In Part I, we discussed the concept of arbitrage. We showed why defining it as a risk-free investment that earns more than the risk-free rate of interest is invalid. There is no such thing as a risk-free investment, and in any case, economics must be focused on the acting man rather than theoretical constructs. We validated that arbitrage arises because the market is constantly offering incentives to the acting man in the form of spreads. Arbitrage is the act of straddling a spread. Arbitrage will tend to compress a spread. The spread will narrow, though not to zero because no one has any incentive to make it zero.

In this Part II, we look at the question: Is gold a currency? Professor Tom Fischer answers, “Yes, gold is a currency with the symbol XAU”[1]

Upon first reflection, one should become slightly uneasy about this logic. The question of what is a currency is essential to his argument about gold backwardation. We should not abdicate our responsibility to address this question, by deferring to the symbol naming committee at Bloomberg. Let’s look at the facts of reality to see what we may discover about this.

I should first disclose that I am president of the Gold Standard Institute USA. I have written many times to advance the understanding of why gold is money, most recently for Forbes.[2] That proposition is not under debate here.

Whether gold is a currency is a separate issue, and it’s key to Fischer’s argument in Why gold’s contango suggests central bank interference. It is important to keep the context firmly in mind. He contends that contango merely means that the rate of interest in gold is lower than the rate of interest in dollars, and further that the interest rate in gold should be higher than in dollars. Thus gold should normally be in backwardation. Therefore its historical contango is evidence of central bank manipulation. This chain of logic depends on gold being a currency in this context.

Deducing from definitions is always fraught with the possibility of error, and if one does it at all then one should be very careful to hold a consistent context. Consider the following reductio ad absurdum. Let’s define a box as a square container. Let’s define square as when someone is socially awkward and unpopular (this is an old-fashioned American expression that has been falling into disuse). Therefore it is awkward to buy products that come in boxes. There is a subtle logical error here which leads to an obviously absurd conclusion.

The error is that we switched contexts. No one proposition is false, but in the progression from proposition to proposition we changed the sense of the key concept. The result is an unsupported conclusion, where one thinks one has proved it.

We are trying to form conclusions about things as they exist in reality. We therefore cannot just manipulate symbols on paper. Those symbols have referents in reality that we must keep firmly in mind at all times. This becomes doubly—triply—a risk if we attempt to deduce from definitions. We cannot assume all characteristics of one thing that fits into our definition apply to other things that also fit into our definition.

Suppose we define currency as “a unit of exchange.” OK, the dollar is a unit of exchange. The dollar is printed in green too. Can we assume that all other currencies are printed in green? The dollar has a rate of interest. Can we assume that all other currencies have a rate of interest? What do we mean by a “rate of interest”, anyway? Are all rates in all currencies equivalent in all regards, regardless of how they are arrived at?

It is not in dispute that, in some contexts, gold is a currency. There are certainly transactions that take place today in which goods are exchanged for gold. Does this fact allow us, without further consideration and without context, to conclude that therefore gold backwardation is simply when the interest rate is higher in gold than in dollars? No way.

I have presented my theories of how the rate of interest is set in irredeemable currency[3] and how it is set under the gold standard.[4] The mechanisms are quite different and there is no reason to expect the spread between the rates to remain consistent, nor to expect any particular relationship between them.

It is not valid to philosophize, as Fischer does, that the rate of interest “should” be higher in gold because of tight credit conditions, or that it “should” be lower because of less inflation. Maybe, but a proper approach to monetary science demands that we find incentives and mechanisms by which the acting man will profit by moving the spread in the direction we suppose it ought to go.

The interest rate in irredeemable paper is unstable. It has spiked to dizzying heights, and it is now collapsing into the black hole of zero. If one wished to make assumptions, there is some reason to expect that the rate of interest in dollars should be higher during the rising cycle, especially as it spikes upwards, and lower during the falling cycle. Even this assumption is tricky because the complicating factor is that the rate of interest in dollars affects what happens in gold. A discussion of this interplay is outside the scope of this paper.

The reality is that we don’t have a gold standard today. We cannot assume that the rate of interest in gold is set today by the mechanisms I describe in In a Gold Standard, How Are Interest Rates Set (indeed it is not). To answer the question of how the gold interest rate is established today, we must look at who the actors are and the mechanics of what they do. Remember, we are not interested in floating abstractions such as definitions that do not refer to reality and the acting man. We want to know who does what, and what his incentives are, and contrast to the actors in a gold standard.

Although I have looked and inquired all over the world, I know of only two businesses that keep their balance sheets in gold. One is the fund I manage. I decided to keep the books in gold both because it’s appropriate to the nature of the fund, and to develop a case study on how to do it. Both of these reasons are way out of the mainstream.

The Perth Mint is the other, and they keep hybrid books for a simple reason. They have both cash costs and significant gold flows. They are specialists in the gold business. It is likely that a few other businesses of which I am not aware also keep their books in gold, but this is clearly a de minimis niche (if you keep your books in gold, I would love to hear from you).

This context is important because only a balance sheet denominated in gold can borrow in gold. Think about the typical case in the dollar world. For example, a chef borrows money to build out an attractive restaurant with posh décor and a hip bar where they plan to sell lots of expensive fancy mixed drinks. They spend some of those dollars to buy tiles, wood, mirrors, and light fixtures. They spend the rest to hire workers to build out the interior space to their design.

Businessmen and even economists do not normally think of the borrower as being “short” dollars. It’s easy to ignore because the borrower usually takes no currency exchange rate risk. He does not “sell” the money, and have to worry about “buying” it back at a later date at much higher prices. The enterprise is long a dollar income stream, and this is a perfectly suitable asset to match the short dollar loan.

Virtually every business and many individuals borrow in dollars, euros, pounds, yen, etc. Every business and most individuals keep their savings in those paper currencies. Savings, in this context, means that they are lenders. It is not possible to hold paper currency without being a creditor.

The extending and utilizing of credit in the dollar is exactly as one would expect of a widely used currency. Virtually everyone participates, with many on both sides simultaneously. It is therefore appropriate to speak of an interest rate in dollars.

What of gold? Why is lending gold called “leasing”? Who lends it? Who borrows it?

Gold lending might be called “leasing” to work around the legal tender laws. If it were legally structured as lending, then the borrower would be able to tender payment in dollars and the law and courts would consider the debt to be repaid. Clearly, no one would lend gold only to be repaid in dollars. Or worse yet, give the borrower a free option, to pay in whichever form is cheaper.

Another possible reason is the tax code. I am no tax expert, but I know that under U.S. law, the lessor does not incur capital gains if the market price of the leased property rises before the lease period is up. This is because the title to the property remains with the lessor. In a loan, a tax expert would have to opine, but the title may legally change hands and therefore there may be a capital gains tax if the price rises. This tax could easily exceed the interest, thus making a loan structure unfeasible.

I propose a third reason. Gold is not borrowed to finance business expansion or to buy machinery and real estate, much less consumer goods such as autos or a university education. Gold is not borrowed to finance purchase of long-term assets.

Businesses that specialize in gold, such as refiners, mints, and jewelers use gold leases, to enable them to carry[5] inventory or hedge inventory. These businesses operate on thin profit margins, and they cannot accept the risk of the gold price moving adversely to the dollar, in which their books are denominated.

I discussed the hedging of currency risk in detail in Theory of Interest and Prices in Paper Currency, so I will not repeat that material here. I will merely note that currency risk occurs when you are either long or short a currency that is not the numeraire of your balance sheet. If you are long the Japanese yen, and the yen drops relative to the dollar, then you incur losses. If you are short the euro and the euro rises, then you similarly take losses.

Those losses will often result in a margin call, which can drain the cash away from productive parts of the business. If they are large enough, then the firm can become insolvent. Businesses therefore buy hedges to protect themselves from these risks. The sellers of this protection themselves buy hedges. The buying and selling of hedges can go round and round, but there is no way for the risk to be eliminated. This lump stubbornly remains under the rug no matter how it’s pushed this way or that.

Consider the case of the coin shop. At any given time, it carries 100 gold Eagles in inventory so that it will be ready whenever a customer walks through the front door to buy gold. To manage the risk, it sells short a gold futures contract. With this hedge in place, it has no exposure to the gold price. The shop owner can sleep easily at night, knowing that so long as he can sell coins at X dollars above the spot price, he can be consistently profitable. He has no price risk.

Jewelry manufacturers and retailers are in the same position. Refiners, mints, and gold miners also have the same risks and needs. Thin margins do not mix with a volatile gold price, as measured in their native paper currency.

There is another way to look at these businesses’ use of gold. They are using gold as financing, similar in some ways to Real Bills. Recall that a Real Bill is used to finance inventory that is moving predictably towards the consumer. The baker doesn’t want to borrow money to buy the flour he carries. The Bill emerged out of the market spontaneously, as a solution to this problem. The Bill enables him to carry his inventory, without him having to have the capital to own it.

The baker’s issue was not volatile flour prices, but the cost of borrowing. Today, if there’s one thing central banks have achieved via their spigots that gush unlimited credit-effluent, it is that dirt-cheap credit flows to bakers, coin shops, and everyone else. It is not to avoid the cost of borrowing that they carry rather than own outright their gold. It is to avoid the risk of price movement.

The analogy to Real Bills is the use of self-liquidating clearing credit. This credit finances inventory that is moving towards the consumer, and it is extinguished by the sale of the inventory. It is not quite the same as the Real Bill, but compare and contrast to bonds. Bonds are used to buy plant or other long-term assets. The credit used to buy such assets is not liquidated by the sale of these assets, but amortized over years by the sale of products produced by operating the assets.

The gold “lease rate” is conceptually closer to the discount rate of Real Bills than the interest rate of bonds.

The opposite need occurs in other businesses. For example, look at the case of a business that seeks to arbitrage a differential between the gold lease rate and the dollar interest rate. They borrow gold and sell it to obtain dollars, which they invest at the LIBOR or use to buy Treasury bonds. This is also a thin spread. Unlike the coin shop, whose concern is a falling gold price, their concern is a rising gold price. This sort of business must buy a gold futures contract to hedge that risk. It would be suicidal for any business that leased gold and sold it unhedged. Sooner or later, the falling dollar—which would be experienced by this foolish business as a rising gold price—would sink them into bankruptcy. And that’s even assuming that the gold lessor of the gold would allow it.

There are other businesses that operate similarly in the gold market. And there are also arbitrageurs who straddle spreads in the gold market. For example, sometimes it is profitable to carry gold, and at other times to decarry it.

The point is that the gold lease rate is not set by the time preference of the marginal saver and the profit of the marginal entrepreneur. Savers who want to keep some of their surplus wealth in gold have only hoarding available to them. There is no such thing as a deposit account denominated in gold, paying interest in gold (if anyone is aware of such an account, please contact me).

The chief objection to holding gold expressed by most mainstream investors is, “gold has no yield”. This means that there is no investing in gold, only speculation on its price. Even the gold bugs whose motto is “the dollar will hyper-inflate soon” buy gold for their belief that its price will rise. They buy it as a speculative vehicle to get more of the dollars that they claim will soon be worthless.

The point of this discussion is that the cost of gold hedging, or alternatively, something akin to the gold discount rate, is a specialty niche. Unlike a bona fide interest rate, the gold lease rate does not emerge from the actions of either savers or entrepreneurs. Nor does it arise from the actions of the consumer and the retail industry in general, as the discount rate would in the gold standard.

The issue is not just the small number of participants or the total trading volume, but the fact that the trades which give rise to the gold lease rate today are a special case, unique to gold’s unnatural role under the worldwide regime of irredeemable paper.

It is interesting that the gold lease rate is not quoted directly. It is derived from two others things. It is calculated as: lease rate = LIBOR – GOFO. LIBOR is a dollar interest rate, and GOFO is the rate on a gold swap. No interest rate in the world has to be derived like this.

One should be careful not to try to read too much into the absolute level of the gold lease, or its spread to LIBOR. To wrap up this part of the discussion, let’s go back to Professor Fischer’s statement about the meaning of backwardation. He says that if gold is in backwardation, then that means that the gold lease rate is above the rate of interest in dollars.

I agree (with the entire discussion above as caveat), though I have one issue with that formulation. The correct definition of backwardation is when the bid on spot gold is greater than the ask on a gold futures contract. This is because backwardation in a commodity refers to when it is profitable to decarry it. This means one can sell the good in the spot market (on the bid) and buy it forward (at the ask). A positive decarry tends to correlate with negative GOFO, but not perfectly.[6] They are separate measurements. The positive decarry is the more accurate signal, not least because it is observable as a function of real market prices and is by definitional actionable. GOFO is calculated as a mean of quotes by six or more bullion banks’ reported rates, and if one wished to act on it one might find the real-world rate different enough to preclude profitable action.

Professor Fischer has published another paper[7] in the time that it has taken to me to write this second part. In this paper, he makes an error that illustrates my theme in this paper.

“The interest rate at which market participants can borrow gold without posting any collateral is called the gold lease rate (GLR). It is usually denominated relative to the Dollar amount of borrowed gold. For example, if the one year GLR was at 2% and gold spot was at USD 1,200, then someone could now borrow 1 oz of gold for one year, and they would have to return 1 oz of gold plus USD 24 in one year’s time. While GLR could also be expressed as a percentage of gold ounces that have to be returned, this is not commonly done. Nonetheless, it is obvious from this definition that GLR is the interest rate for borrowing gold.”

The error is very subtle. He says that if you borrow one ounce of gold then you can pay back the ounce plus $24. However, $24 is not equivalent to 2% interest in gold. 0.02 ounces is 2% interest. 0.02 ounces may work out to $24, or less or far more.

The distinction between leasing and lending may not matter in many contexts. In this one—comparing the dollar interest rate to the gold lease rate—it does. If gold had a proper interest rate, then no lender would treat it repayment in gold as equivalent to repayment in dollars.

Today, gold is leased. It is leased by entities who keep their books in dollars. Repayment in dollars makes it simpler for them, and likely reduces their need to hedge. The lessor, in other words, wants a dollar income and happens to be using gold in this case to make it.

This is a good segue into the topic of gold’s dual nature. In this paper we have discussed gold as a currency. Gold is also a commodity, and analysis from that perspective may shed some more light on the topic.

In Part III, we discuss gold as a commodity.

The popular view today is based on the linear Quantity Theory of Money. It seems to be common sense. If more units of a currency are issued, then the value of each unit should fall. Many people may not think of it in explicit terms, but the idea is that the value of one unit of a currency is 1/N, where N is the total money supply. If you double the money supply, then you halve the value of each currency unit.

Inflation, according to this view, is either the cause—the increase in the money supply itself. Or it’s the effect—rising prices. The Keynesians hold that inflation is good, and the Monetarists basically agree, though they quibble that the rate should be limited. The Austrians universally think inflation is bad.

The Quantity Theory is not based in reality. One should think of this theory like the Lamarckian theory of evolution.[1] Lamarck asserted that changes to an animal’s body—e.g. its tail is cut off—can be passed on to its offspring. At the time, this theory may have seemed only common sense, and it was very convenient, if not tempting. The same is true with the Quantity Theory of Money. It is convenient, seems like common sense, tempting—and wrong.

The Fed has been inflicting Quantitative Easing on us for five years. There are many negative effects, but rising prices, today, is at best debatable. Certainly, even where prices have risen, the increase is not nearly proportional to the increase in the money supply. Advocates of the theory explain this by saying that the money hasn’t entered the economy, it’s sitting on bank balance sheets. However, money is always on bank balance sheets in a debt-based system, so this answer is not satisfying.

Enter, bitcoin, a cryptography-based currency and technology developed by someone with the pseudonym Satoshi Nakamoto. It has been designed to have a limited rate of growth in the total quantity of currency, up to a predefined cap. There can never be more than 21M bitcoins. The Quantity Theory says that this will make prices of goods measured in bitcoins stable.

One problem with this theory is that the real costs in terms of land, capital, and labor to produce things is steadily falling. Every productive enterprise is constantly seeking to drive cost out of production. If a currency had a constant value, then prices in terms of this currency would be falling.

As we shall see below, the value of bitcoin will be anything but constant. Without a mechanism for responding to increased market demand by creating more currency, there is a fatal flaw.

In the real world, when prices appear to be stable it is not because anything is static or unmoving. It is because there is constant arbitrage. Arbitrage is the act of straddling a spread. If one thing becomes more valuable relative to something else, then someone will take the arbitrage. For example, if the price of eggs in a city downtown rises relative to the price of eggs in a farm town 50 miles away, then someone will buy eggs in the farm town and sell them in the city. This will lift the price in the farm town and depress the price in the city center, until there is not much of a gap any more.

To continue with the analogy on to another point, what happens if the price of eggs in the farm town is higher than the price in the city? This arbitrage is one-way. Distributors can only buy in the farm town and sell in the city; they do not distribute in the other direction.

There must be another arbitrage or arbitrages, if the farm-city egg spread is to remains stable. Indeed, there is. If the price of eggs gets cheap in the city, then consumers will prefer eggs to other foods.

In the body of a vertebrate, every joint is stabilized by a pair of muscles. Consider the upper arm. The biceps flexes it, and the triceps extends it. Muscles can only pull, but not push. There must be a second, opposing, muscle to move the joint in the opposite direction. This is analogous to arbitrage, as each arbitrage can only pull a spread tighter in one direction, but not push in the other.

No market is more important than the markets for money and credit.

So what happens when the price of money itself rises? In thinking about this question and the answer, you should not look at the dollar. The dollar is defective by design and does not work the way proper money ought to. The dollar is the product of fiat, not of a market. Everything about it is driven by forced wielded by the government.

It is more instructive to consider gold. Gold is produced by gold miners. They buy labor, oil, truck tires, machine parts, and they sell gold. As we saw above, they bid up these inputs and gold metal onto the market. The gap between the value of gold and the value of this broad swath across the major factors in the real economy is thus closed by the arbitrage of gold mining companies. This keeps the value of gold from becoming too high, or in other words allows gold to be produced in response to market demand.

What happens if market demand for gold drops? One reaction is that the jeweler and the artisan increase their activities. They tend to bid up gold metal, and sell jewelry and objets d’art onto the market. There is another kind of arbitrage, which is outside the scope of this article[2] but it’s worth mentioning. If the demand for gold metal drops, then the owners of gold, otherwise known as savers, can lend gold for interest. This tends to press down the bid on the rate of interest.

Now consider bitcoin. Bitcoin is not a fiat currency. No government forces anyone in any way to use it. However, bitcoin is irredeemable. That is, there is no agreement by anyone to redeem bitcoin in exchange for a defined quantity of gold, silver, or any real good. With its fixed quantity, there are no arbitrages regarding the value of bitcoin. So what does this mean? What will happen?

The value of bitcoin will be set entirely by speculators. In gold, there are numerous forces in reality—i.e. numerous arbitrages—that will keep the value of gold tied to the values of every other thing in the economic universe. The value of gold in a free market is the exact opposite of untethered and arbitrary. The value of gold cannot crash and it cannot shoot the moon.

Satoshi Nakamoto ignored these forces, and his design does not provide for them. The value of bitcoin is not tethered by the value of labor and capital. It was assumed to be sufficient that its quantity is fixed. It is the exact opposite of sufficient—a fatal flaw based on the Quantity Theory of Money, which is flawed to its core.

The speculators will use bitcoin as a toy to generate profits (as they already do). When the value of bitcoin is rising, it will be obvious. Everyone has a chart, and they can pile on. The value can rise much farther than anyone would expect. Eventually, the chart will show a topping pattern. Momentum will dry up. The speculators can see this too, and thus will begin a collapsing wave of bitcoin.

If a giant speculative spike occurred in food, the consequence is that poor people starve. When the price crashes, the consequence is that food producers will go bankrupt. As bad as this is, the consequences when the value of money spikes and crashes are incalculably worse. This is because every business, including food growers, depends on a stable currency.

To understand this, let’s ask the following question. If you take two bushels of corn and feed it to raise one chicken from egg to market, did you create or destroy wealth? Which has greater value, two bushels or one chicken? To answer, we use the common denominator of money. If Two bushels cost ½ ounce of silver and a chicken is 2 ounces of silver, then feeding the corn to the chick creates value.

Simple cases like this can be (and were, in the ancient world) resolved without money. Complex cases cannot be. If you borrow money to buy land, erect a building, buy machines and inventory, then hire people to manufacture computer chips, did you create or destroy wealth? This question cannot be answered without a stable unit of measure. It would not have been possible to answer it in the ancient world.

Businesses keep books to measure profit and loss. The very principle of bookkeeping depends on a constant value of the unit of account, the numeraire. When the value of the numeraire spikes and crashes, then business which produce wealth go can bankrupt. At the same time others, which destroy wealth, can grow larger, employing more people and more capital to scale up their wealth-destroying activities. This is occurring today on a massive scale.

Bitcoin may make a great speculation today, because its unique combination of technologies enables many transactions that would otherwise be impossible (due to government fiat). If you live in a country that does not recognize your right to freedom of speech, you can trade your local currency for bitcoin, pay WordPress, and have your blog hosted safely outside your regime. There are many other kinds of legitimate transactions that are made possible by bitcoin.

Bitcoin would not work as the exclusive currency. Its unstable value is not suited to being used as the numeraire. For the same reason, it is not suitable for hoarding by wage earners. As I explain in In a Gold Standard, How are Interest Rates Set? it is the arbitrage between hoarding and saving (i.e. lending) that sets the floor under the rate of interest. If bitcoin is unsuitable for hoarding, then either it will not develop a lending market, or the lending market will not have a stable interest rate. A destabilized interest rate is the root cause of the ongoing global financial crisis.[3]

Bitcoin works well as a foil to fiat currencies. It makes it possible for people to conduct business that would otherwise be impossible. If enough people participate, then it becomes more difficult and more unpopular for governments to act to squelch those activities. It’s a pointed object lesson, showing people what is possible in a less-unfree market. Hopefully it will motivate them to clamor for more freedom.

Only gold serves as the objective measure of value necessary to act as the numeraire. It is no coincidence that the quantity of monetary gold is not fixed, but has elegant mechanisms to expand and contract in response to changing market demand.

Professor Tom Fischer has written three papers[1][2][3] about gold backwardation and arbitrage. Across these three papers, he makes a case against the ideas of Professor Antal Fekete. I write this response solely on my own behalf. I do not speak on behalf of Fekete or his New Austrian school of Economics. I have two motivations for writing. First, I have written myself extensively about the gold basis and gold backwardation. Second, I have discussed my basis theory[4], and used it both to analyze market events (e.g. the crash of April 12 and 15, 2013)[5] and to make predictions, via the Monetary Metals Supply and Demand Report[6]. Additionally, I want to present a fuller treatment of certain topics.

The best place to begin is with Fischer’s discussion of arbitrage. Before addressing what he thinks is the flaw in Fekete’s definition, I want to look at an important point that Fischer makes. He says that one is not free to arbitrarily change or broaden a definition, in order to smuggle one’s conclusions. In Fekete’s Arbitrage Fallacy, Fischer writes:

“His mistake is akin to someone who has decided that the notion of “gold” was too narrow when only used for actual gold, so, to generalize and broaden the concept, any other metal should be called “gold” as well.”

Of course, I agree that this would indeed be an egregious error.

In each of his three papers on this topic, Fischer offers similar wording to define arbitrage, so let’s take the most complete one, also from Fekete’s Arbitrage Fallacy:

“…arbitrage in any currency is an investment that outperforms the risk-free rate of interest in that currency…”

There are two principles that students of the Austrian School will recognize right away. First, there is no such thing as a risk-free rate of interest. Non-Austrians are discovering this too, for example the European Central Bank. ECB executive board member, on Dec 9 Peter Praet, said:

“Appropriately treating banks’ holdings of sovereign debt according to the risk that they pose to banks’ capital makes it unlikely that the banks will use central bank liquidity to excessively increase their exposure to sovereign debt.”[7]

Banks have been borrowing from the central bank in order to buy the bonds of sovereign governments. The cost of borrowing from the ECB is lower than the interest rate on those sovereign bonds. They would appear to be performing arbitrage, as Fischer defines it.

But, as Mr. Praet reminds us, these bonds do pose risks. If the sovereign bond is risky, then what real instrument pays a risk-free yield?

The banks are not doing this because it has no risk. They are doing it because the ECB is offering dirt-cheap credit. In proposing its new regulations, the ECB is saying that it does not intend to stop offering subsidized credit. It just wants to impose restrictions on what banks can do with this credit or how much they can qualify for.

By the way, Fischer’s definition above does not state explicitly that the arbitrage investment is also supposed to be risk free. Later in the paper, he does state it:

“Yes, an arbitrage is risk-free, but it also needs to be better than the risk-free rate.”

There is no such thing as a risk-free investment either. Even the simple act of buying shares in New York for 99 and selling them a few milliseconds later in London for 100 has certain risks. Defining the unreal risk-free investment in terms of the unreal risk-free rate of interest is the finance equivalent of defining a dragon as a creature which preys upon unicorns.

The second principle—and this should not be controversial—is that the purpose of economics is to study human action. This was the title chosen by Ludwig von Mises, the greatest 20^th century economist, for his greatest work.

The acting man is the proper focus of the economist. Whatever the merits of the notion of a risk-free interest rate, it has no relationship to actors in the economy. Indeed, it has no relationship to reality, and therefore it has no place in a proper theory of economics.

In teaching physics to new students, there is some merit to first studying frictionless surfaces, mass-less strings, and so on. Oversimplification is useful here, to allow the students to concentrate on learning basic principles first. More advanced students must deal with the complexity of the real world including strings that have mass.

There are two differences between positing a mass-less string and a risk-free rate of interest. The real string with mass is quite similar to the mass-less string, especially when the weights it ties together are orders of magnitude more massive. And the physics instructor makes it clear from the beginning that mass-less strings are just for novice students.

I do agree with Fischer on the principle that a proper definition for each concept is essential. Arbitrary definitions will not do, whether invented by a lone dissenting individual or by the consensus of an entire profession.

The opposite of arbitrary is objective, which means based in reality. All proper concepts are based in reality. Therefore, to properly form a concept, and hence define it, one must begin by looking at the various facts that give rise to it.

Ayn Rand wrote about concept formation:

“A concept is a mental integration of two or more units possessing the same distinguishing characteristic(s), with their particular measurements omitted.”[8]

An example is the definition of chair. It’s a piece of furniture that you sit in. The definition does not include any mention of color, size, material, or number of legs. It must be broad enough to include every chair you will ever see in your life. At the same time, the definition must exclude all non-chairs such as tables, lamps, shelves, cars, and computers.

In Fischer’s example of a badly formed concept, gold is defined as all metals. All metals do share certain characteristics such as uniformity, divisibility, electrical and heat conductivity, etc. That is why we have the concept metal.

But we have the concept gold because gold is distinguished from all other metals. A definition of gold, which includes things such as zinc that do not possess its unique characteristics, is invalid. Such a definition is much too broad, and therefore unusable. It would cripple the thinking of anyone who accepted such a definition. Gold, iron, and zinc are all metals. Only gold is gold.

We’re now ready to build up to a proper concept of arbitrage. We will base our approach on something that exists in reality that’s performed by the acting man. Per our discussion of definitions, we must be thinking about what distinguishes arbitrage from all other kinds of actions.

Let’s look at certain principles described by Carl Menger, widely considered to be the founder of the Austrian School of economics. It is a fact that in all markets, there is not a single monolithic price. There is always a bid price and an ask price. Menger arrives at this by noting the problems in a then-popular notion. A certain quantity of one type of goods was assumed to be equivalent to another quantity of a different type of goods, if those goods were exchanged. In his book, Principles of Economics, Menger notes that if the goods were truly equivalent then any transaction could be reversed. But in reality, it does not work this way. If you buy 100 bushels of wheat at the grain market for 5 ounces of gold, then you cannot sell that wheat for 5 ounces unless the market moves upwards. Your loss is the bid-ask spread.

The bid and ask prices open up a whole new mode of thinking in economics. You can see that if you have wheat that you must sell then you must accept the bid price. If the wheat you provided to the bidder satisfies his demand, then this bidder will leave the market. The next-best bidder is the bidder below him. To sell something on the bid tends to cause the bid to drop. The opposite is true with buying at the ask price. It tends to lift the ask.

Consider the case of eggs offered in a farm town and bid in the city center. In this case, an actor can pick up and deliver the eggs. To do this, he must pay the ask price on eggs in the farm town, and be paid the bid in the city center. His profit is the city center egg bid minus the farm town egg ask.

In reality, it’s somewhat more complicated than this simple example. The would-be egg distributor must also buy fuel, a truck, and drivers’ wages in addition to eggs. He must pay the ask on all of these inputs.

The action of this egg-distributing actor will lift the ask price in the farm town and depress the bid price in the city center. As he scales up his activity (or his competitors do) the profit margin of this business will shrink. Will it go away entirely? No, the margin will never shrink to zero in the real world. It will shrink with each new competitor, until no new competitors are attracted to this business. More formally, we say that the marginal distributor walks away from this market; the spread is too small.

Marginality is another key idea introduced by Menger. Marginality provides an elegant and concise way to understand markets. If a bid ticks lower, then a marginal seller will leave the business of producing that good. If an ask ticks higher, then a marginal user of that good will either find a substitute or go out of business.

As markets developed, an actor appeared who was certainly not well understood at the time, and not well understood even today. The market maker stands ready to buy or sell. He makes a bid and an ask in the same good. In so doing, he narrows the bid-ask spread. He is the force that pulls down the ask if the bid is pressed, or pulls up the bid if the ask is lifted. Will the bid-ask spread ever be zero? No, it will compress until the marginal market maker walks away. Incidentally, each good has a different bid-ask spread, as a function of its liquidity (gold has the narrowest by far).

Now let’s move to a different kind of example, a consumer who buys apples every week. On the next visit to the grocer, he sees that pears are on sale. He switches his custom, refusing the apples and buying the pears instead. What will his action (along with the actions of many similar consumers) do? What will be the effect on apples? Without his buying, there is less pressure lifting the ask price. Instead, the apple merchant may have to dump apples on the consumer bid. In the pear market, his action lifts the ask.

The simple act of switching his custom is motivated by a certain kind of incentive offered by the market. And it will have a particular kind of effect on prices in the market.

We have looked at distributors, including those who buy multiple inputs to sell one output, market makers, and consumers who switch goods based on a sale. There are many other kinds of economic action that have something in common with these examples, but these few are sufficient. From them we can identify the essential. What do they have in common? What characteristic unites our examples and at the same time distinguishes them from all other kinds of action?

In my dissertation[9], I offered a definition of arbitrage as, “the act of straddling a spread in the markets.” In arbitrage, the acting man is offered an incentive to act, in the form of a spread. Whether this spread is used to earn a profit, or whether it is simply an inducement to try pears for a change, the spread is constantly signaling the incentives to take certain actions and to avoid taking others. There is also a feedback mechanism. The very act of taking the incentive—of straddling the spread—compresses it.

These are the two universal, absolute, immutable, and essential facts that give rise to the need for a broad concept of arbitrage. First, spreads signal an incentive to the acting man. Second, when an acting man takes the spread he causes it to become narrower; thus he reduces the incentive for the next actor to come along.

Arbitrage is what drives economic action and, therefore, it drives prices, changes to prices, spreads, and changes to spreads in markets.

Fischer asserts that arbitrage opportunities should all be arbitraged away. We can now refine this, and state with precision and clarity that every spread tends to compresses until the marginal actor is not attracted to straddle it. The spread does not go to zero.

It is not necessary to assert that everyone acts to straddle every spread offered; this would be impossible and is obviously false. It is sufficient, if we see an actionable spread, to predict that someone or many someone’s will take the arbitrage.

For those interested, a major part of my dissertation was to show that every attempt by the government to interfere with markets forces spreads to widen. This is why the presence of wide spreads today—with worldwide government intervention gone mad—does not invalidate the concept of arbitrage.

In Part II, I discuss Professor Fischer’s assertion that gold is a currency and hence conclusions may be drawn based on comparing its lease rate to LIBOR.

Happy New Year! As I write this, it’s January 1, 2014. This is my annual Reflections article, my opportunity to write less formally and talk about what I am thinking as I look back over an entire year. This piece is much longer than my typical article, less focused and definitely less edited.

2013 was a year of accomplishments. Most of the time, we’re too busy, well, accomplishing new things to step back, pause, and reflect on what we’ve done. I am as guilty as anyone on this charge, so I like to take the opportunity once a year to reflect.

In January, my company launched the first of its kind gold fund. This fund owns bars of metal, and trades to produce a return in gold. Its goal is to increase ounces of gold owned. It is the only fund to keep its books in gold, and the only fund in which the performance fee is measured based on an increase in gold ounces rather than an increase in the dollar value. Also in January, I went on the Capital Account show with Lauren Lyster, which was, as it turned out, the final episode of the show.

I made bold predictions, stuck my neck out in a video, and in several articles that went out to Zero Hedge and Seeking Alpha. Around Jan 23, I said that the rumors of an alleged shortage in silver were rubbish. Silver will fall in gold terms. I said the ratio would certainly rise over 60 and maybe hit 70. At the time, the dollar price of silver was around $33 and the gold:silver ratio was 52. The goldbugs were vehement there was a shortage, and the gold price would shoot up but silver would really outdo gold and the ratio would fall back towards 30 again. Well, the price fell to $18 and the ratio hit 67.5.

In February, we launched the company’s blog at www.monetary-metals.com. This is where my market analysis, gold conspiracy debunking, and commentary on current events in the gold and silver space are published. We also publish the Supply and Demand Report, providing the data and analysis to show the true picture of the monetary metals markets. We started doing videos, where I could use a different media to cover topics better suited to verbal presentation.

In March, Cyprus banks collapsed. People thought it was a case of the government stealing depositors’ money. It was, but not how they thought. The Greek government stole that money over the prior years. They didn’t call it stealing, they called it “borrowing” but they had neither means nor intent to repay. Cyprus banks bought plenty of these counterfeit bonds. When Greece defaulted, that blew gigantic holes in the balance sheets of the Cyprus banks. Before this event, Cypriots thought of gold as something to buy in the hopes its price will go up. After, some learned that the real reason to buy gold is that gold has no counterparty risk. Cypriots who had euros locked in the banks couldn’t access what’s left of their money. Those few who had gold could carry it in their pockets, get on a boat, and go to the mainland.

Also in March, I introduced the broader gold community to the concept of backwardation. Amusingly, at first several notable names in the space tried to school me and insisted that no such thing was occurring. They were armed with bad definitions and unreliable data. I wrote a short article to set the record straight. I wrote several more pieces on backwardation, and by the end of Spring the situation had reversed. Then everyone wanted to jump on the backwardation bandwagon and some even tried to use it to make some pretty rash predictions of the gold price. Sorry guys, there’s a theory behind the word.

In the Spring, I began collaborating with several other people to launch the Gold Standard Institute USA. This culminated in an exhibit at Freedomfest in Las Vegas in the summer, but I get ahead of myself.

Of course, on April 12 and 15 the prices of gold and silver crashed. Of course, the conspiracy theory mongers came out and said that it showed that “the powers that be” had smashed gold and silver. I did a forensic analysis which showed the opposite. Some time after this, I noticed a bizarre phenomenon. Perhaps it had been occurring all along and I just didn’t see it, or it may have been a new thing. In any case, gold bug commentators began to speak of an alleged fracture, a split between what they called the “paper price” and the “physical demand”. They implied that the price of futures was much lower than the price of gold bars and coins. I am sure that most of the people who used this curious turn of phrase in their writing knew better, but I certainly encountered a number of earnest readers who believed precisely that. I always answered the same way, “please tell me where I can sell physical bars of gold for $1900 or $1600 or whatever it is that you feel is the market price of “phyzz”, because I can buy it for a small spread over the official price of spot that you see on every screen.” In fact, the price of spot gold and the price of COMEX futures remained within a buck or two even at the height of backwardation.

Speaking of which, I began chronicling the onset of temporary backwardation of each future as it neared expiry. The date of first onset was getting earlier and earlier relative to the future itself. By August 1, the December contract went into backwardation 67 days before the start of the contract month. Reuters wrote a few articles about it, included my data and quoted me. And then, it all dried up. Supply loosened up, and now there is no backwardation in silver at all and in gold it is de minimus (not that any backwardation in a monetary metal should be casually dismissed).

In April, I began publishing what turned out to be a seven part series on my theory of interest and prices in an irredeemable currency. No, it’s not just rising money supply –> rising prices. That’s like the Medieval view that if you throw a rock, it flies straight until it runs out of force, then falls straight. Convenient, tempting—and wrong.

When I discuss the reason to own gold, I always explain it in terms of counterparty risk and debt default. Gold is no one else’s liability. When gold bugs discuss it, they say the dollar is going to zero like all other fiat currencies. Though they attribute this to what they predict will be an infinite quantity of dollars, they get to what I assumed was the same conclusion (if very different timing). But it kept striking me that gold bugs are so upset at the falling gold price. Why would they be upset that the dollar isn’t collapsing right now? Then it clicked. They use this story as the reason to buy gold, but they don’t really buy it. They want the gold price to rise so they can sell gold and get “profits” (more dollars). If you buy an ounce of gold and the gold price doubles, you still have an ounce worth of money. Sure it exchanges for twice as many dollars as before, but each of those dollars are worth half as much. And the taxman will take many of these dollar “gains” from you. The gold bugs picture the same world we have now, with luxury cars driving around, and private jets, celebrity chef restaurants, jewelry, etc. Only when the gold price hits $5000 or $50,000 or whatever, they will be the fat cats who own it all. They are sadly mistaken. When the gold price hits those numbers—if it hits those numbers before it goes into permanent backwardation—there there will be some very ugly things going on out there. It won’t be a pleasant world, and those with gold won’t want to reveal their wealth, for fear of kidnapping or worse.

Another thing that struck me is how—suddenly, it seems—people became enamored of Chinese central planning. The Chinese are smart, they are wise, they think far ahead into the future. They will issue a new currency, that is “backed” by gold. Ahah, this must be it. They are buying gold. Salvation! Their relentless buying of gold will bail the goldbugs out of their losing positions, by driving the price up to new records and all losses will turn into gains once again.

By the way, it is not possible to reverse cause and effect. The cause is trust, credit extended, and gold deposits into the banking system. The effect is the issuance of a paper bank note that is redeemable in gold. One cannot declare that a previously-irredeemable currency is now redeemable, lest one find that one runs out of gold in one’s ill-fated and short-lived gold price fixing scheme. Unlike the alleged bullion bank naked shorting of gold, such a gold “backed” currency would be a price fixing scheme. It would last no longer than the central bank’s gold reserves.

I had a chance to write about most of the mechanical aspects of the gold market: COMEX open interest, COMEX inventories, GLD inventories, and negative GOFO. I also addressed several episodes of what I called the QTM Gap. Typically, Bernanke would go on TV and promise more QE (or back away from a promise to reduce it). BANG the price of gold would smash upwards, breaking a downtrend it had been in prior to the announcement. One could plot the time to rise, the time the price remained elevated, and the time to fall back to where it had been. My hat’s off to those speculators who must have had orders to buy keyed in, with their finger hovering over the ENTER key waiting for Bernanke to say the word. As to the fools who bought off those early speculators 5 or 10 minutes later, when the price had maxed out, well your losses speak to you more loudly than my words. Once and for all, the price of gold does not depend on the quantity of dollars. You’d think that would be bloody obvious by now, with the money supply rising all year and the gold price, well, not.

In July, Gold Standard Institute exhibited at Freedomfest. I had a chance to meet a few fans, and to moderate a debate on whether we should end the Fed and adopt a free market in money.

In October, I had a chance to attend the annual CMRE monetary policy conference. In November, I went to the Cato annual monetary conference. I was at Cato in 2012 as well. This year, it was a better event, because of the influence of new Cato president, John Allison.

As I write this, the gold price is around $1205 and silver is $19.50. Everyone has been asking me, what do I predict? Let me back up to cover the massive rise in the prices of the metals from 2009 through 2011. As with many other assets, it began with a genuine shortage and the reason to buy was real. More and more people began to buy, and momentum begat momentum drove more momentum. Soon enough, the original story is no longer true, but few know or care. A rising price is its own story.

And the narrative developed that with a massive increase in the money supply due to the Fed’s Quantitative Easing, that will lead to a massive increase in prices especially gold and silver. So buy not only for price gain, but to protect yourself from the dreadful losses in wealth that will be coming to those who hold dollars.

By 2012, it was obvious that the “inflation” story wasn’t working out in reality. There was no massive spike in prices, much less the hyperinflation predicted by some goldbugs. When the story collapsed, it was only a matter of time before the prices of the metals did. The “inflation” trade was busted.

That brings us to the present. I’ve been discussing in recent editions of the Supply and Demand Report that it looks like speculators in gold have basically capitulated. But in silver, they still cling to hope on hope. I suspect there is another leg down in the price, in part because I see much more abundance of silver metal to the market than there is in gold. I also think that this stubborn hope is causing people to hold silver out of false premises. Assuming that we get this last leg down, then both gold and silver are at or near multiyear bottoms. Then what?

There is no driver for a sustained price rise right now. The question is: what will bring it? I think the answer will not likely come from the US but from somewhere else. Right now, numerous credit markets, some of them large, are teetering. Major currencies like the Indian rupee and Brazilian real (remember the “BRICs will save the world from recession” story?) not to mention Japan and several others are at risk. The winding path towards final default is one of debtors getting crushed under the burden of their liabilities. This is likely to be a period of downward pressure on prices, or at most flat prices. But what happens in the final default?

Creditors lose their money. If the creditors are banks, then they will be unable to honor their obligations to depositors (see Cyprus). If this happens on a large enough scale, then it will trigger another wave of gold buying. Unlike the last one, this will be a flight into coins and bars—along with rising prices, we’ll see a rising cobasis. That is one big sign that the price rise is real and permanent. The impetus will be a desire to avoid exposure to struggling counterparties. Only real metal will do.

As I said earlier, this is not likely to be a happy time for gold bugs or anyone else. There will likely be bankruptcies, unemployment, supply chain failures, and all manner of bad things. These events may be more muted in the US than elsewhere.

There is no particular limit to how high this could drive the gold price. That’s assuming this is not the pell-mell rush into permanent backwardation, when gold goes off the board and there is no more gold price! Assuming not, it could easily go to $3000 in gold and $60 in silver. If this is driven by fear of depositor haircuts, then the dollar will get astonishingly strong compared to other paper currencies. And after the dollar the rush will be into gold more than into silver. So I estimated a gold:silver ratio of 50, as a first guess.

I will end on a more positive note. There is a way to avoid permanent gold backwardation. The way is to transition to a proper gold standard. With Forbes publishing some of my articles recently, and other Gold Standard Institute activities planned for the future, we may build a movement for the gold standard into a groundswell. In 1950, very few people thought that Jim Crow could be brought to an end. What they didn’t realize was that, by then, a growing majority had come to regard it as unconscionable.

I think we are close to the point where a majority regards the legal tender laws and capital gains taxes that force us to use the Fed’s paper scrip as money as unconscionable.

The behavior of the dollar system is nonlinear and counterintuitive. In my reading, I have rarely encountered understanding of even the mechanics, much less the dynamics that drive it. Most debate is stuck on level zero: money printing as panacea vs. imminent hyperinflation.

This is a tragedy, because the monetary system is in the final stages of self-destruction, though not by runaway rising prices. As one would expect of any terminal patient, the pathologies are numerous and severe. We just need to take off the price-blinders to see them.

This is my theory of how interest and prices are set under our corrupt fiat paper system. I wrote it in six parts, and then wrote one more paper that should also be included in the series. This blog entry serves as the single landing page for all seven papers.

In Theory of Interest and Prices in Paper Currency Part I (Linearity), I discuss the concepts of nonlinearity, dynamics, multivariate, state, and contiguity. I show that whatever the relationship may be between prices and the money supply in irredeemable paper currency, it is not a simple matter of rising money supply –> rising prices.

In Theory of Interest and Prices in Paper Currency Part II (Mechanics), I move on to the mechanics of the formation of the bid price and ask price, the concepts of stocks and flows, and the central concept of arbitrage. I show how arbitrage is the key to the money supply in the gold standard; miners add to the aboveground stocks of gold when the cost of producing an ounce of gold is less than the value of one ounce.

In Theory of Interest and Prices in Paper Currency Part III (Credit), I look at how credit comes into existence via arbitrage with legitimate entrepreneur borrowers. I also look at the counterfeit credit of the central banks, which is not arbitrage. I introduce the concept of speculation in markets for government promises, compared to legitimate trading of commodities. We also discussed the prerequisite concepts of Marginal time preference, marginal productivity, and resonance.

In Theory of Interest and Prices in Paper Currency Part IV (Rising Cycle), I introduce the rising cycle. The central planners push the rate of interest down, below the marginal time preference and unleash a storm whose ferocious dynamics are more than they bargained for. The hapless subjects of the regime have little recourse, but they do have one seeming way out. They can buy commodities. The cycle is a positive feedback loop of rising prices and rising interest rates. Ironically, the central planner’s clumsy attempt to get lower interest results in rising interest. Alas, the cycle eventually ends. The interest rate and inventory hoards have reached the point where no one can issue more bonds or increase their hoards.

In Theory of Interest and Prices in Paper Currency Part V (Falling Cycle), I discuss the end of the rising cycle. There was a conflict between commodity speculation and leverage. Leverage won. Liquidations impaired bank balance sheets, and the result was a spike in the interest rate. It finally rose above marginal time preference. Unfortunately, it rose over marginal productivity as well. Slowly at first, the bond market entered a new bull phase. It becomes ferocious, as it pushes down the interest rate, which bleeds borrowers of their capital. Companies find it harder to make money and easier to borrow. They are obliged to borrow to get a decent return on equity. In short, they become brittle.

In Theory of Interest and Prices in Paper Currency Part VI (The End), I present The End. At the beginning of Part I, I noted in passing that we now have a positive feedback loop that is causing us to spiral into the black hole of zero interest. In astrophysics, the theory says that a black hole is a singularity with infinite gravity at the center. There is a radius called the event horizon, and everything including light that gets inside this radius is doomed to crash into the singularity. This is a good analogy for the end of the irredeemable financial system.

Finally, The Theory of Interest and Prices in Practice is a follow-up piece, which should be considered part of the series. As the rate of interest rose in 2013, many people asked me if I thought this was a new rising cycle. The short answer is no. The long answer is given in this paper, which looks at the interest rate as the spread between cash and bonds. It’s perverse and counterintuitive.