Here is a post I made to Facebook yesterday.

I was making two points. One, virtually all commodities are in falling trends now (except certain foods affected by the government-create drought conditions in California). Two, it has nothing to do with the money supply.

Some comments on the thread reminded me most people accept the idea that changes in the money supply lead to changes in prices (though not necessarily evenly or instantaneously). This idea is tempting, convenient, and it seems only “common sense”. However, it is facile.

I decided to write this post to add some context. Since 2008, there has been a massive increase in the money supply. M0 has increased from about $875B to $4T. It is now 3.5X what it was. M1 went from $1.4T to $2.8T, or 2X. M2 went from $7.8T to $11.4, or about 1.5X.

Prices haven’t done any such thing. The Bloomberg Commodity Index fell from about 175 to 118 today. In other words, the commodity index is 0.67X what it was.

How do we explain this? I have offered my theory of interest and prices. To condense 12,000 words into a sentence: rising interest rates and rising prices go together.

Here is a graph of the Bloomberg Commodity Index overlaid with the 10-year US Treasury yield, going back to 1996. The correlation is imperfect, but quite visible.

I would like to share a few additional thoughts about this correlation.

At least as far back as 1897, Knut Wicksell observed it. It is interesting to note that he was a believer in the quantity theory of money, but he was honest enough to recognize when the data did not fit the theory. Here is a quote from his address before the Economic Association of Stockholm on April 14, 1898:

“Logically speaking it does not seem possible to give any other answer to our question… than the following:… the level of commodity prices must depend… on the rate of interest. A low rate of interest must lead to rising prices, and a high rate of interest to falling prices. This is in full agreement with the basic principles of the quantity theory of money… Unfortunately, we are once more faced with the same regrettable circumstance: a lack of correspondence between theory and reality [emphasis added]. If we compare… the wholesale prices in Hamburg… on the one hand and the rate of interest in Berlin… on the other, it must be admitted (if it is possible to discover any connection between them at all) that a high rate of interest is associated with high commodity prices and a low rate of interest with low commodity prices, rather than the other way around…”

Irving Fisher, a monetarist, and promoter of the Quantity Theory of Money, realized that rising prices caused high interest rates and falling prices caused low interest rates. He thought the connection worked in the other direction as well, but didn’t know why.

Gilbert E. Jackson was the first to see the bidirectional linkage between prices and interest. He studied wholesale prices and interest rates in Britain from 1782 to 1947. But he could not give a full theoretical explanation.

Antal E. Fekete was the first to propose the theory that there is normally a positive spread between the marginal time preference of the saver and the marginal productivity of the entrepreneur (also integrating the two major theories of the formation of the interest rate). The market rate of interest can move freely between those two boundaries. However, when government interferes, it can either invert this spread or it can push the market rate of interest outside the boundaries (e.g. when the central bank buys bonds). Then, it sets off a self-perpetuating trend.

I think it’s important to acknowledge that the economy is not stateless. A change in one variable—e.g. money supply—may have a different effect depending on the states of individual actors in the economy. It may even have the opposite effect one time as compared to another.

I like to use the example of a pilot pulling back on the yoke. The layman expects that this will cause the plane to climb. However, if the plane is in a spiraling descent, then it will cause the spiral to tighten, and the plane will auger into the ground if the pilot does not correct.

When you’re saturated in debt, you don’t behave the same way as when you’re unencumbered.

Interest rates have been falling for three decades, with no sign of (nor reason to expect) a reversal. Therefore we should expect a trend of falling commodity prices (consumer prices are more sensitive to labor law, taxes, regulations, and other factors).

 

The Gold Standard Institute Presents The Gold Standard: Both Good and Necessary, in Manhattan on Nov 1. You are cordially invited to join us for a discussion of ideas you won’t get anywhere else. The gold standard is the monetary system of the free market—of capitalism. Dr. Andy Bernstein, a rock star of the liberty movement, shows why capitalism is good. In my talk, I explain why capitalism is impossible with fiat money, and why we have not recovered from 2008, and we won’t without gold.

There is much confusion over what the legal tender law does. I have read articles, written by people who are otherwise knowledgeable about economics, claiming that legal tender forces merchants to accept dollars under threat of imprisonment. Recently, I wrote a short article for Forbes clarifying how legal tender law works in the US.

Legal tender law has nothing to do with merchants. If you want to sell steak dinners in your restaurant for silver, you may legally have at it. Unfortunately, the tax code discourages your would-be customers as I wrote in another article.

The legal tender law targets the lender. It grants to debtors a right to repay a debt in dollars. In practice, this means that if you lend gold, the debtor gets a free put option at your expense. If the gold price rises, he can repay in dollars. If it falls, of course he will be happy to repay in gold. It’s a rotten deal for the lender.

The relationship between lender and borrower is mutually beneficial, or else it would not exist. The parties are exchanging wealth and income, creating new wealth and new income in the process. The government is displeased by this happy marriage, and busts it up by sticking a gun in the lender’s face. His right to expect his partner to honor a signed agreement is violated.

Because no lender will lend gold under such circumstances, gold is relegated to hoarding and speculation only. This strikes a blow to savers, because the best way to save is to lend and earn interest. Savers are forced to choose between hoarding gold, getting no yield, or holding dollars and getting whatever yield crumbs are dropped by the Fed.

If there’s no lending in gold, what takes its place? The Fed force-feeds credit in ever-larger amounts, and at ever-falling interest rates.

The Fed is supposed to make its credit decisions in order to optimize two variables. First, employment shouldn’t be too high or too low. Second, consumer prices shouldn’t rise too quickly or too slowly. The Fed has little ability to predict employment and prices, and even less control over them.

Most Fed critics focus on the quantity of money. Is there too much, or too little? Is the rate of increase too fast or too slow? Is monetary policy too tight or too loose? Lost in this noise is any discussion of who the lender is.

If you buy Treasury bonds, then you know you are lending to the government. You are enabling welfare spending, and a few cases of lending to such worthy activities as housing speculation.

What if you don’t? Well if you deposit dollars in a bank, you are funding the bank’s purchase of Treasury and other bonds. You know, or reasonably ought to know, that this money is being lent.

But suppose you don’t even do that. Suppose you keep a wad of dollar bills under the mattress. You are still lending. The dollar is the Fed’s credit paper. You are financing the Fed’s activities, which consist of buying Treasury bonds and various other bonds.

You’re the patsy. You are the lender.

Anybody who wants to earn dollars is bringing demand for dollars to the market—in other words, making a bid on dollars. With what do they bid? They bid with their labor, with tangible goods, and with land. All assets today are bidding on the dollar, though most people look at it inside out. They think that all assets are offered for sale at the right price.

In any case, this universal bid on the dollar provides credit to the Fed. By placing wealth in the Fed’s hands, everyone gives it their savings to lend out.

Forget about what this does to consumer prices. There are much more serious implications. In place of the delicate, mutually beneficial relationships involved in lending, the Fed sucks the savings from the people, and pumps it out at high pressure. The Fed’s indiscriminate deluge of credit is not a substitute for individual thinking, planning, acting, and lending.

The consequence is incalculable destruction.

The legal tender law does not attack the ability to do a trade here and now, “cash on the barrel head.” It attacks something subtler but just as important. It destroys your ability to plan long range, to prepare for the passage of time. Time is a universal in the human experience. We all work during our adulthood with urgency, because some day we will grow old and be unable to work. To plan for that day, we save while we work and lend our savings to earn interest.

The motivation to borrow also comes from planning for the passage of time. The entrepreneur wants to start or grow a business now, while he has the opportunity, and energy. That’s why he is willing to pay interest out of part of his profits.

In a loan, the borrower gets money immediately, but the lender gets paid later. Time is an integral part of the deal, as one party prefers to be paid later.

In the free market, nothing comes between the saver and the entrepreneur. In central banking, by contrast, the legal tender law attacks the very heart of the free market, like an insidious poison. It disenfranchises the saver, enabling the Fed to plunder his nest egg and undermine his retirement plans.

At the same time, the Fed abuses the hapless entrepreneur too. It lures him to borrow with the promise of low rates, and then like Lucy pulling the football out from under Charlie Brown, cuts the interest rate again. This drives down his profit margin and plunders his capital.

Legal tender law takes away your ability to plan for the future. It replaces a hundred million individual decisions whether or not to have tea, with a giant high-pressure fire hose that blasts hot wastewater indiscriminately. No matter whether they open the spigot further, or close it slightly, the scalding deluge of Fed credit is not in any way equivalent to the individual planning, saving, and borrowing that would go on if we had a free market.

Many people today see the Fed’s Quantitative Easing as money printing. They remember what happened in the 1970’s, and they instantly jump to conclusions. However, we live in a different world. To illustrate this, consider the following story about Joe, a promising and eager young manager in a struggling manufacturing company.

Joe excitedly walks into the boardroom and pitches his idea. “Let’s borrow a billion dollars. We can use it to build a massive warehouse and to buy massive quantities of our raw materials!”

The senior management team stares at him. The CEO demands, “Why?”

“We need to have a stockpile at every level. We should start with 3 months of raw materials, and a three-month buffer of work-in-progress in between every one of the 27 steps of our manufacturing line. And even better, we need to warehouse finished product. We shouldn’t ship anything that hasn’t been sitting for at least 4 months. Ideally six, but we can start with four.” Joe has the bit in his teeth now.

He rushes on. “Bernanke has printed so much money, and Yellen is going to continue. We already have massive inflation and it’s going to get worse! By borrowing to buy stuff that is only going up in price, we can make extra profits and protect ourselves from supply shocks as the cost of commodities rises out of sight!”

The CFO leans over to whisper in the ear of a young assistant, Bill. Bill does a quick Google search and finds the price of copper, which is one of the most important raw materials the company buys. Bill puts the copper chart up on the screen. It has fallen a third over the past few years.

Joe will be lucky to remain employed when he leaves the room. To be fair to him, his mistake is simply to try to implement a business strategy around what most casual observers and many economists believe.

Sometimes, the best way to debunk an idea is to take it seriously.

Though it makes no sense today, holding inventory was not the crazy idea of a young fool back in the 1970’s. It was how many businesses conducted business. In that era, the game was to accumulate inventories. The more, the better. First people were trading excess cash for inventories. I can recall my parents stockpiling things like canned tuna fish. It was better to keep one’s wealth stored in a durable food product than in a bank account. Consumer prices were rising about 20 percent per year.

Next, companies began selling bonds to finance inventory growth. This pushes down the bond price, which is the same thing as pushing up the interest rate. And of course it pushes up prices.

In the 1970’s, cash was trash. Inventories rose relentlessly in value, at least as measured in terms of the dollar. This, by the way, is a great example of how irredeemable money distorts the economy. You aren’t producing any more, or creating any kind of new wealth, and yet, you are rewarded with a profit.

Now we have the opposite condition. Since the interest rate began falling in the early 1980’s, companies have been finding ways to reduce inventory accumulation. The Lean manufacturing movement began to gain acceptance at this time. Lean, also known as the Toyota Way, defines inventory—such as work-in-progress sitting on a shelf—as waste. Lean is all about eliminating waste.

Today, cash is king. Excess inventory quickly become obsolete.

Companies are not borrowing to hold inventory, but to expand production when they can make a profit above the cost of capital. Since the interest rate keeps falling, the hurdle to get over for minimum acceptable profit keeps going lower.

Think of it this way, if you manufactured handheld electronic devices, would you want to keep inventory a minute longer than you had to? Of course not, because your competitor is about to release a new model that will make your product less desirable, or even unsalable. How about clothing? Cars?

In the 1970’s, the interest rate was rising. When a worn-out plant needed replacing, it may not have been feasible to borrow to replace it. That’s because the new interest rate was much higher than at the time when the plant was first acquired, a decade or more earlier.

This is the connection between the rate of interest and the rate of profit. It’s impossible to borrow at a higher rate than the profit one hopes to earn. A rising rate will therefore lead to rising margins, and a falling rate to falling margins.

Other than the problem of financing plant replacement, business was easy. Sleepy conglomerates had travel policies that allowed managers and executives to fly first class, even for domestic travel. With the cost of borrowing rising all the time, profit margins were expanding. And there was the kicker, holding inventory before selling it fattened margins further.

Business had a lazy pace to it, as I look at it today (though business managers at the time might not have agreed with that characterization).

In comparison, today it is the opposite. Limitless oceans of dirt-cheap credit issue forth, like effluent from the world’s central banks. The problem is not replacing worn-out plant when the cost of capital is higher. The problem is that every competitor has ever-cheaper cost of capital. The challenge is that rapid product cycles are driving rapid obsolescence. It is harder and harder to recoup design and tooling expenses. Inventory that sits for a week may have to be liquidated at a massive discount. Profit margins are under constant pressure.

Business executives routinely fly coach, even for international travel.

If the word for the 1970’s business environment was lazy, the word for today’s climate is frenetic.

Neither is the ideal behavior for a rational enterprise. They are the direct fault of the regime of irredeemable paper money.

Everyone’s attention is misdirected towards prices. Is the Consumer Price Index rising? Is it rising more than expected? How about the producer price index? Is that dropping into the dread D-word—deflation?

It’s the greatest economic sleight of hand ever perpetrated.

Instead of zeroing in on prices, we should be looking at the enormous distortions of our centrally banked irredeemable currency. We have bubbles, malinvestment, insolvencies, volatility, with exponentially rising debt and derivatives outstanding.

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 Part II, we looked at the question of whether gold is a currency. The answer cannot be provided by the symbol naming committee at Bloomberg. Gold is indisputably money, and it may be used in the occasional transaction today. The reason for considering it as a currency was to look at contango and backwardation simply as states of gold having an interest rate that is lower or higher, respectively, than the dollar. However, as we concluded in Part II, there is no proper interest rate in gold. The gold lease rate is closer to being a discount rate than an interest rate.

In this final Part III, we look at the fact that gold is a tangible commodity. While the question of whether gold is a currency is important, and it’s good to think about philosophical concepts such as arbitrage, let’s not forget that gold is a material good. It can be held in the hand, it can be bought and sold, and it can be warehoused.

Warehousing is an important innovation. Did you ever wonder how people coordinate their actions over many months between wheat harvests? How is it possible that farmers, bakers, financiers, and consumers could somehow work out a mechanism in the free market to store grain at the time of the harvest and release it throughout the year? The fact that this occurred is amazing. Wheat is not only available out of season, but its price does not gyrate radically (at least no more than every other price these days, as the failing dollar goes off the rails). It does not crash when the grain is harvested and it does not skyrocket as the grain stocks are consumed later in the year.

Obviously, a warehouse suitable for storing grain is necessary. However, without another innovation the warehouse won’t be able to solve the problem. It is necessary but not sufficient. The innovation of the futures market is also necessary.[1]

Today, we think of futures market as a venue to speculate on the price of something, such as wheat. If we expect the price to rise, we go long a futures contract. To bet on a falling price, we could go short. Speculators indeed play an important role in the market. They drive prices up, when they expect goods to be scarce, which prevents overconsumption and running out. They also drive prices down, when they expect a glut, which encourages consumption before stockpiles overflow.

The futures market evolved to fulfill the needs of two other actors. The producer of a good—the farmer in the case of wheat—wants to lock in a price at which he can make a profit. If, in March when he is making his decision of what crop to plant, the price of wheat is $6 per bushel, he can sell wheat futures and lock in a price of around $6 immediately. This removes the risk of an adverse price move. It may also help him obtain financing to produce the wheat.

On the other side of the trade, there is a bakery that wants to secure access to wheat and to hedge the risk that the price could rise. The bakery can buy wheat futures.

The speculator is not able to deliver, or take delivery of, any goods. By contrast, the producer and consumer intend to exchange wheat and cash. The farmer intends to deliver wheat when he harvests it. The bakery intends to take delivery when he needs it to bake bread.

One other actor is necessary to make this market work. The warehouseman arbitrages the spread between wheat in the cash market and wheat in the futures market. Suppose that cash wheat is selling for $5 during the harvest season, but January future wheat is selling for $6. The warehouseman can simultaneously buy spot and sell January, pocketing $1. He stores the wheat until delivery in January.

The warehouseman has no exposure to the wheat price.

This is a really important idea. He is a specialist in knowing when to store wheat, not in speculating on the price. If the warehouseman were forced to take price exposure, there would either not be warehousing, or the cost of warehousing would have to rise dramatically to cover the price swings.

If the warehouseman has no exposure to price, what does he have exposure to? On what does he make his money? He has exposure to the spread between the cash or spot market, and the futures market—called the basis. In our example, this was $1.

If the price of wheat in the futures market is greater than the price in the spot market, this is called contango. In a contango market, if the warehouseman has space for more wheat, he will add wheat to his warehouse. Putting wheat into the warehouse for delivery under contract later is called carrying it.

This works in the other direction, too. If the price in the spot market is higher than in the futures—called backwardation—then the warehouseman will sell wheat in the spot market and buy back the futures he shorted. Selling wheat and buying back the futures contract is called decarrying.

If there is contango and the basis is rising, then we can be sure that more wheat is going into warehouses. If there is backwardation and the basis is falling, then we know that wheat is leaving the warehouses. This can continue until there is no more wheat in the warehouses.

It is worth mentioning what one must have in order to take these arbitrages. To carry wheat, one must have money. With current credit conditions, this is not much of a constraint. One must also have extra warehouse capacity. To decarry it, one must have wheat. This makes for a lopsided set of risks to the basis.

The basis isn’t going to rise much above the cost of credit plus storage costs, because in normal circumstances warehousemen have access to credit and warehouse space (in some commodities, space can be a problem such as crude or natural gas).

Consider the other direction. Suppose you drove a truck up to a grain elevator town two days before the harvest. Workers have the equipment partially disassembled and they’re cleaning it, getting ready for the trucks that will soon be coming off the farm fields. You hop out and go over to a group of elevator operators chatting on the edge of the parking lot. You ask them how much to fill up your truck with wheat, right now?

They begin to laugh, so you take out a wad of $100 bills. They stop laughing and stare at you and eventually one of them says $20 a bushel. He reminds you that if you can sign a contract to take delivery in a month, the price is $7.

Clearly, just days before the harvest, no one has any extra wheat. If you pay that $20, he will make a phone call and a truck halfway to some bakery in another county will turn around. That bakery will end up getting paid more money to be idle for a week than it would have made by selling bread.

This is a case of extreme backwardation (exaggerated to make a clear point). Think of backwardation as being synonymous with shortage. This is a pretty strong statement, so let’s look at the proof.

If there was no shortage of wheat, then why isn’t someone decarrying it? The markets do not normally offer you a risk-free profit that grows day by day. If, for example, IBM shares traded in NY for $99 and for $101 in London, then someone would buy in NY and sell in London and keep doing it until the prices were brought together. Arbitrage acts to compress the very spread from which it derives its profit.

In our example, no one is taking the wheat decarry arbitrage because no one has any wheat left over.

While, as we saw above, there is a limit to how high the basis can go, there is no limit to how low. The scarcer the good, the lower the basis could fall.

One other thing is worth noting before we proceed. With the advent of the futures market, the price of a good that’s produced seasonally but consumed all year need not fluctuate much due the time of year. Price fluctuation would harm producers or consumers.

What can fluctuate harmlessly is the basis spread.

What does this have to do with gold? Virtually every ounce of gold ever mined in thousands of years of human history is still held in human possession. The stocks to flows ratio—inventories divided by annual production—is measured in decades for gold, but months for wheat and other regular commodities.

This means that there is no such thing as a glut in gold, and no such thing as scarcity. Gold is not produced seasonally, and it is not consumed. There should not be a futures market in gold. It exists as a perverse byproduct of the regime of irredeemable paper money. It would not exist in a free market, which would have a robust global market for gold lending.

Right before the harvest, the wheat market can go into backwardation because no one has any wheat to decarry. It is truly scarce. In gold, backwardation should not be possible. There is always enough gold in existence, to decarry and eliminate any backwardation.

And yet, there has been an intermittent gold backwardation since December of 2008. It has become typical for each futures contract to go into backwardation as it headed into expiration, and I have coined the term temporary backwardation.[2]

Gold backwardation is incredible. Like a unicorn, it should never be seen! All of this gold just sitting around, and the owners stare at their screens and don’t take the bait. It’s a risk free profit, according to the conventional view. And yet gold is becoming scarcer, at least to the market. All of those gold owners are choosing to let their gold sit idle, not earning anything at all, rather than trade away their bars for futures contracts.

It’s not possible to understand this phenomenon with mathematical models. Sure, you can measure the basis and use it to model all sorts of things, but to understand the big picture you have to take a step back. You have to see the forest and that means backing away from that tree for a minute.

Perhaps one of the biggest news items pertaining to gold as I write this is the ongoing situation regarding Germany’s gold. Germany asked for the Federal Reserve to give back a quantity of their gold over a period of 7 years. And by the end of 2013, the Fed had delivered too little, and was falling behind even that leisurely pace. I won’t speculate on what’s happening, but I do want to point out what the Germans are thinking.

They don’t trust the Fed.

They didn’t trust the Fed in the first place, which is why they pressured the Bundesbank to ask for the gold to be shipped to Germany. The Fed’s apparent failure to deliver only deepens their convictions that they were right not to trust the Fed, and of course increases the distrust of many observers around the world too.

Many in the online gold community want to see Germany get their gold, but are concerned that they won’t. They have themselves taken possession of their own gold. They urge everyone to take his own gold in the form of coins or bars out of the banking system, and hold it at home or someplace that’s safe and secure.

This is the process of gold withdrawing from the market. It is an inexorable trend towards permanent backwardation.[3] One ignores this at one’s peril. It cannot be dismissed by the assertion that gold is a currency. Whether or not gold has a rate of interest, and whether this rate is above or below LIBOR has no bearing here.

Gold is a physical commodity. Its owners are removing it from the tradable markets, squirreling it away in nooks and crannies where they feel it’s safe. This is not merely a phenomenon of differing interest rates. Real metal is being moved in the real world, and everyone would do well to understand why, and what it means.

Trust is collapsing, and for good reason. The foundation of the global financial system is the US Treasury bond. It is backed by nothing more nor less than the full faith and credit of a government with exponentially rising debt, and which has neither the means nor intent to repay. If you don’t trust that the US government can pay, then you can’t trust a bank deposit because the bank uses the Treasury as their asset. If you can’t trust a bank, then you can’t trust a gold futures contract.

It is in this light that one must view gold backwardation. In wheat or any other ordinary commodity, there is sometimes a state of shortage. When that occurs, anyone with the commodity can make a risk-free profit by decarrying it. However, there is no such thing as a shortage of gold. There is a shortage developing—a shortage of trust. Decarrying gold does incur a risk. One may be giving up good metal for bad paper, and never be able to reverse the swap.

Unfortunately, with the collapse of trust comes the collapse of coordination of economic activity. The disappearance of gold from the monetary system will have momentous consequences. This is why I founded the Gold Standard Institute USA to promote the gold standard, and reverse this trend before it reaches the end.

[1] What follows is material I shared with my private subscribers in Feb 2012.

[2] What Drives Negative GOFO and Temporary Gold Backwardation

[3] When Gold Backwardation Becomes Permanent

Government spending is out of control and, while most say they want spending cuts, people oppose cuts that impact them. Among those who get government money, there’s practically an unspoken, unbreakable pact to keep the money coming. But when I say that the national debt cannot be paid off, it’s not a political forecast; it’s a statement on the flawed nature of the dollar.

Astute observers call the dollar a fiat currency. Fiat means force. It’s true that we’re forced to use the dollar (e.g. by taxes on gold) but the dollar is also irredeemable. There’s no way to cash it in. The dollar is credit that is never repaid. Today’s dollar is a dishonored promise.

This was not always true. Before 1933, the dollar represented an obligation to pay 1/20 ounce of gold. People could deposit gold and get paper notes in receipt. Those notes circulated, and any bearer could redeem them for gold. Back then, $20 was not the gold price. It was the legal rate at which gold was deposited and redeemed.

In 1971, President Nixon changed the monetary system with the stroke of his pen, making the Fed no longer obligated to redeem dollars for gold. The consequences of using debt as if it were money were soon clear. Rising debt became a more serious problem than rising prices.

To understand debt, credit and the importance of redemption, consider Joe borrowing sugar from neighbor Sue. To pay Sue back, Joe goes to the store, buys sugar and hands it to Sue. Not only is Sue repaid; the debt goes out of existence—it is extinguished. Borrowing money used to be like borrowing sugar. The repayment of debt in gold-backed dollars settled the loan and wiped the debt clean.

Not anymore, since Nixon detached the dollar from gold. By making people pay with paper-only dollars, each debt is transferred, not cleared.

Suppose Sue owed Joe $1,000, then hands Joe ten $100 bills. Sue gets out of the debt loop. But now the Fed owes Joe the $1,000. What does Joe do? He deposits his cash in a bank. Now the bank owes Joe money, while the Fed owes the bank. What does the bank do? It buys a Treasury bond. Now the Treasury owes the bank. And so on.

By Nixon’s design, the system omits a crucial feature. The extinguisher of debt, gold, is not allowed to do its job. Debt can only be transferred from one party to another. It’s like a lump being pushed around under a rug. With no means of final payment, that lump is never put in the trash. Debt is never extinguished.

In fact, the debt must increase, because the interest is constantly accruing. Interest is added to the debt, as it can’t be paid off either. Total debt must grow by at least the interest. Debt actually increases faster than that, because the government craves what now passes for growth.

The rate of debt increase is proportional to the debt itself. It is not a fixed dollar amount, such as $100 billion a year. It is instead a percent of total debt. Mathematics has a term for this type of growth: an exponential function.

Exponential growth is not sustainable, according to credible scientists. Mainstream economists ignore this fact in the hope that that somehow growth can outpace debt, one year a time.

But exponentially rising debt is not sustainable because the capacity to service the debt is finite. Without a means of extinguishing debt, servicing is merely borrowing new money to pay off old debts. This is the equivalent of taking out a home equity loan to get money to pay the mortgage.

The U.S. debt is putting us in danger of economic catastrophe. Like Greece, which found no more buyers for their bonds, the U.S. relies on selling new bonds to pay interest and principal when due. The difference is that the whole world bids on U.S. Treasury bonds, for now. But eventually, market participants will realize that the American debt cannot be paid off.

I originally wrote this in September 2013. It is just as relevant now in December.

The big news in America is that the rate on the 10-year Treasury bond has risen dramatically from around 1.6% to over 2.9% [now on December 5, 2.84%]. This is 130 basis points from a starting point of 160, or an increase of more than 80%!

So naturally, the financial media are discussing the “essential” issues. They have commentators philosophizing about whether the tapering of Quantitative Easing is “priced in” (an invalid question, as I argue in my in the Theory of Interest and Prices). They credulously entertain the view that it signals “economic recovery”. If the economy were really recovering for four years, there would be no need for such hype.

On CNBC this week, Larry Kudlow’s guest was a sell-side analyst. He worried that either the absolute level of the rate, or the speed with which it has risen, will interrupt the bull market in stocks. Why is he concerned? Higher rates may discourage companies from borrowing to buy back their shares and issue dividends. I have previously written about this madness.

It is a strange politically correct world that makes it a taboo to say the simple truth. Unfortunately, freedom of speech in America is slipping—at least on controversial topics that matter. It may still be legal, but there is a very real chilling effect. In a crony system, one’s career is at risk to say the unpopular. So the gentlemen in the club safely confine their discussion to the M1 and M2 measures of the money supply, and the number of angels that can dance on the head of one pin.

Let’s take a step back from the noise. In the real world, every change in the interest rate destroys capital. To avoid this, firms hedge using derivatives. The good gentlemen in the club do sometimes acknowledge the derivatives problem, but never the cause, never why derivatives grow and grow and grow until they are now estimated to be approaching one quadrillion dollars. Those who sell these hedges must, themselves, hedge. They can push risk around and around in a circle of the big multinational banks. They cannot eliminate it.

Historically, the Federal Reserve has exhibited what I’ll call “bipolar interest rate disorder”. They vacillate between bingeing and purging. First they try to encourage the economy to “grow” by offering a buffet of too much credit, dirt-cheap. Then with pangs of regret if not guilt, they try to “fight inflation” by raising the price of credit. This leads to a bogus debate among economists: which evil should the Fed be pursuing at any given moment. Wall Street, of course, has a strong bias towards more credit, dirtier and cheaper. So do politicians seeking reelection.

Today, these two false alternatives are called “stimulus” and “austerity”. Fans of the latter sometimes fantasize about a mythological place, like Atlantis or El Dorado, called the “Exit”. Unfortunately, the Fed cannot sell their bonds. If they reversed from big buyer to even a small seller, it would reignite the very conflagration they fought in 2008. Leveraged market players would be unable to sell new bonds to pay their old bonds when due, and would therefore be forced into default. Talk of a Fed “exit” is a smokescreen.

Let’s take a further step back. The collapse of the Soviet Union proved that central planning doesn’t work. It can’t even deliver simple goods like food. The Fed is the central planner of something much bigger and vastly more complex. Money and credit are the foundation of our economy, and everything else depends on them.

The issue is not what the Fed should do next!

We should be discussing how to transition from irredeemable currencies to a free market based on gold without collapsing the financial system. I wrote a paper proposing how to do this. There may be others with good ideas. Let’s begin the discussion. Unfortunately, few want to risk their careers. I am not sure what would be worse: the cowardice of remaining silent in the face of a Big Lie, or the fact that saying the truth would indeed jeopardize one’s career in finance or economics.

We should be talking about the evolution of the Fed. Let’s not get distracted by conspiracy theories, stories about ancient banking families and creatures from islands with unfortunate names. And no, the Fed is not a “private cartel”.

The Fed began in 1913; it was the liquidity provider of last resort. If a bank needed gold, it could take Real Bills to the Fed, who would buy them at a discount. The government should have no role in the financial system at all, but Fed v1.0 was not the destroyer of markets as Fed v8.2 is today.

Subsequently, they began to buy government bonds. Incrementally, over many decades, the Fed evolved into the central planner it is today. Some of these steps were by presidential decrees, some were Acts of Congress, and of course the Fed took new powers for itself at opportune moments.

Today, there are many distribution channels, but the Fed is the only provider of credit of any resort. Should they cease issuing new credit, every bond market in the world would seize up followed immediately by the default of every bank, insurer, annuity, and pension. Despite the Fed’s record pumping of credit effluent, some bond markets are beginning to collapse anyway, along with the national currencies backed by those bonds.

We face a bitter dilemma. Without credit, large-scale production is not possible. The economy would devolve into medieval villages, with subsistence production done on family farms and workshops. On the other hand, continuing a system based on ever more counterfeiting will destroy more and more capital until the economy collapses.

Markets are being slammed back and forth between “austerity” and “stimulus”, between credit contraction and credit expansion. The number of units of the Fed’s credit paper required to buy an ounce of gold has long been rising. In other words, those units of credit were falling in value. But in the past few years, one has needed fewer of them to trade for gold. One day, traders are borrowing freely to speculate in the markets, driving prices up. The next, they are squeezed in a vice, desperate to roll over their liabilities, or if they cannot, to sell assets, especially assets that do not have a yield.

In conclusion, here is what I think the Fed should do. The Fed should go on buying bonds and doing what it has to do to keep the system going. No one wants the system to collapse. We should all be clear that the Fed is doing nothing more than buying time.

We need to use that time to transition to the gold standard, to begin the process of gold and silver to circulate, to develop a market for lending and borrowing gold. We need to repeal the capital gains, VAT, GST, and any other taxes that make it impractical to use gold. We need to repeal laws that force creditors to accept paper as payment in full. We need to develop the institutions such as gold banking and Real Bills.

Medieval thinkers were tempted to believe that if you throw a rock it flies straight until it runs out of force, and then it falls straight down. Economists are tempted to think of prices as a linear function of the “money supply”, and interest rates to be based on “inflation expectations”, which is to say expectations of rising prices.

The medieval thinkers, and the economists are “not even wrong”, to borrow a phrase often attributed to physicist Wolfgang Pauli. Science has to begin by going out to reality and observing what happens. Anyone can see that in reality, these tempting assumptions do not fit what occurs.

In my series of essays on interest rates and prices[1], I argued that the system has positive feedback and resonance, and cannot be understood in terms of a linear model. When I began this series of papers, the rate of interest was still falling to hit a new all-time low. Then on May 5,2013, it began to shoot up. It rose 83% over a period of exactly four months. That may or may not have been the peak (it has subsided a little since then).

Several readers asked me if I thought this was the beginning of a new rising cycle, or if I thought this was the End (of the dollar). As I expressed in Part VI, the End will be driven by the withdrawal of the gold bid on the dollar. Since early August, gold has become more and more abundant in the market.[2] I think it is safe to say that this is not the end of the dollar, just yet. The hyperinflationists’ stopped clock will have to remain wrong a while longer. I said that the rising rate was a correction.

I am quite confident of this prediction, for all the reasons I presented in the discussion of the falling cycle in Part V. But let’s look at the question from a different perspective, to see if we end up with the same conclusion.

In the gold standard, the rate of interest is the spread between the gold coin and the gold bond. If the rate is higher, that is equivalent to saying that the spread is wider. If the rate is lower, then this spread is narrower.

A wider spread offers more incentive for people to straddle it, an act that I define as arbitrage. Another way of saying this is that a higher rate offers more incentive for people to dishoard gold and lend it. If the rate falls, which is the same as saying if the spread narrows, then there is less incentive and people will revert to hoarding to avoid the risks and capital lock-up of lending. Savers who take the bid on the interest rate (which is equivalent to taking the ask on the bond) press the rate lower, which compresses the spread.

It goes almost without saying, that the spread could never be compressed to zero (by the way, this is true for all arbitrage in all free markets). There are forces tending to compress the spread, such as the desire to earn interest by savers. But the lower the rate of interest, the stronger the forces tending to widen the spread become. These include entrepreneurial demand for credit, and most importantly the time preference of the saver—his reluctance to delay gratification. There is no lending at zero interest and nearly zero lending at near-zero interest.

I emphasize that interest is a spread to put the focus on a universal principle of free markets. As I stated in my dissertation:

“All actions of all men in the markets are various forms of arbitrage.”

Arbitrage compresses the spread that is being straddled. It lifts up the price of the long leg, and pushes down the price of the short leg. If one buys eggs in the farm town, then the price of eggs there will rise. If one sells eggs in the city center, then the price there will fall.

In the gold standard, hoarding tends to lift the value of the gold coin and depress the value of the bond. Lending tends to depress the value of the coin and lift the value of the bond. The value of gold itself is the closest thing to constant in the market, so in effect these two arbitrages move the value of the bond. How is the value of the bond measured—against what is it compared? Gold is the unit of account, the numeraire.

The value of the bond can move much farther than the value of gold. But in this context it is important to be aware that gold is not fixed, like some kind of intrinsic value. An analogy would be that if you jump up, you push the Earth in the opposite direction. Its mass is so heavy that in most contexts you can safely ignore the fact that the Earth experiences an equal but opposite force. But this is not the same thing as saying the Earth is fixed in position in its orbit.

The regime of irredeemable money behaves quite differently than the gold standard (notwithstanding frivolous assertions by some economists that the euro “works like” the gold standard). The interest rate is still a spread. But what is it a spread between? Does arbitrage act on this spread? Is there an essential difference between this and the arbitrage in gold?

Analogous to gold, the rate of interest in paper currency is the spread between the dollar and the bond. There are a number of differences from gold. Most notably, there is little reason to hold the dollar in preference to the government bond. Think about that.

In the gold standard, if you don’t like the risk or interest of a bond, you can happily hold gold coins. But in irredeemable paper currency, the dollar is itself a credit instrument backed by said government bond. The dollar is the liability side of the Fed’s balance sheet, with the bond being the asset. Why would anyone hold a zero-yield paper credit instrument in preference to a non-zero-yield paper credit instrument (except as speculation—see below)? And that leads to the key identification.

The Fed is the arbitrager of this spread!

The Fed is buying bonds, which lifts up the value of the bond and pushes down the interest rate. Against these new assets, the Fed is issuing more dollars. This tends to depress the value of the dollar. The dollar has a lot of inertia, like gold. It has extremely high stocks to flows, like gold. But unlike gold, the dollar’s value does fall with its quantity (if not in the way that the quantity theory of money predicts). Whatever one might say about the marginal utility of gold, the dollar’s marginal utility certainly falls.

The Fed is involved in another arbitrage with the bond and the dollar. The Fed lends dollars to banks, so that they can buy the government bond (and other bonds). This lifts the value of the bond, just like the Fed’s own bond purchases.

Astute readers will note that when the Fed lends to banks to buy bonds, this is equivalent to stating that banks borrow from the Fed to buy bonds. The banks are borrowing short to lend long, also called duration mismatch.

This is not precisely an arbitrage between the dollar and the bond. It is an arbitrage between the short-term lending and long-term bond market. It is the spread between short- and long-term interest rates that is compressed in this trade.

One difference between gold and paper is that, in paper, there is a central planner who sets the short-term rate by diktat. Since 2008, Fed policy has pegged it to practically zero.

This makes for a lopsided “arbitrage”, which is not really an arbitrage. One side is not free to move, even the slight amount of a massive object. It is fixed by law, which is to say, force. The economy ought to allow free movement of all prices, and now one point is bolted down. All sorts of distortions will occur around it as tension builds.

I put “arbitrage” in scare quotes because it is not really arbitrage. The Fed uses force to hand money to those cronies who have access to this privilege. It is not arbitrage in the same way that a fence who sells stolen goods is not a trader.

In any case, the rate on the short end of the yield curve is fixed near zero today, while there is a pull on the long bond closer to it. Is there any wonder that the rate on the long bond has a propensity to fall?

Under the gold standard, borrowing short to lend long is certainly not necessary.[3] However, in our paper system, it is an integral part of the system, by its very design.

The government offers antiseptic terms for egregious acts. For example, they use the pseudo-academic term “quantitative easing” to refer to the dishonest practice of monetizing the debt. Similarly, they use the dry euphemism “maturity transformation” to refer to borrowing short to lend long, i.e. duration mismatch. Perhaps the term “transmogrification” would be more appropriate, as this is nothing short of magic.

The saver is the owner of the money being lent out. It is his preference that the bank must respect, and it is for his benefit that the bank lends. When the saver says he may want his money back on demand, and the bank presumes to lend it for 30 years, the bank is not “transforming” anything except its fiduciary duty, its integrity, and its own soundness. Depositors would not entrust their savings to such reckless banks, without the soporific of deposit insurance to protect them from the consequences.

Under the gold standard, this irrational practice would exist on the fringe on the line between what is legal and what is not (except for the yield curve specialist, a topic I will treat in another paper), a get-rich-quick scheme—if it existed at all (our jobs as monetary economists are to bellow from the rooftops that this practice is destructive).

Today, duration mismatch is part of the official means of executing the Fed’s monetary policy.

I have already covered how duration mismatch misallocates the savers’ capital and when savers eventually pull it back, the result is that the bank fails. I want to focus here on another facet. Pseudo-arbitrage between short and long bonds destabilizes the yield curve.

By its very nature, borrowing short to lend long is a brittle business model. One is committed to a long-term investment, but this is at the mercy of the short-term funding market. If short-term rates rise, or if borrowing is temporarily not possible, then the practitioner of this financial voodoo may be forced to sell the long bond.

The original act of borrowing short to lend long causes the interest rate on the long bond to fall. If the Fed wants to tighten (not their policy post-2008!) and forces the short-term rate higher, then players of the duration mismatch game may get caught off guard. They may be reluctant to sell their long bonds at a loss, and hold on for a while. Or for any number of other proximate causes, the yield curve can become inverted.

Side note: an inverted yield curve is widely considered a harbinger of recession. The simple explanation is that the marginal source of credit in the economy is suddenly more expensive. This causes investment in everything to slow.

At times there is selling of the short bond, at times aggressive buying. Sometimes there is a steady buying ramp of the long bond. Sometimes there is a slow selling slide that turns into an avalanche. The yield curve moves and changes shape. As with the rate of interest, the economy does best when the curve is stable. Sudden balance sheet stress, selloffs, and volatility may benefit the speculators of the world[4], but of course, it can only hurt productive businesses that are financing factories, farms, mines, and hotels with credit.

Earlier, I referred to the only reason why someone would choose to own the Fed’s liability—the dollar—in preference to its asset. Unlike with gold, hoarding paper dollar bills serves no real purpose and incurs needless risk of loss by theft. The holder of dollars is no safer. He avoids no credit risk; he is exposed to the same risk as is the bondholder is exposed. The sole reason to prefer the dollar is speculation.

As I described in Theory of Interest and Prices in Paper Currency, the Fed destabilizes the rate of interest by its very existence, its very nature, and its purpose. Per the above discussion, the Fed and the speculators induce volatility in the yield curve, which can easily feed back into volatility in the underlying rate of interest.

The reason to sell the bond is to avoid losses if interest rates will rise. Speculators seek to front-run the Fed, duration mismatchers, and other speculators. If the Fed will “taper” its purchase of bonds, then that might lead to higher interest rates. Or at least, it might make other speculators sell. Every speculator wants to sell first.

Consider the case of large banks borrowing short to lend long. Let’s say that you have some information that their short-term funding is either going to become much harder to obtain, or at least significantly more expensive. What do you do?

You sell the bond. You, and many other speculators. Everyone sells the bond.

Or, what if you have information that you think will cause other speculators to sell bonds? It may not even be a legitimate factor, either because the rumor is untrue (e.g. “the world is selling Treasury bonds”) or because there is no valid economic reason to sell bonds based on it.

You sell the bond before they do, or you all try to sell first.

I have been documenting numerous cases in the gold market where traders use leverage to buy gold futures based on an announcement or non-announcement by the Fed. These moves reverse themselves quickly. But no one, especially if they are using leverage, wants to be on the wrong side of a $50 move in gold. You sell ahead of the crowd, and you buy ahead of the crowd. And they try to do it to you.

I think it is likely that one of these phenomena, or something similar, has driven the rate on the 10-year Treasury up by 80%.

I would like to leave you with one take-away from this paper and one from my series on the theory of interest and prices. In this paper, I want everyone to think about the difference between the following two statements:

1. The dollar is falling in value
2. The rate of interest in dollars must rise

It is tempting to assume that they are equivalent, but the rate of interest is purely internal to the “closed loop” dollar system. Unlike a free market, it does not operate under the forces of arbitrage. It operates by government diktats, and hordes of speculators feed on the spoils that fall like rotten food to the floor.

From my entire series, I would like the reader to check and challenge the sacred-cow premises of macroeconomics, the aggregates, the assumptions, the equations, and above all else, the linear thinking. I encourage you to think about what incentives are offered under each scenario to the market participants. No one even knows the true value of the monetary aggregate and there is endless debate even among economists. The shopkeeper, miner, farmer, warehouseman, manufacturer, or banker is not impelled to act based on such abstractions.

They react to the incentives of profit and loss. Even the consumer reacts to prices being lower in one particular store, or apples being cheaper than pears. If you can think through how a particular market event or change in government policy will remove old incentives and offer new incentives, then you can understand the likely first-order effects in the market. Of course each of these effects changes still other incentives.

It is not easy, but this is the approach that makes economics a proper science.

P.S. As I do my final edits on this paper (October 4, 2013), there is a selloff in short US T-Bills, leading to an inversion at the short end of the yield curve. This is due, of course, to the possible effect of the partial government shutdown. The government is not going to default. If this danger were real, then there would be much greater turmoil in every market (and much more buying of gold as the only way to avoid catastrophic losses). The selloff has two drivers. First, some holders of T-Bills need the cash on the maturity date. They would prefer to liquidate now and hold “cash” rather than incur the risk that they will not be paid on the maturity date. Second, of course speculators want to front-run this trade. I put “cash” in scare quotes because dollars in a bank account are the bank’s liability. The bank will not be able to honor this liability if its asset—the US Treasury bond—defaults. The “cash” will be worthless in the very scenario that bond sellers are hoping to avoid by their very sales. When the scare and the shutdown end, then the 30-day T-Bill will snap back to its typical rate near zero. Some clever speculators will make a killing on this move.