Since late January, the February gold contract has been in backwardation.  This means that one could make a profit by simultaneously selling a gold bar and buying a February contract.  One would still have one’s gold plus a little extra.  I coined the term “temporary backwardation”, to describe this curious and very recent phenomenon.  In our “new normal”, most gold and silver contracts go into backwardation as they get close to expiry.

When the Feb contract first jumped into backwardation, it was well within the “contract roll” period.  The roll is when naked longs sell the expiring contract and buy a contract for a more distant month.  This heavy selling of the expiring contract pushes down its price.  Since cobasis is Spot minus Future (oversimplified slightly), the cobasis rises purely due to the mechanics of this selling.

But today something more serious occurred.  The April contract, which is not yet being  “rolled”, fell into backwardation.  See the chart.

The title of the video clip under review and subject of their discussion is: “Would returning to the gold standard end currency wars?”  Obviously, countries which use gold as money would have to accept the fact that gold cannot be devalued.  This would be a huge improvement over today.

Michael Woolfolk from Bank of New York Mellon takes the anti-gold position, and Komal Sri-Kumar from Sri-Kumar Global Strategies is pro-gold.  Mr. Woolfolk seems the perfect representative of the establishment.  He works for a major bank and just wants to continue the status quo, though as most do, he has some quibbles with it.  While he admits that there is no long-term benefit to “currency wars”, he asserts that there is a short-term benefit.

Mr. Sri-Kumar, answers Mr. Woolfolk as he deserves.  Nothing good comes from robbing savers and productive enterprise via devaluation, in the short term or in the long term.  Unfortunately, he is not a great representative of the gold standard, as we shall see below.

Mahatma Ghandi once said, “First they ignore you, then they laugh at you, then they fight you, then you win.”  In this Bloomberg video clip, we see that we are currently somewhere between laughing and fighting.   Gold can no longer be ignored.

Mr. Woolfolk seems barely able to conceal his contempt at times.  In rebutting Mr. Sri-Kumar, he interrupts “but you can’t do that [adopt gold]… right?”  His face flickers to a smirk, which he quickly suppresses.  “I mean the value of gold would have to be astronomically high to be able to back the money supply.”  He adds,  “Wouldn’t it?”  He takes on a tone of exaggerated patience.

Mr. Woolfolk says we don’t have enough gold.  Whenever I hear that, I always feel an urge to ask three questions.  First, How much gold do you think we have?  Second, how much do you think we would need to have?  And finally, how did you arrive at these numbers?  There is little point in spending further electrons dwelling on Mr. Woolfolk.

Mr. Sri-Kumar made a point that I think is under-appreciated: central banks create uncertainty.  I would add that economic calculation as such is impossible under paper.  A construction worker cannot use a rubber band to measure the length of a beam; he must use a steel tape.  An accountant cannot use a rubber dollar to measure the worth of an enterprise; he must use gold.  Well, today, they do try to use dollars, but there is a systemic bias towards overstating profits and understating losses.

Unfortunately, Mr. Sri-Kumar’s main idea is wrong.  He wants governments to fix the price of gold.  He even claims he knows the magic number: $1675 per ounce.  Mr. Sri-Kumar and everyone else should be reminded that price fixing never works (and the price is always fluctuating in a free market).

Apart from this fatal problem with price fixing, government always gets the wrong price for two reasons.  First, they don’t have perfect information, and second there are special interest lobbyists.  Imagine the debate in Washington about a fixed gold price.  Debtors would want the price to be high, so they could liquidate their debts with as little gold as possible.  Creditors would want the gold price set low, so they can get more gold out of their counterparties.  The fighting between the special interest groups would be like the shoot-out at the OK Corral!

Mr. Sri-Kumar proposes to return to the last throes of the terminal gold standard, the twisted husk known as the “Bretton Woods System”.  In this system, it was a criminal offense punishable by imprisonment for a US citizen to own gold.  While Mr. Sri-Kumar did not endorse this particular feature, it is a necessary feature because otherwise unpredictable people could begin buying gold and force governments to either let the price rise or else drain their reserves of gold.

In Bretton-Woods, the dollar was redeemable only by foreign central banks.  Those banks were indeed redeeming, at an accelerating pace.  By 1971, they were bringing enough dollars to the US to take home over 100 tons per day.  The US government was within a few months or running out of gold at that rate.  President Nixon made his fateful decision to “temporarily” suspend redeemability as a response to this monetary crisis.

The failure of Bretton-Woods was inevitable.  Economists Jacques Rueff and Robert Triffin predicted it many years before it happened.

I covered some of the problems of the pre-1913 gold standard, but it was superior in every way to Bretton Woods.  It certainly did not self-destruct.

It’s good that Mr. Sri-Kumar pointed out that there cannot be debasement and thus endemically rising prices under gold.  But there is much more to be said, if we are to avoid the fate of Rome.  The next time Bloomberg needs someone to talk about the gold standard, let’s hope they pick someone who  understands it fully. 

For those who are interested, I published a video yesterday discussing an important consequence of irredeemable dollar: the system is collapsing under the weight of the rising debt.

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It’s curious, isn’t it?  So-called “paper gold” (a futures contract) has a price that is not only very close to physical gold, but it remains locked to it.  This is despite the fact that “paper gold” is reviled in the gold community. 

I am writing this on Sunday evening with little liquidity in the market, and yet spot gold (XAU) is 1665.80 and the December future (GC Z3) is 1674.40.  There is a small positive spread, about 0.5%, between spot and future.  This spread is remarkably consistent from day to day.  If spot gold goes down 1.2% then the December future,and the other months as well, go down by almost exactly 1.2%.

It’s worth underscoring that these are different prices for different things in different markets.  “Paper gold” is not physical metal!  If there weren’t some force that kept their prices locked together, they would detach and one could rise while the other falls, or vice versa.  This is not, in fact, how they behave.  They remain locked (at least for the time being).  Why?  What is this mysterious force that binds them tightly together? 

Let’s take a step back for a moment.  The futures market exists to serve the needs of producers and consumers.  Producers—miners in this case—need to have predictable and consistent cash flow so they sell some of their production forward.  Consumers, such as electronics manufacturers, and jewelers, have the same need so they buy some of their raw materials forward.  Both can sign a contract now that locks in a price at some date in the future.

Of course, in the gold standard, there would be no such thing as a gold futures market.  Futures for all other goods would be priced in terms of gold.  Gold itself would not be available at a discount, nor would one ever need to pay a premium to get it.  One could borrow it at interest, but that is in the bond market not in the futures market.

Once a futures market is established, speculators come in to bet on the direction of the price.  They do not produce the good—gold in this case—nor use it.  They cannot deliver gold to a buyer, nor do they wish to be delivered gold.  They want to profit from a change in the price.  They believe they have superior knowledge compared to the other market participants, and so use the futures market as an easier and more convenient way to bet than the physical metal market.  And besides, the futures market offers leverage.

This is the basic theory of the futures markets, in a nutshell.  Producers and consumers are trying to reduce risk.  Speculators are making bets, pushing prices around, sometimes annoying the producers and sometimes annoying the consumers. 

We still have not explained the fact that the price of “paper gold” tracks the price of gold metal.  To do that, we need to introduce a third type of actor in the futures markets.  The arbitrageur does not care about price; he is focused on spread.  The arbitrageur can buy physical metal and at the same time sell a futures contract.  This will earn him a little over $8 per ounce based on the prices I quoted at the top, or a bit more than 0.5% annualized.  Compared to the yield on a 1-year Treasury, about 0.15%, this isn’t bad.

So long as the price of the futures contract is higher than the price of the physical metal, then the arbitrageur can buy metal and sell a contract to pocket this spread.  This will obviously lift the price of the metal and depress the price of the paper, compressing the spread.  The arbitrageur will stop when the spread becomes too small to be worth his time, effort, and risk. 

If the futures contract ever became cheaper than the physical metal (called “backwardation”) then anyone who owns a gold bar can sell it and simultaneously buy a future with the intent to stand for delivery.  In this case, the arbitrageur sells physical metal and buys a future, thus depressing the price of metal and lifting the price of the future.  As in the previous case, the spread is compressed.

This is not merely academic theory.  Analysis of this spread (called the “basis”) can shed light on what’s really happening in the markets.  Sometimes (as now) there is a simple trade that is obvious, but only to someone looking at this spread.

In Part II of this article (free enrollment required for full access), we walk through the analysis and propose a contrarian precious metals trade.

There is an article in the Financial Times (http://www.ft.com/intl/cms/s/0/35bb9e50-6a13-11e2-a7d2-00144feab49a.html#axzz…) about debt problems in China.

I have taken the liberty of summarizing the key points:

This article originally appeared in The Gold Standard, the journal of Gold Standard Institute.

What does Japan hope to get from this?