed customers what they already want to hear. No spiel sells as well as the one which allows an after-the-fact rationalization of an unlooked-for outcome. If you can’t be smart about where the market is going, it at least assuages wounded pride (and patches up a tarnished professional reputation) to sound knowledgeable about where it has been.
All this has contributed to a poisonous mix of factors – fundamental, technical, and sentimental – among which we can include the following shifts.
Firstly, in terms of the guiding mantras which the crowd is so wont to adopt, ‘Peak Oil’ has given way to ‘Shale Glut’ and ‘Super-Cycle’ Chinese gluttony has been transmuted to an expression of faith in the all-seeing Confucian Mandarins who will shrewdly rebalance economy and unleash consumer spending, needing no copper in excess of the present quota to do so. (Big Mining itself has been reinforcing this shift, leading to the unusual result that Big Mining share prices are showing even worse returns than are commodities, despite the overall vogue for equities).
Next, financial momentum itself is now a killer, since the more commodities lag, the more people fear being left behind in any less than full commitment to the incipient equity bubble whose warm glow of instant mark-to-market gains they again avidly crave.
Again, given the appalling price action of late, the same trend chasers who did so much to boost commodities on the way up have been liquidating/shorting stuff and buying financial assets for some time, even before the gold/silver purgative. Their potential overstretch is our present best hope.
Finally, a glance at break-evens shows that inflation fears have dissipated, possibly in a very premature fashion. For our part, we have always argued that the CB actions will be slow burners, as in the 1960s, until debt re-gearing and bank expansion again come to magnify solo CB pumping. It will be the inevitable reluctance to withdraw stimulus that will lead to catastrophe more than the initial decision to provide it and then, as monetary trust first falls and then is entirely lost, velocity will rise, CPI will accelerate, and real commodity prices will turn.
The widespread impatience with the inflationary argument arises partly because no one understands that for there to be ANY price rises, however CPI-modest, in a world awash in un(der)employment and surplus capacity, this can only be evidence of a deliberate monetary excess. Alas, for us, as investors, the fact that we understand the root of this error does not make its consequences any less significant for the pricing calculus with which we must contend or for the timescale over which we must deal with it.
Thus, QExtreme is now exclusively bidding up financial assets (the Herd comfort zone, as we have said) and real estate (the default for the Ordinary Joe). Yet all the while it is preventing a genuine re-invigoration by keeping zombie companies alive and bad governments in funds, thus depressing organic, vigorous ‘growth’ and so acting without immediately igniting an inflationary holocaust which may well require a much longer gestation process than most are prepared to countenance. Not a great near-term mix for tangibles, it must be said.
In this article I will argue that the recent slide in the gold price has generated substantial demand for bullion that will likely bring forward a financial and systemic disaster for both central and bullion banks that has been brewing for a long time. To understand why, we must examine their role and motivations in precious metals markets and assess current ownership of physical gold, while putting investor emotion into its proper context.
In the West (by which in this article I broadly mean North America and Europe) the financial community treats gold as an investment. However, of the global pool of gold, which GoldMoney estimates to be about 160,000 tonnes, the amount actually held by western investors in portfolios is a very small fraction of this amount. Furthermore investor behaviour, which in itself accounts for just part of the West’s bullion demand, is sharply at odds with the hoarders’ objectives, which is behind underlying tensions in bullion markets. To compound the problem, analysts, whose focus incorporates portfolio investment theories and assumptions, have very little understanding of the economic case for precious metals, being schooled in modern neo-classical economic theories.
These economic theories, coupled with modern investment analysis when applied to bullion pricing, have failed to understand the growing human desire for protection from monetary instability. The result has for a considerable time been the suppression of bullion prices in capital markets below their natural level of balance set by supply and demand. Furthermore, the value put on precious metals by hoarders in the West has been less than the value to hoarders in other countries, particularly the growing numbers of savers in Asia.
These tensions, if they persist, are bound to contribute to the eventual destruction of paper currencies.
The ownership of gold
The amount of gold bullion that backs investor-driven markets is not statistically recorded, but we can illustrate its significance relative to total stocks by referring back to the time of the oil crisis of the mid-1970s. In 1974 the global stock of gold was estimated to be half that of today, at about 80,000 tonnes. Monetary gold was about 37,000 tonnes, leaving 43,000 tonnes in the form of non-monetary bullion, coins and jewellery. Let us arbitrarily assume, on the basis of global wealth distribution, that two thirds of this was held by the minority population in the West, amounting to about 30,000 tonnes.
This figure probably grew somewhat before the early 1980s, spurred by the bull market and growing fear of inflation, which saw investors buy mainly coins and mining shares. Demand for gold bars was driven by the rapid accumulation of dollars in the oil-exporting nations, as well as some hoarding by wealthy investors from all over the world through Switzerland and London.
The sharp rise in global interest rates in the Volcker era, the subsequent decline of the inflation threat and the resulting bear market for gold inevitably led to a reduction of bullion holdings by wealthy investors in the West. Swiss and other private banks, employing a new generation of fund managers and investment advisors trained in modern portfolio theories, started selling their customers’ bullion positions in the 1980s, leaving very little by 2000. In the latter stages of the bear market, jewellery sales in the West became a replacement source of bullion supply, but this was insufficient to compensate for massive portfolio liquidation.
So by the year 2000, Western ownership of non-monetary gold suffered the severe attrition of a twenty-year bear market and the reduction of inflation expectations. Portfolios, which routinely had 10-15% exposure to gold 40 years ago even today have virtually no exposure at all. Given that jewellery consumption in Europe and North America was only 400-750 tonnes per annum over the period, by the year 2000 overall gold ownership in the West must have declined significantly from the 1974 guesstimate of 30,000 tonnes. While the total gold stock in 2000 stood at 128,000 tonnes, the virtual elimination of portfolio holdings will have left Western holders with little more than perhaps an accumulation of jewellery, coins and not much else: bar ownership would have been at a very low ebb.
Since 2000, demand from countries such as India and more recently China is known to have increased sharply, supporting the thesis that gold has continued to accumulate at an accelerating pace in non-Western hands.
Western bullion markets have therefore been on the edge of a physical stock crisis for some time. Much of the West’s physical gold ownership since 2000 has been satisfied by recycling scrap originating in the West, suggesting that total gold ownership in the West today barely rose before the banking crisis despite a tripling of prices. Meanwhile the disparity between demand for gold in the West compared with the rest of the world has continued, while the West’s investment management community has been actively discouraging investment.
The result has been that nearly all new mine production and Western central bank supply has been absorbed by non-Western hoarders and their central banks. While post-banking crisis there has presumably been a pick-up in Western hoarding, as evidenced by ETF and coin sales and some institutional involvement, it is dwarfed by demand from other countries. So it is reasonable to conclude that of the total stock of non-monetary gold, very little of it is left in Western hands. And so long as the pressure for migration out of the West’s ownership continues, there will come a point where there is so little gold left that futures and forwards markets cease to operate effectively. That point might have actually arrived, signalled by attempts to smash the price this month.
This admittedly broad-brush assessment has important implications for the price stability essential to bullion banks operating in paper markets as well as for central banks attempting to maintain confidence in their paper currencies.
Precious metals in capital markets
In the West itself, the attitudes of the investment community are fundamentally different from even those of the majority of Western hoarders, who are looking for protection from systemic and currency risks as opposed to investment returns. Western investors are generally oblivious to the implications, the most fundamental of which is that falling prices actually stimulate physical demand. Before the recent dramatic slide in prices the investment community undervalued precious metals compared with Western hoarders, let alone those in Asia, encouraging physical bullion to migrate from financial markets both to firmer hands in the West as well as the bulk of it to non-West ownership. There is now irrefutable evidence that these flows have accelerated significantly on lower prices in recent weeks, as rational price theory would lead one to expect.
Pricing bullion is therefore not as simple as the investment community generally believes. It is being put about, mostly on grounds of technical analysis, that the bull markets in gold and silver have ended, and precious metals have entered a new downtrend. The evidence cited is that medium and longer-term moving averages have been violated and are now falling; furthermore important support levels have been breached.
These developments, which arise out of the futures and forward markets, have rattled Western investors who thought they were in for an easy ride. However, a close examination of futures trading shows the bearish case even on investment grounds is flawed, as the following two charts of official statistics provided by weekly Commitment of Traders data clearly show.
The Money Managers category is the clearest reflection in the official data of investor portfolio positions, representing sizeable mutual and hedge funds. In both cases, the number of long contracts is at historically low levels, and shorts, arguably the better reflection of money-manager sentiment, remain close to high extremes. On this basis, investor sentiment is clearly very bearish already, with the investment management community already committed to falling prices. Put very simplistically there are now more buyers than sellers.
Money Managers are in stark opposition to the Commercials, who seek to transfer entrepreneurial risk to Money Managers and other investor and speculator categories. The official statistics break Commercials down into two categories: Producer/Merchant/Processor/User, and Swap Dealers. Both categories include the activities of bullion banks, which in practice supply liquidity to the market. Because investors and speculators tend to run bull positions, bullion banks acting as market-makers will in aggregate always be short. A successful bullion bank trader will seek to make trading profits large enough to compensate for any losses on his net short position that arise from rising prices.
A bullion bank trader must avoid carrying large short positions if in his judgement prices are likely to rise. He will be more relaxed about maintaining a bear position in falling markets. Crucially, he must keep these opinions private, and the release of market statistics are designed to accommodate these dealers’ need for secrecy.
Bullion banks’ position details are disclosed at the beginning of every month in the Bank Participation Reports, again official statistics. They are broken down into two categories, based on the individual bank’s self-description on the CFTC’s Form 40, into US and Non-US Banks. Their positions are shown in the next two charts (note the time scale is monthly).
In both gold and silver, the bullion banks have managed to reduce their exposure from extreme net short over the last four months. The reduction of their market exposure suggests that they have been deliberately transferring this risk to other parties, and is consistent with an anticipation that bullion prices will rise. It is the other side of the high level of bearishness reflected in the Money Manager category shown in the first two charts. The bullion banks control the market; the Money Managers are merely tools of their trade.
There has been little reduction in open interest in gold and it has remained strong in silver, because risk has been transferred rather than extinguished. Daily official statistics on open interest are provided by the exchange and summarised in the next two charts (note that data is daily).
From these charts it can be seen that recent declines in the gold price are failing to reduce open interest further, and in silver open interest remains stubbornly high. Therefore, attempts by bullion banks to reduce their net short exposure by marking prices down are showing signs of failure.
We can therefore conclude that investor sentiment is at bearish extremes and the bullion banks have reduced their net short exposure to levels where it risks rising again. Therefore the downside for precious metals prices appears to be severely limited, contrary to sentiments expressed by technical analysts and in the media.
This market position is against a background of a growing shortage of physical bullion, which is our next topic.
Casual observers of precious metal prices are generally unaware that the headline writers focus on activity in the futures markets and generally ignore developments in physical bullion. This is consistent with the fact that market data is available in the former, while dealing in the latter is secretive. However, as with icebergs, it is not what you see above the water that matters so much as that which is out of sight below.
It is not often understood in investment circles that gold and silver are commodities for which the laws of supply and demand are not overridden by investor psychology. Therefore, if the price falls, demand increases. Indeed, the increase in demand has far outweighed selling by nervous investors; even before the price-drop, demand for both silver and gold significantly exceeded supply. Evidence ranges from readily available statistics on record demand for newly-minted gold and silver coins and the net accumulation of gold by non-Western central banks, to trade-based information such as imports and exports of non-monetary gold as well as reports from trade associations reporting demand in diverse countries such as India, China, the UK, US, Japan and even Australia.
All this evidence points in the same direction: that physical demand is increasing on every price drop. There is therefore a growing pricing conflict between futures and forward markets, which do not generally involve settlement but the rolling-over of speculative positions, and of the underlying physical metal. Furthermore, analysts make the mistake of looking at gold purely in terms of mining and scrap supply, when nearly all gold ever mined is theoretically available to the market, in the right conditions and at the right price. The other side of this larger coin is that if the price of gold is suppressed by activity in paper markets to below what it would otherwise be, the stimulus for physical demand, being based on a 160,000 tonne market, is likely to be considerably greater on a given price drop than analysts who are myopic beyond 2,750 tonnes of annual mine production might expect. The numbers that are available confirm this to have been the case, particularly over the last few weeks, with reports from all over the world of an unprecedented surge in demand.
This is at the root of a developing crisis of which few commentators are as yet aware. Demand for physical has accelerated the transfer of bullion from capital markets to hoarders everywhere and from the West’s capital markets to other countries, which has been the trend since the oil crisis in the mid-Seventies. This is what’s behind an acute shortage of physical gold in capital markets, explaining perhaps why bullion banks feel the need to reduce their short positions.
While we can detail their exposure in futures markets, meaningful statistics are not available in over-the-counter forward markets, particularly for London, which dominates this form of trading. Forwards are considerably more flexible than futures as a trading medium, generating trading profits, commissions, fees and collateralised banking business. The ability to run unallocated client accounts, whereby a client’s gold is taken onto a bank’s balance sheet, is in stable market conditions an extremely profitable activity, made more profitable by high operational gearing. The result is that paper forward positions are many multiples of the physical bullion available. The extent of this relationship between physical bullion and paper is not recorded, but judging by the daily turnover in London there is an enormous synthetic short physical position. For this reason a sharply rising price would be catastrophic and any drain on bullion supplies rapidly escalates the risk.
Overseeing this market is the Bank of England co-operating with other Western central banks and the Bank for International Settlements, whose combined interest obviously favours price stability. They have been quick to supply the market if needed, confirmed by freely-admitted leasing operations in the past, and by secretive supply into the market, which has been detected by independent supply and demand analysis over the last 15 years. Furthermore, as currency-issuing banks, central banks are unlikely to take kindly to market signals that suggest gold is a better store of value than their own paper money.
We can only speculate about day-to-day interventions by Western central banks in gold markets. In this regard it seems that the slide in prices on the 12th and 15th April was triggered by a very large seller of paper gold; if this market story and the amount mentioned are correct, it can only be central bank intervention, acting to deliberately drive prices lower. Given the market position, with Money Managers in the futures markets already short and highly vulnerable to a bear squeeze, the story seems credible. The objective would be to persuade holders of physical ETFs and allocated gold accounts to sell and supply the market, on the assumption that they would behave as investors convinced the bull market is over.
For the last 40 years gold bullion ownership has been migrating from West to elsewhere, mostly the Middle East and Asia, where it is more valued. The buyers are not investors, but hoarders less complacent about the future for paper currencies than the West’s banking and investment community. There was a shortage of physical metal in the major centres before the recent price fall, which has only become more acute, fully absorbing ETF and other liquidation, which is small in comparison to the demand created by lower prices. If the fall was engineered with the collusion of central banks it has backfired spectacularly.
The time when central banks will be unable to continue to manage bullion markets by intervention has probably been brought closer. They will face having to rescue the bullion banks from the crisis of rising gold and silver prices by other means, if only to maintain confidence in paper currencies. Any gold held by struggling eurozone nations, theoretically available to supply markets as a stop-gap, will not last long and may have been already sold.
This will likely develop into another financial crisis at the worst possible moment, when central banks are already being forced to flood markets with paper currency to keep interest rates down, banks solvent, and to finance governments’ day-to-day spending. Its importance is that it threatens more than any other of the various crises to destabilise confidence in government-backed currencies, bringing an early end to all attempts to manage the others systemic problems.
History might judge April 2013 as the month when through precipitate action in bullion markets Western central banks and the banking community finally began to lose control over all financial markets.
This article was previously published at GoldMoney.com.
The crypto-currency Bitcoin is still merely a speck on the global monetary landscape. It is young, experimental, and for all we know, it may ultimately fail to break into the monetary mainstream. However, on a conceptual level I am willing to call it a work of genius and arguably the most exciting development in the field of money for more than 130 years. Let’s say since the start of the Classical Gold Standard in 1879. Does this sound like hyperbole? Well, let me explain.
The Decline and Fall of Capitalist Money
The 20th century was, broadly speaking, a period of almost constant monetary decay. At around 1900 most economists, politicians and bankers would have correctly stated that global capitalism – an international market economy facilitating the free exchange of goods and services across political borders and thus allowing extensive human cooperation through trade – required an international, apolitical, and hard form of money. Such money was gold. It was the basis of the capitalist economy and it imposed strict discipline on all market participants. Crucially, that included governments and banks. Governments had to operate pretty much like private businesses. They had to balance their books, i.e. live within the means provided by taxation, and if they borrowed money in the marketplace their lenders were at full risk of default as no government could print money (gold) to repay loans or even meet interest payments on loans. Banks, of course, issued banknotes or bank-deposits that were not backed by gold but still used by the public as if they were money proper – these were and still are ‘money-derivatives’ – but again they did so at full risk of default as nobody could ‘print’ bank-reserves (gold again) to bail out the banks in case the public tired of the ‘derivatives’ and wanted to hold gold instead.
Over the course of the 20th century – or to be precise, from 1914 to 1971 – the monetary system was completely changed as a consequence of a number of entirely political maneuvers, all of them undermining the quality of money. Today, hard, international and apolitical money has everywhere been replaced with entirely elastic, national and politicized money, with money that central banks issue under a territorial monopoly at no cost and with no meaningful constraints on issuance, and that the central bankers use to ‘manage’ the ‘national’ economy (itself increasingly an out-of-date-concept), and to fund the state and grow the domestic banks (which, under the protection of a lender-of-last-and-first-resort, now issue unprecedented amounts of money derivatives).
Today the global monetary map resembles a patchwork of local, “nationalistic” paper monies, each of which is a political tool, often openly manipulated in an attempt to benefit the local export industry at the expense of foreign competitors or to ‘stimulate’ the ethereal concept of ‘aggregate demand’. Not surprisingly, the global economy is drowning in debt (increasingly public sector debt), suffers from a bloated financial sector and international trade tensions, and stumbles from one crisis to another, each one worse than its predecessor.
Bizarrely – but not entirely surprisingly – politicians, bankers and modern ‘enlightened’ economists now tell us that this unhinged financial system is to our benefit, really, just trust us.
Truth be told, the present monetary system is a hindrance to free trade, properly functioning markets and human cooperation across borders, and it might already be on its last leg. Yet a powerful but entirely misguided, consensus seems to have taken hold of public opinion, namely that ‘elastic’ money could be beneficial if money’s supply was only managed astutely by some clever monetary central planners.
I wrote Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown to challenge that consensus, to show that ‘elasticity’ of supply is always a negative for money. Elastic money is not needed. It is entirely superfluous. Moreover, elastic money is always disruptive. A monetary system based on an inherently elastic and constantly expanding supply of money is unstable and ultimately unsustainable. The reason why gold made such good money for thousands of years is precisely its essentially inelastic supply.
The word ‘Bitcoin’ does not even appear in my book. The reason is simply that I had not heard of Bitcoin by the time I handed in my final manuscript in early 2011. But when I learnt about Bitcoin soon afterwards I was immediately fascinated. Like many others, I could conceive of ‘internet money’ or ‘virtual money’. As I had explained in the book, money does not have to exist in physical form and the fact that most money today is electronic money poses no problem for the monetary theoretician. The problem with this type of money is not that it is immaterial but that its supply is completely elastic, and I simply could not see how money that was not based on a nature-given and strictly limited commodity could have an entirely inelastic supply. It was Bitcoin’s inelasticity by design that I saw immediately as one of its greatest strengths and its true genius.
My work rehabilitates the gold standard. It shows that it was a mistake to abandon gold as the basis of our financial system and replace it with entirely elastic state fiat money. When (not if) the present fiat money system finally ends we could and should return to gold. The only alternative I now see, at least on a purely conceptual level, is Bitcoin, or something like Bitcoin: hard, apolitical, immaterial, virtual money.
Bitcoin is cryptographic gold
By now most readers will probably have heard of Bitcoin and have some notion of what it is. But in any case, let me give you a quick run-down. The economist Nikolay Gertchev, in a blog on the Mises Institute website (republished here), explains it quite well, although Gertchev, like many other members of the “Austro-Libertarian” movement, is somewhat reserved when it comes to embracing Bitcoin. I am surprised by the extent of scepticism in that community and believe that in general it is unfounded. But first the description:
“A bitcoin is a unit of a nonmaterial virtual currency, also called crypto-currency, by the same name. (Bitcoin is a medium of exchange that only exists in the virtual world. DS) They are stored in anonymous “electronic wallets,” described by a series of about 33 letters and numbers. Bitcoins can travel from a wallet to a wallet, by means of an online peer-to-peer network transaction. Any inter-wallet transfer is registered in the code of the bitcoin, so that the record of its entire transaction history clearly identifies its owner at any single moment, thereby preventing potential ownership conflicts. Bitcoins can be further divided into increments as small as one 100 millionth of a bitcoin. The current outstanding volume of bitcoins is above 10 million and is projected to reach 21 million in the year 2140.”
“This brings us to the truly fascinating production process of the bitcoins. They are “mined” based on a pre-defined mathematical algorithm, and come in a bundle, currently of 25 units, as a reward for carrying out a large number of computational operations that aim at discovering the solution to what could be described as a randomized mathematical puzzle. The role of the algorithm is to ensure a declining progression of the overall stock of bitcoins, by halving the reward every four years. Thus, somewhere in the beginning of 2017, the reward bundle will consist of 12.5 units only. Also, the more bitcoins are produced, the harder are the randomized mathematical puzzles to be solved.”
Bitcoin is immaterial money yet strictly limited in its supply. Once 21 million units are in existence, probably in 2140, that’s it. No more Bitcoin can be issued. In fact, the supply of Bitcoin is more inelastic than the supply of gold. Also, the available supply of Bitcoin at any moment in time is substantially more transparent than that of gold.
If Bitcoin ever became money in its own right (how it could do so, I will discuss below), then it would be international, hard and entirely inelastic money. Like gold it also does not decay, is homogenous and (almost) perfectly divisible. Bitcoin fulfils all the requirements of good money. In the long run, gold does not have to fear fiat money, which is always suboptimal as it always is national, politicized, manipulated, unstable and inflationary money. For one thousand years, state paper monies have come and gone. Gold (and silver) stayed. Gold just has to sit still and wait for this, the latest and most audacious and arrogant, experiment with global free-floating paper money to fail, and it will come back. But now it faces, potentially, its first meaningful challenger: inelastic crypto-currency, Bitcoin.
Money of no authority
There is no central authority that issues Bitcoin and can manipulate its supply for its own gain or for any alleged ‘greater good’ of society. Positively cringe-inducing, although sometimes unintentionally funny, are the embarrassing attempts by establishment spokespeople to discredit Bitcoin on account that, unlike all that astutely managed state fiat money, Bitcoin would not constantly be losing purchasing power. In fact, just as in the case of gold, Bitcoin’s purchasing power can reasonably be expected to constantly appreciate over time.
But, so we hear the assorted ‘enlightened’ economists of the Keynesian persuasion exclaim in horror, that would mean we would all suffer from dreadful deflation, from which only an elite of highly-qualified government-appointed central bank bureaucrats and a well-oiled printing press can save us. Apart from the fact that these self-appointed money masters have neither proper economic theory nor the experience of a thousand years of financial history on the side of their destructive agenda, they obviously do not even comprehend how far their system of manipulated funny money has already discredited itself.
Inelastic money can satisfy ANY demand
As I have explained in Paper Money Collapse no society (not even a healthily growing one) needs a constantly expanding supply of money. Money is a unique economic good. Because it is the medium of exchange, money is the only good that is demanded exclusively for its exchange value, not for any use-value its substance (if it has a substance at all) may also have.
Nobody who has demand for money has demand for a certain quantity of paper notes, or a certain weight of gold, or a certain number of digits on a computer hard-drive. Money-users have demand for the exchange value that these items contain in exchange for other goods and service, i.e. qua being accepted by others as money. Demand for money is always demand for readily exercisable purchasing power.
Once a good is widely accepted as a medium of exchange (whether that good is gold, paper tickets, or sequences of digital ones and noughts), the public can, at any moment in time, hold precisely the amount of money – readily exercisable purchasing power – it wants to hold. If the demand for money goes up, the public will sell non-money goods for money or reduce money-outlays for non-money goods. As a result, the money-prices of non-money goods fall and the purchasing power of each monetary unit (whether gold, paper tickets, or digital code) will rise. This process satisfies – automatically, instantly and naturally – the higher demand for money. The public now holds more readily exercisable purchasing power in the form of money, not because a clever, über-prescient money producer has created new money units, but simply and much more straightforwardly, because the exchange-value of the existing money stock has increased.
Once a good is widely accepted as money, no further production of that good is required. In fact, as I also demonstrated in Paper Money Collapse, any attempt to flexibly inject money into the economy in order to ‘stabilize’ money’s purchasing power, or, as is declared policy today, to constantly debase it at an officially sanctioned rate, must not only fail in its primary objective (‘price level stability’) but must cause grave distortions in the wider economy. Furthermore, the steady secular deflation that is to be expected under inelastic money, such as gold or Bitcoin, is not only not economically disruptive, it is even beneficial. Just consider one aspect: as money will then have a moderate positive real return, people who have no knowledge of financial markets and investing, and who do not have the resources to hire professional advisors, can save by simply holding money. This is impossible in our fiat money economy of constant inflation and increasing monetary instability.
As Bitcoin has no issuing authority it has no country of residence or origin. It is truly global money. It can be used for payment anywhere in the world without going through banking systems or foreign-exchange markets. It is undeniable that the multitude of local paper monies poses a considerable hindrance to free trade and thus the rise of living standards in large parts of the world as this system necessarily introduces an element of partial barter into international trade relations. Today’s massive foreign-exchange markets are nothing but a make-shift, a crutch to deal with the suboptimal and politically motivated arrangement of various local currencies. This market ties up capital (both financial and human) without adding any real wealth to society.
If Bitcoin were to get widely accepted – and that is still a big if – it could become a great platform for connecting potentially any two counterparties in the world in direct financial transactions. It is the ultimate disintermediator: no banks needed.
At this point it might be objected that it only connects people who have access to the internet or smartphones but this is obviously a rapidly shrinking barrier. On my travels in Africa last year, I found that internet access was usually more ubiquitous than bank branches. And by the way, Kenya and Tanzania already have M-Pesa, the world’s most developed mobile payment system that uses the mobile phone network to facilitate money transfers. These countries could easily make the transition to smartphone-based payment systems without ever making the detour through clunky bank branch networks.
On the issue of tying down capital, Bitcoin wins hands-down against any other financial system, including a gold standard. Bitcoin does not require any physical storage, which naturally is always expensive. Bitcoin is monetary raw material and payment system in one. (Although, fascinatingly, the free market has already created physical Bitcoins.)
Money requires trust. We presently do not live under a gold standard but, as Jim Grant has observed so astutely, a PhD-standard, a system of flexible, state-sponsored money, managed by people like Ben Bernanke and his team at the Fed, who enjoy the privilege of implementing policies based on their own faulty monetary theories and hair-raising interpretations of economic history, while a cheap-money-addicted class of speculators plays them like a fiddle and laughs all the way to the bank. The appeal of gold has always been that it does not require the public to put trust in a ‘money elite’ but that it only has to trust gold’s creator: mother nature. With Bitcoin you only have to trust the algorithm, and as this is open software, there cannot even be a hidden agenda. Bitcoin, just like a proper gold standard, is hard, capitalist money with no politics, no Federal Open Market Committee meetings, no monetary policy, no central banking bureaucracy. It is free market money.
Common objections to Bitcoin
Given its free market and ultra-hard-currency credentials, the scepticism towards Bitcoin in parts of the Austro-Libertarian community is somewhat surprising. I think some of the objections are easily refuted. There is, first of all, the idea that Bitcoin could have many imitators, which would undermine its uniqueness and reduce its attractiveness. If Bitcoin itself cannot be inflated, what about the concept of crypto-currencies, could it be inflated by too many different currencies on offer?
This argument strikes me as weak. By all accounts Bitcoin’s design and cryptographic robustness are an exceptional accomplishment. It is not as if any hacker of medium talent could pull off something similar tomorrow. But even if he could, the argument completely underestimates first-mover advantage in the area of goods and services with substantial network effects. How many people have launched a second Facebook or a second Twitter since these inventions kicked-off the social media craze, although technologically, these inventions are much simpler than crypto-currency? – Nobody. The network effects of these goods are immense. Once they have a certain acceptance it is hard, if not impossible, for late-comers to break in. These goods and services have value for their users predominantly because others use them too, and the more people use them, the more valuable they get. There is no good for which this is truer than money – the general medium of exchange. Customized money is an oxymoron. Consequently, once a form of money is accepted, it is very difficult to take business away from it.
This feature of money is obviously a problem for Bitcoin in its fight against established state paper monies but is equally a big plus when it comes to keeping potential new entrants into the crypto-currency arena at bay. Bitcoin now dominates the market for crypto-currencies (it pretty much IS the market for crypto-currencies, in my view) and I believe that only the discovery of major flaws in Bitcoin – none seem to have surfaced in its four-year life up to now, and every day they are less likely to appear – or if some vastly superior crypto-currency came along but I am hard-pressed to see in which aspect it could outperform Bitcoin. But just launching another crypto-currency – a Bitcoin clone – is certainly not going to put a dent into Bitcoin.
Menger and Mises would love Bitcoin
Many ‘Austrians’ get thrown off by Menger’s theory of the origin of money and Mises’ so-called ‘regression theorem’, and somewhat rashly conclude that Bitcoin can never achieve money-status because it did not originate from a non-money commodity. Mises was correct when he stated that something could only become money if it had previously, that is, before it was used by somebody as a medium of exchange in its own right for the first time, established some value in trade. For if that had not been the case, how could the first person to employ the commodity as money have any point of reference by which to assess its value and determined its exchange value for the first monetary transaction? However, this theorem, which remains unrefuted in my view, does not apply to Bitcoin. Bitcoin can simply piggyback on established forms of money that already have exchange-value and derive its original value from them before it does, over time, establish its own value.
The same has, in fact, happened in the case of paper money. The paper notes that are used as money today did not start their ascent to widely used and generally accepted monetary assets from humble beginnings as commodities – that is, as mere paper – but started out as paper-claims on physical gold. Gold was money and the paper tickets simply a technology to transfer ownership of gold. When the first banknote was used it did not derive its exchange value from its paper content but from the fact that it could be exchanged for a fixed amount of gold. That was the necessary reference point – in accordance with Mises’ regression theorem. Paper money started as payment technology and as the public got used to paying with paper rather than with gold coins and gold bars, the underlying gold content could be reduced over time and ultimately the link to gold completely severed. What gives value to these paper tickets today? – The fact that the public still accepts these paper tickets in exchange for goods and services. That is all. And in fact, it is all that is needed. Any form of money – even gold, which still retains some functionality as industrial commodity or consumption good (jewellery), although that functionality is now irrelevant for its role as monetary asset – any form of money derives its money-value from the trading public and the public’s willingness to exchange the monetary asset for goods and services.
And herein lies in fact Bitcoin’s biggest challenge. However, this challenge is not of a conceptual nature. The concept of Bitcoin as money is, as I have tried to show above, extremely compelling. But Bitcoin has to offer something to the average money-user that state paper money cannot offer. Just as the banknote bestowed an instant and discernible benefit to each money-user relative to heavy gold coins, that allowed it to become a widely used medium of exchange in its own right and ultimately even operate without any link to gold, so Bitcoin has to set itself apart from fiat money and overcome fiat money’s powerful network advantage. The fact that fiat money is suboptimal in terms of its inflation characteristics and its disruptive effects on the broader economy is not something that bothers the average money user at the moment he desires to engage in monetary transactions, and do so as conveniently, securely and easily as possible. The state paper money system today offers easily useable ‘computer money’ and the broader public is still happy to use it. Why switch to Bitcoin?
Will Bitcoin get accepted by the wider public?
It is my impression that the community of Bitcoin users, although apparently growing strongly, is still largely composed of those who are fascinated by the technology as such and who want to be part of something new, and those who like it for ‘ideological’ reasons, i.e. those who detest state paper money or dislike the banking system. Thus, there is apparently still a big contingent of computer ‘nerds’, hackers, crypto-anarchists, anti-government libertarians and Occupy-Wall-Street-types among its user base (which is not to say that there are not many who do not fall into any of these categories). How could Bitcoin attract a broader base of money-consumers beyond these groups?
One powerful aspect is cost. Bitcoin transactions are free, so Bitcoin could become – or maybe it is already – the Skype of payment systems. Another attraction could simply be the usually reasonable, and with some effort potentially considerable, anonymity and untraceability that Bitcoin offers. This seems to be a hotly debated topic. On the one hand, Bitcoin is incredibly transparent. All transactions are literally in the open domain. However, each ‘user’ is only identified by his ‘address’ and the number of addresses is practically unlimited. One could use a new address for each transaction. This may not mean instant untraceability from ‘the authorities’ but then again, certain techniques and add-ons, some of which are still being developed, have the potential to increase anonymity and untraceability even further. Additionally, it is possible to acquire Bitcoin for cash – rather than via the established and already regulated exchanges – and thus anonymously.
This means Bitcoin could be used, as is a frequent charge against it already, for illegal transactions involving drugs and guns. But people do not have to be drug or arms dealers, or even ordinary tax cheats, to appreciate a certain degree of financial privacy. As bank secrecy laws disappear everywhere and as almost all governments are waging a ‘war on cash’, by which any transaction that involves more than just petty cash is to be moved to electronic systems within the state’s fiat money network, so that ‘the authorities’ achieve full ‘transparency’ as to what the citizenry is up to at any moment, there could well be a widespread demand for ‘outside’ electronic payment systems offering privacy. For example, a range of ‘activities’ exist engaging in which may not be, or not yet be, illegal but considered a major potential embarrassment to the parties involved if made public (gambling, pornography, escort services), so that many people would not want to have payment for them on their permanent records. This potential development is not lacking in irony: our modern information society with its trends towards the ‘transparent citizen’ and unlimited data storage holds many threats to a free society, privacy and individual liberty. It would be fitting if countermoves to these trends emanated from the same technology.
An additional boost to Bitcoin may come straight from the crumbling state paper money infrastructure itself. The cases of Iceland and in particular Cyprus have driven home the point that ‘money in the bank’ is far from safe, and even if your deposits have survived the bank collapse and the ‘bail-in’, you may not get them out of the country any time soon as capital controls are likely be imposed. As the overstretched paper money economy staggers towards its inevitable demise, more of these instances will occur providing an additional opening for Bitcoin. To the best of my knowledge, Bitcoins cannot be confiscated and Bitcoin accounts cannot be frozen Additionally, you store Bitcoin yourself rather than put them into a fractional-reserve bank that would conveniently use them as ‘reserves’ for its own ‘money derivative’ production.
What are Bitcoins worth?
I agree with Jon Matonis that nobody can give a reasonable answer but that the outcome is probably binary: Either Bitcoin ultimately fails and the individual Bitcoins end up worthless. Or Bitcoin takes off and Bitcoins are worth hundreds of thousands of paper dollars, paper yen, paper euros, or paper pounds. Maybe more. Those who buy Bitcoin as a speculative investment should consider it an option on the future success of the crypto-currency. At time of writing, Bitcoins are trading at $127 and £83 at Bitcoin-exchange Mt. Gox.
On a personal note, my biggest ‘liquid’ asset continues to be physical gold. As I explained on numerous occasions, I consider gold to be the essential self-defense asset in the ongoing paper money crisis. Gold is not being used presently by the wider public as a medium of exchange either but its two-thousand-plus year history as global money means that it retains monetary asset status and that its historic function as a liquid and lasting store of value – a function that fiat money cannot fulfil – remains unrivalled. By comparison, the brand-new crypto-currency Bitcoin has to first earn its stripes as a monetary asset by proving itself as a ‘common’ medium of exchange. That is why I view Bitcoin very differently from gold, although the attraction of both has its origin in the demise of entirely elastic, politicized state fiat money. I will certainly continue to follow the Bitcoin revolution with interest and sympathy.
In the meantime, the debasement of paper money continues.
This article was previously published at DetlevSchlichter.com.
Gold’s swoon has triggered a good deal of schadenfreude, some subtle, some less so.
It’s hardly a surprise after eleven years of gains and often tiresome crowing from its more partisan supporters. Question is, apart from the emotional satisfaction of putting the boot in, are these critics justified?
Their complaints seem to revolve around four principal themes:
• Gold isn’t an investment. It produces no income and should therefore, at best, be regarded as a trade.
• It can’t be valued properly. With no income, and no shortage of existing stocks, the bull case is entirely reliant on an unending supply of greater fools.
• Gold’s supporters are true believers, more akin to members of a cult than rational economic actors.
• In any case, it’s way too volatile to ever be a proper currency, even if that were theoretically possible or desirable. All the fools who bought the “gold is money” pitch are going to get buried.
♦ ♦ ♦
In any case, let’s consider them one by one.
• No argument: gold isn’t an investment. If it’s anything (monetarily speaking), it’s base money, or currency. To believe otherwise is a category error. Most serious gold bulls understand that even if the word “investment” is sometimes bandied about carelessly.
Whether “trade” is the right descriptive term is a bit trickier. For some, it certainly is. For others, however, those who categorise gold as money, it’s a precautionary holding, likely to do tolerably well if most other things financial are going down the tubes.
• Can gold be valued properly? Seems more like a zen koan than a question with a clear answer, doesn’t it? At one level, the critics are undoubtedly right: with no income stream and superabundant existing stocks, gold is entirely at the mercy of perceptions. Still, it’s also true that greater fools have shown up with reassuring regularity for the last few thousand years. Is that likely to change any time soon? We’re probably each obliged to answer that question individually. And to accept the consequences.
By the way, while gold doesn’t yield anything, nor does physical currency. To earn anything on either, you have to lend them out.
• It’s certainly true that there’s a sizeable subspecies of goldbugs who are cultlike in the intensity of their beliefs. They have their demons, their gods, their sacred texts, and see this crisis as the final scene in a battle between good and evil. Gold for them is a symbolic lightning rod, not to be subjected to dispassionate analysis, much less ridicule.
Thing is, stripped of this emotional baggage (which is in any case rooted in politics and often religion), their monetary beliefs aren’t without foundation.
There is, after all, a long history of gold as money. Not as the reflection of some quasi-religious belief, but as a matter of cool, pragmatic, bottom-up agreement. It’s what the markets chose and for all its intermittent problems, the (real) gold standard worked well for a long time. Even today central banks all have gold on their radar screens (unaccountably or otherwise) and quite a few are busy acquiring more. Indeed, much of the non-Western world continues to view gold as real money. Foolish? Perhaps, although I don’t think so. In any case, ignoring that possibly uncomfortable fact is even more foolish. After all, right now these are the guys and gals with the savings.
• And yes, it does fluctuate, sometimes a lot. It’s hardly alone though, is it? US stocks fell 23% in one day in 1987 and some 30% in a few weeks in 2008; the yen tumbled 18% in under a week in 1998. And so on.
Did this lead to their dismissal as an asset class? Of course not. These things sometimes happen in markets where speculation has run rife. When the stars then align and players from every time frame suddenly find themselves on the same side of the market, weird stuff happens. Sensible people understand that and form their views accordingly. Certainly, drawing far reaching conclusions from such structural aberrations is plain foolishness.
Time alone will provide the answers to most of these vexing issues. We’d probably be wisest to pay no more attention to the (often amusing) fulminations of the more extreme critics than to those of their targets.
♦ ♦ ♦
So, has gold bottomed?
Well, nobody knows of course. Short-term, it depends on whether the weak hands are finally out. FWIW, I think most of them probably are. Longer term, what matters are the policies governments and central banks run in years to come. If fiscal and monetary prudence took centre stage, gold would almost certainly go into a long-term nominal bear market. If, as seems to me more likely, the current activist extravagance persists, or intensifies, then the nominal (and probably real) upside still beckons, perhaps with even greater volatility. And, quite possibly, for years to come. We may as yet have only seen Act I.
In any case, caveat emptor.
P.S. The title comes courtesy the traditions of a popular Urdu newspaper. According to a friend who once read it regularly, whenever a local notable died it invariably printed a minor editorial with the heading (for example): “Ah! Qasim Rizavi.”
Last Friday I participated in a (very short) debate on BBC Radio Four’s Today Programme on the future direction of gold. Tom Kendall, global head of precious metals research at Credit Suisse argued that gold was in trouble, I argued that it wasn’t. So yours truly is on record on national radio on the morning of gold’s two worst trading days in 30 years arguing that it was still a good investment.
I still think that what I said on radio is correct and even after two days of brutal bloodletting in the gold market and two days of soul-searching for the explanations, I believe that this is the only question that ultimately matters for the direction of gold:
“Has the direction of global monetary policy changed fundamentally, or is it about to change fundamentally? Is the period of ‘quantitative easing’ and super-low interest rates about to come to an end?”
If the answer to these questions is ‘yes’ then gold will continue to be in trouble. If the answer is ‘no’, then it will come back.
Reasons to own gold
The reason why I own gold and why I recommended it as an essential self-defense asset is not the chart pattern of the gold price, the opinion of Goldman Sachs, or the Indian wedding season but the diagnosis that the global fiat money economy has check-mated itself. After 40-years of relentless paper money expansion and in particular after 25 years of Fed-led global bubble finance, the dislocations in the global financial system are so massive that nobody in power dares to turn off the monetary spigot and allow market forces to do their work, that is to price credit and to price risk according to the available pool of real savings and the potential for real income generation rather than according to the wishes of our master monetary central planners.
The reason why for almost half a decade now all the major central banks around the world keep rates at zero and print vast amounts of bank reserves is that the system is massively dislocated and nobody wants the market to have a go at correcting this.
There are two potential outcomes (as I explain in my book): 1) This policy is maintained and even intensified, which will ultimately lead to higher inflation and paper money collapse. 2) This policy is abandoned and the liquidation of imbalances through market forces is allowed to unfold.
Gold is mainly a hedge against scenario 1) but it won’t go to zero in scenario 2) either. So far, I see little indication that central bankers are about to switch from 1) to 2) but we always have to consider the fact that the market is smarter than us and has its ears closer to the ground. What is the evidence?
Cyprus and EMU
Taken on their own, events in Cyprus were not supportive of gold, not because the island nation could potentially sell a smidgeon of gold into the market but because the EU masters decided to go for liquidation and deflation rather than full-scale bailout and reflation. Cyprus’ major bank is being liquidated not rescued and ‘recapitalized’ as in the bad examples of RBS, Northern Rock, Commerzbank, or more indirectly – via shameless re-liquification – in the case of Goldman, Morgan Stanley, Citibank and numerous others. The ECB’s balance sheet has been shrinking over the past 3 months, not expanding. Depositors in EMU (and even EU-) banks are being told that in future they shouldn’t rely on unlimited money-printing or on unlimited transfers from taxpayers in other countries to see the nominal value of their deposits protected. This is a strike for monetary sanity and a negative for gold. It should reduce the risk premium on paper money on the margin.
If this sets an example of where the global monetary bureaucracy is moving than gold is indeed in trouble. However, I don’t see it. As I argued before, it seems more likely to me that Japan is the role model for where other central banks will be heading: aggressive fiat money debasement, a last gasp attempt at throwing the monetary kitchen sink at the economy. Additionally, the EU bureaucracy may not be as principled on the question of hard or soft money when the patient brought in on a stretcher is not a European midget like Cyprus or even Greece but one of the big boys, i.e. Spain, Italy or France, the latter having been the EMU’s big accident waiting to happen for some time. Mr Draghi’s phone will immediately ring off the hook. My sense is that even in Europe the days of ‘quantitative easing’ are not numbered by any stretch of the imagination.
Bernanke, the anti-Volcker
But the central bank that really matters is the Fed. Will we one day look back on the days of April 2013 as the moment an incredibly prescient gold market told us that Bernanke was getting isolated at the Fed, that people had begun to seriously tire of his academic stubbornness about the U.S government having a technology, a printing press, that allows it to print as many dollars as it wishes….blah, blah, blah…., and finally got the knives out and finished this undignifying spectacle of madcap dollar debasement? – Of course, I don’t know but I somehow doubt it.
Monday was the worst day in the gold market since February 1983. Back then gold was in a gigantic bear market, not because of what Goldman thought or said, but because Paul Volcker was Fed chairman and had just applied monetary root canal treatment to the US economy simply by stopping the printing presses, allowing short rates to go up and restoring faith in the paper dollar. Hey, 20 percent on T-bills, how is that for a signal that paper money won’t be printed into oblivion! The important thing was that Volcker (and some of his political masters) had the backbone to inflict this near-term pain to achieve longer-term (although, sadly, not lasting) stability and to live with the consequences of the tightening. Today, the consequences would be much more severe, and there is also much less central banker backbone on display. Over the past two decades, the central banker has instead become the leveraged trader’s best friend. Volcker was made of sterner stuff.
If the gold market knows that easy money is about to end, how come the other markets haven’t got the news yet? Do we really believe that stocks would be trading at or near all-time highs, the bonds of fiscally challenged nations and of small-fry corporations would be trading at record low yields, if the end of easy money was around the corner?
To justify the lofty valuations of these markets on fundamentals, one would have to assume that they no longer benefit from cheap money but instead have again become the efficient-market-hypothesis’ disinterested, objective, reliable, and forward-looking barometers of our economic future, and of a bright future indeed, in which apparently all our problems – cyclical, structural, fiscal, demographic- have now been solved, so that the central bankers can pack up the emergency tool kit and gold can be sent to the museum. – Well, good luck with that.
The sucker trade
In the debate last Friday, my ‘opponent’, Tom Kendall, made a very good point. Tom said that what causes problems for gold was the ‘direction of travel’ of the economy and other asset markets. It is maybe a bit of a strange phrase but the way I understood it it is quite fitting: equities are trading higher (in my view, mainly because of easy money and the correct expectation that easy money will stay with us) while bonds are stable and inflation (so far) is not a problem. In this environment, the gold allocation in a portfolio feels like a dead weight. For most investors it is difficult to stand on the sidelines of a rallying equity market. They need to be part of it.
I think that what is happening here is that Bernanke & Co, are enjoying, for the moment, a monetary policy sweet spot at which their monetary machinations boost equities sufficiently to suck in more and more players from the sidelines but do not yet affect the major inflation readings and do not upset the bond market. This policy is not bringing the financial system back into balance. It does not reduce imbalances or dissolve economic dislocations. To the contrary, this policy is marginally adding to long-term problems. But it feels good for now.
Bernanke is blowing new bubbles, and as we have seen in the past, it is in the early inflation phases of new bubbles that gold struggles. Equity investors are getting sucked in again, and the gold bugs may have to wait until they get spat out again and the Fed’s cavalry again rides to their rescue, that gold comes back.
In any case I remain certain of one thing …
This will end badly.
This article was previously published at DetlevSchlichter.com.
“The modern Keynesian state is broke, paralysed and mired in empty ritual incantations about stimulating ‘demand’, even as it fosters a mutant crony capitalism that periodically lavishes the top 1 per cent with speculative windfalls.”
- From ‘The Great Deformation – how crony capitalism corrupts free markets and democracy’ by David A. Stockman.
First they ignore you, said Mahatma Gandhi. Then they laugh at you. Then they fight you. Then you win. On the basis of the vitriol that David Stockman’s new book has stirred up, he is close to winning – the debate, if nothing else. Someone called Jared Bernstein described Mr. Stockman’s book as “a horrific screed, an ahistorical, dystopic, Hunger Games vision of America based on debt obsession and wilful ignorance of macro-economics and the impact of market failure”. Sounds like America to us. Someone else called David Frum labelled it “primitive” as economics, “silly” as advice and suggested that Mr. Stockman might be suffering from elderly depression. “As an insight into the gloomy mindset that overtakes us in middle age, it’s a valuable warning to those still middle-aged that once we lose our faith in the future, it’s time to stop talking about politics in public.” Perhaps. Or perhaps Mr. Stockman’s new book is an accurate portrayal of a dysfunctional kleptocracy beset by venal politicians and inept and greedy financiers in which “politics” is reduced to an endless clown parade of the economically illiterate attempting to perpetuate an illusory boom fuelled only by ever more desperate spasms of unsustainable credit. Thanks to Amazon, we will soon know one way or the other.
These are certainly days of miracle and wonder. Well, of absurd and extraordinary financial experimentation, at any rate. Last week saw the Bank of Japan abandon any last pretence of restraint and topple headfirst into a gigantic pile of monetary cocaine. The scale of the policy is daunting (and could perhaps prove terminal for Japan Inc’s finances, if Kyle Bass is correct): the Bank of Japan intends to double the country’s monetary base over two years via the aggressive purchase of long term bonds. In their so far fruitless fight against deflation, the Japanese have finally wheeled out the big guns, what Gavyn Davies called “one of the largest monetary injections ever announced by the central bank of a major developed economy.. a deliberate change in philosophy, and a complete abandonment of everything that the Bank of Japan has said about monetary policy in the past two decades. Those who believe in quantitative easing certainly have their experiment, writ large in Tokyo.. The doubling in the Japanese monetary base over a period of 21 months is in itself remarkable. Taken together with the extension of the duration of bonds purchased from less than 3 years to an average of 7 years, the injection becomes of historic proportions.”
Wigram Capital Advisors illustrate the scope of the stimulus. The chart below depicts planned purchases of Japanese Government Bonds (JGBs) over the coming two years:
The chart below indicates the scale of the monetary expansion:
It would be difficult to overstate the drama of this monetary stimulus (although we favour the word debauchery). Japanese traders struggled to come to terms with the enormity of the announcement in its immediate aftermath, and Japanese financial markets enjoyed some wild swings. As Espirito Santo’s Marcus Ashworth points out, the BoJ bond purchase machine is going to gobble up between Y200 to 300 billion of long-dated bonds every week, raising its consumption from Y4 trillion to 7.5 trillion a month, which will account for between 70 and 75% of monthly debt issuance and 45% of all debt issuance beyond 10 years in duration. 10 year JGB yields gapped down to 0.315% (no, that is not a typo), and the 30 year yield, which had been sitting at 1.55% earlier in the week, gapped down to 0.935%. But as the markets struggled to comprehend the implications of a nuclear strike launched effectively at themselves, JGB futures very nearly went limit down three times in a row as circuit breakers kicked in – volatility not seen since Lehman Brothers failed. 10 year yields then doubled, blowing out from that 0.315% low to 0.625%, although one doubts whether much paper actually changed hands. And then one of the Japanese megabanks apparently came in and bought JGB futures in huge size which steadied the ship. As Marcus asks, “Was this ordered by the BoJ to protect the market just as it had launched the biggest buying programme in history ? How weird is that ?”
Plenty weird, obviously.
While JGB markets oscillated like a weeble being flicked by Godzilla, the Japanese stock market abandoned any semblance of sobriety and decided to go moon-rocket. Unlike the Yen, which reacted as one might expect on the foreign exchanges when one’s central bank has suddenly decided to double one’s supply. The recent collapse of the Yen against the US dollar is shown below:
Given the enormity of the BoJ’s announced stimulus, long Yen positions for the foreseeable future should either be avoided or else undertaken with extreme care.
As the Japanese monetary authorities declare a holy war against deflation, it would only be fair to draw attention to the colossal opportunity being presented by current markets as the antidote to monetary intemperance, namely gold and gold miners. We think that the temporary weakness of the price of bullion is closer to being a buying opportunity than anything else in the light of Japan’s vast money-printing experiment, and the same likely holds for the price of gold mining companies. QB Partners point out the mismatch between the prices of gold and silver mining shares and spot gold; the HUI is an index of gold and silver miners:
As they observe, the lower the ratio, the weaker the relative performance of precious metal miners. Quite why the miners are trading so poorly relative to the physical is unclear to us. It may be because the market expects the price of gold and silver to fall (not a belief to which we subscribe, given current monetary events for example in Japan). It may be because the rise of gold exchange-traded funds has removed a natural bid for shares of the miners. And it may be because the market is waiting for goldbug hedge fund manager John Paulson to capitulate on his own holdings of precious metal mining stocks. Whatever. We don’t know, and are merely content to play the long – and rational – game. As the good folk at QB point out,
the ratio [HUI Index / spot gold] is again at its ten year weekly low. If there is any remaining validity to the merits of investing in financial assets based on historical value, this would be the time to buy miners. Obviously, we are aware that value is being suspended by central bank monetary policies; however, we also think the great unpopularity of precious metals in developed economies with large financial asset markets, and the attendant ignorance and small size of the precious metals mining industry, have further forced an almost complete lack of sponsorship. Market cap to reserve ratios remain at insane levels.
They go on to add (and we concur),
Our strong bias is that prices of bullion will rise significantly. Selling the miners at current absolute and relative valuations would be tantamount to throwing in the towel on the entire concept of value investing, now and in the future. Our strategy is to buy low and sell higher, which turned into buying low and lower (and lower still) because our sense of value has increased.
The reality is that we cannot be 100% sure of the outcome from all the monetary mayhem in Europe, Japan and the US, and we do not have a good sense of timing if and when our outcome proves correct. (A capital control template for the EU and yet gold can’t find a bid ?!) All we can do is try to recognize value within the context of current and extrapolate-able events.
Doubt is uncomfortable in this environment, but certainty is absurd. We supplement our precious metal holdings (physical and equity) with debt holdings of unimpeachable quality (a hedge against outright deflation), mostly defensive non-metal equities, and uncorrelated funds. Courtesy of the sort of activity now being aggressively pursued by the Japanese, cash has long been a source of liquidity but irrelevant as an investment.
The money printing ritual goes on. In response to the increasingly strident shrieking of the crowd, the monetary fairground ride managers run their machine faster than ever. What price sanity in an insane world ? When the prices of everything are being so grievously distorted, this is not an easy question to answer.
This article was previously published at The price of everything.