Category Archives: Monetary Science

Quack Economic Doctors

Suppose you go to a doctor. You are in pain and you tell him that you feel like you are going to die. He takes your temperature, and sees that it is a perfectly normal 98.6F. He tells you to go home, you must be fine. He does not seem to be aware of any problem that can cause pain but not a fever (e.g. a broken vertebra, cancer, or bleeding). He is a quack.

It’s a good thing that real doctors have many diagnostics and indicators. They are not limited to just body temperature.

Let’s turn our attention to the monetary system. The quacks focus their attention on prices. The rate of change of prices—which they improperly define as inflation—is the monetary equivalent of body temperature in medicine. In some cases, it’s an important part of making a diagnosis.

And it is far from the only indicator.

If prices are like temperature, then what is analogous to the patient’s pulse? Interest rates. And interest rates have been falling for 34 years.

Is there a doctor in the house? Should we be worried?

Chinese GDP Surpasses USA (*when Measurement Adjusted)

A story has been echoing around the financial news for a few weeks. One article about it, It’s official: America is now No. 2 by Brett Arends at MarketWatch, came to my attention. Arends asserts that the Chinese economy is now larger than the economy in the US. Here’s what he said.

“We’re no longer No. 1. Today, we’re No. 2. Yes, it’s official. The Chinese economy just overtook the United States economy to become the largest in the world.”

With GDP data from the IMF, we can easily see that the US economy is bigger than China’s. The IMF estimates 2014 GDP at $10.4T for China and $17.4T for the USA. So how does Arends claim the contrary? He uses different data that IMF adjusts. By this methodology, the Chinese economy is “really” $17.6T.

Really?

Although Chinese GDP is lower when measured in yuan and converted to dollars, Arends and others claim that this isn’t right. Goods and services are cheaper in China. So they don’t think we should convert yuan to dollars using the market exchange rate. They use a concept called Purchasing Power Parity (PPP). PPP is used to determine a different exchange rate for the yuan than the market rate. This is how they arrive at a “real” Chinese GDP of $17.6T.

We have long been trained to accept purchasing power as the means of adjusting the dollar from historical periods. For example, JP Morgan was worth $68M at his death in 1913. To calculate what that’s worth in today’s dollars, most people would refer to the Consumer Price Index. They use CPI to adjust the $68M figure from 1913 to a $1.6B modern value. As I wrote on Forbes, that approach is wrong. They should use gold which, unlike the dollar, is the same in 1913 as in 2014. Morgan was worth 3.4M ounces of gold, which is $4.1B today.

Adjusting the Chinese economy by PPP is simply applying the consumer price idea to a whole economy. If we use prices to adjust dollar figures from historical periods in the US, why not use them to adjust foreign but contemporary dollar amounts? If we can use consumer prices to measure the net worth of a man who died in 1913, then it seems like we can use them to measure the economic output of China also.

The approach is fatally flawed, because the value of a currency isn’t derived from prices. As an analogy, suppose you are using a steel meter stick to measure a rubber band. When you stretch the rubber band, it gets longer. This is not equivalent to saying that the meter stick gets shorter. You do not measure meter sticks by how many rubber bands fit end to end. Measurement is one-way.

Money is the meter stick of economic value (though this principle is clouded in paper currencies, because they are falling). Prices rise or fall for non-monetary reasons. Prices may be cheaper in China for a variety of reasons, such as lower wages. Money measures these changes, not the other way around.

By the same principle, prices may be higher in New York than in Phoenix. Does anyone dare to say that these are different dollars? Should we adjust New York dollar downwards towards the Phoenix dollar, based on PPP? How about the Scottsdale dollar (Scottsdale is a ritzy suburb) vs. the south Phoenix dollar?

Standards of living certainly vary based on local prices, but that is a separate issue. The dollar is the same in New York as it is in Phoenix. We say that the dollar is fungible—a dollar is a dollar is a dollar, and each is accepted in trade the same as any other.

Arends uses the Starbucks venti Frapuccino as an example, which he says is cheaper in Beijing than in Minneapolis. A cup of coffee produced in China cannot be sent to Minneapolis where it will fetch a higher price. However, money is unlike coffee. It can go from Beijing to Minneapolis instantly. That’s why there is one price for the yuan globally, but a different price for coffee on every street corner. Bulk commodities are of course more transportable than cups of coffee, but even they cost time and money to transport.

It’s an essential property of money that it is quick and cheap to send it somewhere. Money will always move from where it has less value to where it is valued more highly. The result is that money’s value is consistent everywhere.

This consistency allows us to convert the yuan to dollars, to compare Chinese GDP to American GDP. This is perfectly valid (well, if you accept that GDP itself is valid), because the comparison is instantaneous. We do not have to worry about the falling value of either currency that occurs over longer periods of time. We could use gold to compare the Chinese economy to the American, but it’s not necessary in this.

The price of Frapuccino in China may be important to caffeine addicts who travel to Beijing, but it cannot be used to adjust a currency or a country’s GDP.

Chinese GDP is a lot smaller than American GDP. Will that change? Maybe, but it’s not the job of economists to embed such speculative assumptions into the data.

The Wrong Idea About Inflation

Here is a post I made to Facebook yesterday.

FB post

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.

int com

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.

interest-spread

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.

Legal Tender Renders Planning Impossible

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.

The Price of Shipping Is Collapsing

A recurring theme of mine is that one cannot understand the world in terms of the linear Quantity Theory of Money. Let’s look at the cost of shipping.

The money supply has certainly been expanding since 2008. And yet the price of shipping has almost completely collapsed. From a high over 11,000 it’s now down to 755. This is a drop of almost 94%.

The Baltic Dry Index is a dollar price of moving the major materials by sea. The chart shows from just before the acute phase of the crisis to today, July 16, 2014.

BDI

I like to look at the Baltic Dry because, unlike commodities, there is no way to speculate on it and hence drive up the price. (If readers are aware of some sort of futures market or other way for speculators to use credit to bid up prices, then I encourage them to please contact me.)

Neither the money supply nor supply and demand adequately explains this collapse. Supply and demand may be a tempting model, but it raises more questions than it answers. Is it falling demand or rising supply? Why would supply rise so much? Why would demand collapse? Could both be occurring at the same time, and if so are the business managers and their bankers that blind?

The Austrian Business Cycle Theory is a much better way of thinking about this.

Ultimately, this graph tells a story of credit expansion and credit contraction. During the expansion there was lots of demand for shipping. Naturally this led to malinvestment in ships. During the contraction, the ships aren’t needed but they cannot be unmade. More importantly, the money borrowed to finance them cannot be unborrowed.

Why was there so much malinvestment? The rate of interest has been falling during this time (and much longer). The lower the rate, the more attractive it is to borrow to buy a capital good, such as a bigger ship. On this graph, the interest rate on the 10-year US Treasury bond is added. The correlation isn’t perfect by any means, but there is something here.

BDIUST10

It is important to realize that a company that borrows to malinvest sees a profit at the time. That’s what so deadly about central planning of money and credit. The central planners push down the interest rate, and this sends a false signal. The shipping companies and financing companies calculate the profit in building new ships. They are neither stupid nor incompetent.

They may not lose money at all. The losses may go to some existing shippers, particularly those who previously built ships, with money borrowed at higher interest rates.

No matter who it is, we can be certain that somewhere in the world, there are debtors being put to the squeeze. And with equal certainty, we can say that their lenders—including banks—have assets on their balance sheet that will need to be written down (or written off).

And when that happens, it adds to the bust. Desperate lenders sell assets onto whatever bid they can find. Asset prices begin to plunge. Arbitrages connect those assets to other assets, not to mention margin calls. Workers lose their jobs, investors lose their money, and businesses close.

The dollar, with its interest rate dictated by the monetary politburo, is destroying people’s lives. One important virtue of the gold standard is that it has a stable interest rate, set by the participants in a free market. It worked and it will work again when we finally reject the regime of irredeemable paper money.

The Lazy 1970’s vs. the Frenetic 2000’s

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.

Gold Arbitrage and Backwardation Part III (Gold as a Commodity)

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