SPEAKING FREELY It's not a dollar crisis, it's a gold crisis
By Antal E Fekete
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Thirty-five years ago, gold, symbol of permanence, was chased out from the
monetary Garden of Eden, replaced by the floating irredeemable US dollar as the
pillar of the international monetary system. That's right: a floating pillar.
The gold demonetization exercise was a farce. It was designed as a fig leaf to
cover up the ugly default of the US government on its gold-redeemable sight
obligations to foreigners.
The word "default" itself was put under taboo even though it punctured big
holes in the balance sheet of every central bank of
the world, as their dollar-denominated assets sank in value in terms of
anything but the dollar itself. These banks were not even allowed to say "ouch"
as they were looking at the damage to their balance sheets caused by the
default. They just had to swallow the loss, obediently and dutifully join the
singing of the Hallelujah chorus of sycophants in Washington praising the
irredeemable dollar and the Nirvana of synthetic credit.
For a time it looked like a clever coup, as the United States has benefited at
the expense of the rest of the world. It could now buy all the goods and
services it wanted from foreign countries in exchange for "little scraps of
paper on which some ink has been sprinkled". More importantly, America could
establish military bases and start wars on foreign soil paying for them with
dollars created out of thin air. Foreigners had to put up and shut up. What
used to be "deficits without tears" has now become "deficits with laughter".
Few people realized at the time that America, far from giving itself a gift at
the expense of foreigners, had fatally shot itself in the foot. At first the
wound from this self-inflicted gunshot did not hurt and was quite invisible.
Festering and pain came later. The long time-lag makes the causal relationship
between the two events fade. Yet the connection exists, creating ever-more
mischief, misdiagnosis, monetary quackery and, ultimately, the greatest credit
collapse in history.
America had to foster an anti-gold psychosis in the world to cover up default.
Milton Friedman was the high priest of the new paradigm with his monetarism,
preaching the unmatched virtues of the floating dollar. It was supposed to
eliminate the American current account deficit. It never did. Instead, it
killed the healthy American trade surplus, as American industry was pushed into
an endless decline by the self-mutilation of the dollar.
The worst part of the anti-gold psychosis was its effect on the banking system.
American banks were deprived of a chance to hedge their assets, all of it held
in the form of irredeemable debt (irredeemable in the sense that at maturity it
was payable in irredeemable currency) by holding monetary metals, gold and
silver, as a reserve.
Those foreign banks that did were made the laughing stock of the banking
industry. "Progressive" banks were free to heap debt upon debt in the asset
column of the balance sheet without any regard to reserve ratios, in a mad
chase of illusory paper profits. If the balance sheet was not big enough, why,
they could simply go "off balance sheet" to add more debt.
Foreign banks chimed in: "Me too, me too!" It was truly an incredible sight
watching the Union Bank of Switzerland, a solid and liquid bank before 1973,
throwing all caution to the winds in its zeal to embrace hare-brained
securitization schemes, and to put a lot of bad debt made in the US on its
balance sheet.
We were also treated to another incredible sight: the Bank for International
Settlements (BIS), the only sane central bank left after the
gold-demonetization farce, committing hara-kiri. Since its establishment, the
BIS carried its books in Swiss gold francs. The implication was clear: the BIS
wanted to stay above the hurly-burly of competitive currency devaluations which
humiliated even the lofty Swiss franc in 1936. The BIS continued to carry its
books in Swiss gold francs, never mind the vicious anti-gold agitation that
started in 1973. Yet ultimately it threw away all good banking sense and caved
in.
On March 10, 2003, BIS abandoned the Swiss gold franc and embraced the SDR
(Special Drawing Rights) as its unit of account. The SDR has the dubious
distinction among fiat currencies that it does not even have an obligor. It is
an out-and-out, make-believe currency. It does not arise as an obligation. It
arises as a free gift, manna from heaven, brought by Santa Claus alias the
International Monetary Fund. (This Santa has just announced that, in a move of
belt-tightening, he was selling gold to cover the cost of mending his bag). In
want of a definition of an accounting unit no bank is subject to any meaningful
accounting rules any more. The last central bank with the ability to step into
the breach, offering sound credit in case of a world-wide credit collapse, has
disappeared from the scene.
Because of the anti-gold psychosis, the dollar went into a downward spiral,
never to come out of it. The question arises whether gold is just an
embellishment, a barbarous relic, a superstitious talisman, or whether gold is
a real mooring without which the banking systems cannot safely manage risks in
the long run.
To answer this question we must understand the first principles of hedging.
Gold and silver, as monetary metals, are the two most important hedges banks
can have to offset risks to the asset column of their balance sheets. You
cannot hedge these risks through owning more debt - the liability of someone
else. A hedge that is subject to exactly the same risks would not diminish but
magnify risks. It is a " Texas hedge". (The reference is to the rancher who,
when it was pointed out to him that his long contracts on live cattle could in
no way hedge his herd on the ranch, proudly answered: "My hedge is a Texas
hedge".)
For a true hedge, you need an ultimate asset that is not the liability of
anyone. Such an asset is furnished by the monetary metals. It is foolish to
suggest that gold and silver have lost their value as hedges since their prices
fluctuate. The fluctuation of their price does not prove that the value of gold
and silver fluctuates. On the contrary, it is the value of the dollar, in which
gold and silver prices are quoted, that fluctuates.
Because of this fluctuation it is inherently treacherous to trade gold and
silver on the variation of price. Proper hedging replaces price risk with basis
risk, which is less erratic and more predictable. The basis is the difference
between the nearest futures price and the cash price of the monetary metal,
gold or silver. There is a long-term trend for the basis to fall, and
ultimately to go negative. Traditionally the basis has been positive.
The condition that holds when the futures price exceeds the cash price is
called contango. Permanent contango is a characteristic of the monetary metals,
indicating large above-ground stores relative to the annual output of the
mines. But fiat currencies keep losing value through monetary debasement. It
makes the basis of gold and silver fall, and contango disappear. The opposite
condition, obtaining when the futures price goes to a discount against the cash
price, is called backwardation. It is equivalent to a negative basis. It is an
indication of the fact that the monetary metals are going into hiding.
The international monetary system is inevitably drifting towards the black hole
of backwardation, and will ultimately succumb to its pull. Governments and
central banks tell you that they are combating inflation. They do so in the
forlorn hope that they can escape the pull of the backwardation of monetary
metals. But they cannot, because that pull is the global manifestation of
countless individuals seeking shelter against deliberate monetary debasement in
the ownership of monetary metals.
The point is that the only way to measure the more or less slow deterioration
in the collective value of irredeemable currencies is the gold and silver
basis. It is precisely the change in the basis that provides clues for hedging
against the risk of monetary debasement. The outstanding fact is that the basis
can be traded with greatly reduced risk, as compared with trading the price.
It should be clear that some banks in the world are doing just that. They are
trading the gold and silver basis (as opposed to trading the gold and silver
price) continuously. This means that they are buying hedged metal when the
basis is high, and selling it when the basis is low. This enables them to earn
a steady income on their gold and silver reserves in gold and silver.
The proof that they indeed engage in this activity is furnished by the
inordinate size of the short interest in the gold and silver futures market. It
is altogether erroneous to attribute this short interest to the activities of
Jurassic Park creatures, and to that of the bogeyman of "naked" silver
commercials. The inordinate size of short interest in gold and silver is just
the visible side of the hedges of bullion banks and others, the invisible side
of which is their metallic reserves.
Gold Standard University Live is the only organization that advocates paying
attention to features such as silver and gold contango, backwardation, basis
and short squeeze. The vocabulary of analysts and other observers of the
passing scene doesn't even include these market terms. They follow statistics
of production and off-take, the commitments of traders in the futures market,
and are trying to divine coming moves in the gold and silver price through
supply and demand equilibrium analysis. Theirs is a wrong-headed approach.
Supply and demand equilibrium analysis is inapplicable to the monetary metals,
both the supply of and the demand for which tend to be unlimited. That's just
what makes gold and silver a monetary metal. Nevertheless, the threat of a
short squeeze or, if the worse comes to the worst, that of a corner, is very
real. A corner in precious metals also goes by the name hyperinflation. Reams
and reams of supply/demand statistics will not predict when it will hit. Only
the basis will. It provides an early-warning system indicating, with the
precision of a seismograph, the escalating shortages in silver and gold. And
only Gold Standard University Live is willing, "without fear or favor", to
publish the results of research which tell you how to read basis signals.
In summary, the present crisis is far from over. Far from being an oil crisis,
it is not even a dollar crisis (The headline to this article is a bow to Peter
Schiff for his admirable report
It's not an oil crisis: It's a dollar crisis published last month on
www.321gold.com). It is a gold crisis. It is preying on American and other
banks, punishing them for their failure to hedge paper assets with gold. The US
government is trying to bail out large multinational banks by stuffing them to
bursting with more paper assets.
In a recent move, the US Federal Reserve made history when it swapped US
Treasury bonds for the so-called asset-backed securities held by brain-dead
banks for which the market refuses to put in a bid. The trick won't work. And
it is doubtful that the only meaningful bail-out that would work, namely,
opening the US Mint to gold and silver as advocated by presidential candidate
Ron Paul, is in the cards.
To be sure, opening the Mint to the monetary metals should work. It would make
US Treasury gold available to American banks, to save them from insolvency.
What they need is not augmentation of capital in the form of more paper
credits. What they need is metallic hedges to prop up the value of paper
assets. Opening the Mint would mobilize the world's metallic reserves, at
present in hiding, and put them back into the public domain to assume their
traditional role as the foundation of the world's credit system.
Antal E Fekete has since 2001 been consulting professor at Sapientia
University, Cluj-Napoca, Romania. In 1996, Professor Fekete won first prize in
an International Currency Essay contest sponsored by Bank Lips Ltd of
Switzerland. He also runs the Gold Standard University.
Gold Standard University Live, Session Four, will take place in Szombathely,
Hungary, from July 3-6. The subject of the 13-lecture course is The Bond Market
and the Market Process Determining the Rate of Interest (Monetary Economics
201). It will be followed by a panel discussion on the topic: The Silver Basis
and the Present Banking Crisis: Phony Bond Insurance Schemes and the Lack of
Hedging Irredeemable Dollar Debt with Monetary Metals. For more information
please see www.professorfekete.com/gsul.asp or contact GSUL@t-online.hu.
(Copyright 2008 A E Fekete. All rights reserved.)
Speaking Freely is an Asia Times Online feature that allows guest writers to have
their say.
Please click hereif you are interested in contributing.
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