Let’s start with an analogy to the federal deficit. Both the political Left and the Right talk about the deficit. There are two basic approaches. One is zero-sum: to increase taxes (favored by the Left). The other is positive-sum: to cut spending (generally favored by the Right, but few specific program cuts have any real support).

It is similar with unemployment. The Left (and the Right) favor the zero-sum approach: cutting the number of job seekers, via curbing immigration. The positive-sum approach is job creation. While everyone from Bill Clinton to Ben Bernanke has an opinion about how to create jobs, obviously it hasn’t been working. Hint: no act of government can durably increase employment.

Two things should be clear: when a new company is started and when it grows, it hires people. Starting and growing a company takes capital.

Unfortunately, capital formation is heavily restricted. Prior to the JOBS Act, entrepreneurs were barred from openly soliciting for investors. All investors had to be “accredited” (an SEC term that basically means “rich”). Non-rich people could buy all the bonds of bankrupt cities like Detroit they wanted, all the overhyped and overpriced stocks they wanted, and many other products made on Wall Street. But they could not invest in startups.

The recent JOBS Act was supposed to ease this regulatory burden. Indeed it does reduce one little regulation in one corner of the capital markets. It allows entrepreneurs to openly solicit for investors. But what Congress can give, the SEC can taketh away. Under the new rules, investors that are openly solicited must meet a higher burden of proof. A signed statement is no longer sufficient. Now they must either provide their tax returns, or a letter by their lawyer, accountant, or broker.

Would you be willing to give your tax forms to a startup company in order to be allowed to have the privilege of giving them your money? Would you want to pay your accountant or lawyer for a letter?

Qui bono? The beneficiaries of this regime are the big corporations and the lawyers. Big corporations have no problem getting access to capital (indeed they are drowning in a flood of unlimited liquidity from the Fed).

Just as a free market does not regulate what size soft drink you can buy (even if drinking 44oz of sugar soda is bad for you), it does not regulate what you can invest in (even if losing your money in a startup is bad for you).

The question asked by the title of this article is not rhetorical. It came up in the debate about Arizona Senate Bill 1439, which recognized gold and silver as legal tender. The bill passed in both the Senate and the House but was vetoed by Governor Jan Brewer, who was concerned the state would lose revenues from taxing rare old coins. She recently promoted a major new welfare program, so at least she is consistent.

Dennis Hoffman, an economics professor at Arizona State University, asked the Arizona Republic, “Can you imagine going in to buy clothing or a pizza with a lump of gold? The retailer is going to look at you like you are crazy.”

I must correct Professor Hoffman on something. No one has ever had to be forced to accept gold. Modern laws don’t force us to accept gold; they force us to accept paper. Otherwise, no one would trade the hard-earned product of his labor in exchange for a mere piece of paper, an irredeemable promise. Today, most stores would not accept gold, but that is just reiterating the status quo. It’s not a reason to keep legal obstacles to the use of gold.

This is the short answer to my question. The government has established coercive barriers to gold circulation. Let’s look at some. First is the capital gains tax, as this was the subject of the Arizona bill.

When you sell gold or silver, you must report the gain or loss and pay a tax if there is a gain. You must keep records of your purchases. This is bad enough if you buy and hold for a long period of time. You may have more dollars but each of them is worth proportionally less. Then (in the US) the government takes away 28 percent of that increase in dollars, and most states take also. The end result is a loss measured objectively in gold, even if it appears as a gain measured in shrinking dollars.

Consider the practical concerns of using gold or silver in commerce. If you pay a restaurant bill with a one-ounce silver coin, the IRS considers this a sale of silver at the current market price. You must prove what you paid for that particular bit of metal and pay a tax if the price rose. Unlike in long-term holdings, you might have several small purchase transactions per day (e.g. gasoline, groceries, and coffee.) The reporting alone—not to mention the tax—makes it impractical to use precious metal coins.

Gold and silver coins are for hoarding only.

Hoarding is in the self-interest of every saver who wishes to avoid Cyprus-style losses when an insolvent counterparty defaults. But the trend of hoarding is leading towards a catastrophe: permanent gold backwardation. This is the first step in the process of gold withdrawing its bid on the dollar. Inevitably, gold will become unavailable in exchange for dollars. When that happens then the dollar will collapse.

Gold owners will no longer demand dollars, but the problem is that dollar holders will still want gold. They will buy whatever gold owners do demand, like commodities. Driven purely by their goal to exchange their dollars for gold, they will drive up the price of every good that can be used as an intermediary. Prices will go up faster and faster. At the end, the dollar will have no value.

Another obstacle to gold circulation is legal tender law that forces creditors to accept dollars as payment in full. No one would lend gold to a borrower who had the option to repay in dollars. As an aside, I believe that if this were the only problem, there would be ways to work around the law and write an enforceable contract.

Next, the taxpayer is forced to pay taxes in dollars. While this does not outright prevent the use of gold, it makes it more difficult. If one uses gold as the unit of account, then this dollar expense poses a risk in case the dollar rises during a tax year.

Further, taxpayers must keep their books in dollars. Anyone is free to keep another set of books in gold (for example my fund does), but this costs money and requires some rare and specialized expertise. Most businesses will not go to this length.

Now, let’s consider the concept of savings. After all expenses, one has some money left over. If this surplus is in the form of a gold coin, there are two possible things to do with it: invest it to earn a yield or hoard it. Today, there is no rate of interest on gold, so that forces the gold or silver saver into hoarding.

If people constantly remove metal from circulation then circulation would stop, even if it somehow started in the first place. There must be an interest rate, to lure gold out of hoards and into productive enterprises that spend it into circulation as they pursue profits. Otherwise it will all disappear.

Finally, we have all grown up in a dollar world. If I say, “I bought $10,000 worth of gold” then everyone knows what I mean. Shifting to the gold paradigm, if I said “I bought 7 ounces worth of dollars” then even longtime gold owners would pause. What is 7 ounces worth of dollars? (It’s about $10,000.)

People think of the value of their gold in terms of dollars. It is madness, like thinking of the length of a steel beam in terms of rubber bands. We all know that the dollar changes in value. Mostly, it falls, though there is some occasional volatility like April 12 and 15. And yet we use it to measure our wealth, our profit or loss, and shareholder’s equity.

One pundit who opposes the gold standard dismissed Arizona SB 1439 by demanding how merchants will know the value of gold or silver tendered in payment. How indeed? Of course, he meant the price in dollars, but I wonder how do merchants know the value of the dollar? People will one day be comfortable speaking of value in terms of ounces. Until then, this is a serious obstacle to gold circulation, if self-imposed.

The discussion of why gold does not and cannot circulate today leads to an insight about the price of gold measured in dollars or, as I prefer to think of it, the price of the dollar measured in gold (as of this writing about 21 milligrams). The recent drop in the price of gold is a pointed reminder that the price of gold has little to do with the quantity of dollars.

The gold price derives from the perceived quality of the dollar. While we still use the dollar to measure all economic values, it is hard to accept that the dollar is in terminal decline. The dollar is just an irredeemable promise, and it is based on bad debt that cannot possibly be paid. We measure the price of gold in dollars, and wait for others to bid up the gold price. Sometimes the timing is good and this happens, sometimes not. The chaotic motions of the dollar cause many goldbugs to have moments of doubt and pain.

The price of gold does not necessarily go up in a straight line or a smooth curve. Abrupt dislocations can occur such as the gold price drop on April 12 and 15, or the silver price jump in the early part of 2011.

The above reasons why gold cannot circulate explain why gold is not priced far higher in dollars. Every one of them could suddenly cease to be relevant. Most people are basically law abiding and pay their taxes. But they will feed their families over obeying the tax law, should they be forced to choose.

We should expect many abrupt, if not violent, moves across all financial markets not least of which will be gold.

It will not be the value of an ounce that changes. It will be the value of a dollar.

Posterous was acquired by Twitter a while ago. At first, it seemed like it was an expansion play by Twitter to cover blogging as well. But then they announced that they were shutting down Poster.com permanently without even leaving up blog pages in an archive form. Twitter wanted to use the employees of Posterous for other projects (a dubious HR strategy, in my opinion).

At any rate, that left me without a home for my papers. Now I have moved to this hopefully permanent home at keithweinereconomics.com.

I have migrated all the content from the Posterous site here, so hopefully nothing was lost. If you find that something does not work or look right, please let me know!

Here’s to years of happy blogging in my new home! 🙂

Do you think that depositors in Cyprus are being taxed? That their money is being taken from them to go to the government in Cyprus or to Europe? Most analysis of the Cyprus bailout is wrong on this point.

Cypriot banks are like all banks in one respect. They raise capital to buy assets that earn a yield, keeping the difference between what they must pay for the money and what they earn on it. Like all banks, they raise money first from equity investors. Equity investors get to keep all of the gains on the upside and therefore are first exposed to losses on the downside.

Banking uses leverage, which multiplies gains when assets rise and losses when they fall. Imagine using 20:1 leverage. You buy a house for $100,000 using $5,000 of your own money (equity) and $95,000 of borrowed money. If the house rises to $110,000 you have tripled your $5,000 of initial equity to $15,000. If the house falls to $94,000 you have negative equity. That may be fine for a homeowner so long as you can pay the interest and principle when due. It’s not fine for a bank.

Banks raise money next from junior, unsecured creditors. Equity capital is expensive capital. Borrowing money is cheaper than selling a stake in the business. Next on the capital hierarchy is senior, secured creditors. Borrowing at this tier is cheaper because the risk of loss is lower. Not only would the shareholders have to be wiped out first, but also the junior creditors. Additionally, secured creditors can take the assets pledged as collateral.

Finally, banks raise money from depositors. Depositors get the lowest rate of interest, which is the tradeoff for having the strongest position in case of bankruptcy. In addition to not suffering any losses until all other classes of capital are zeroed out, depositors also enjoy a government guarantee today, at least up to a certain amount (€100,000 in the case of Cyprus)—so long as the government can pay. It is important to note that while the government maintains the fiction of a “fund” to cover such losses, in a bank crisis the losses are imposed on the taxpayers. Today in the US, for example, the FDIC has a tiny reserve to cover an enormous deposit base.

In the modern world, government bonds are the key security in the financial system. They are defined as the “risk free asset” by theory and regulatory practice. They are used as collateral for numerous other credit transactions. And banks hold them as core assets. Let’s focus on that. A bank borrows from depositors and buys a government bond (and not entirely by choice). There are two problems with this.

First is duration mismatch. The bank is borrowing from depositors, perhaps via demand deposits, and then buying multiyear bonds. Read the link to see why this will sooner or later blow up.

Second, the government bond is counterfeit credit. Governments are borrowing to pay the ever-expanding costs of their welfare programs and the interest on their ever-expanding debt (it is no help that they lower the rate of interest to keep down the interest expense—this increases their burden of debt and destroys capital). Governments have neither the means nor intent to ever repay the debt. They just endlessly “roll” the liability, selling new bonds to pay the principle and interest on old bonds at maturity. This would be like taking out a new credit card to pay off the old one. It “works” for a while, until it abruptly stops working. It has stopped working in Greece; it will stop working everywhere else at some point.

The Cypriot banks bought lots of government bonds, including the defaulted bonds of bankrupt Greece. They lost the euros that were invested by their shareholders, bondholders, and a majority of what was lent to them by depositors. In a way it is accurate to say that the government took it. However, his taking did not occur this week. It occurred when governments sold them fraudulent bonds over many years.

The money is now long gone.

Call it what you will, the government, central bank, and commercial banks of Cyprus are bankrupt; they needed a bailout—new credit from outside the country to postpone collapse. In a week of drama, posturing, demands, reversals, and a vote in parliament, a deal was struck. No one is likely to be happy. Here are the key points so far as we can glean them:

• A fresh tranche of €10B will be lent to Cyprus
• Funds to come from (presumably?) the “Troika”: ECB, EC, and IMF
• Shareholders and bondholders in Laiki (2^nd biggest bank) will be wiped out
• Laiki deposits under €100,000 will be transferred to Bank of Cyprus
• Larger deposits will bear big losses (not specified at this time)
• No bailout funds will go to Bank of Cyprus (presumably to government?)
• 50% or more of large deposits in Bank of Cyprus converted to equity
• “Temporary” capital controls will remain when banks reopen Thursday
• CEO of Bank of Cyprus just resigned, fueling rumors it too will collapse

The Europowers have a big dilemma. If they allow euro backwardation to persist much longer, or they open a schism in the euro where Cyprus euros are not fungible, they risk the collapse of the euro. On the other hand, if they do not impose capital controls then depositors would run on the Bank of Cyprus and it will collapse (ZeroHedge has been covering the story that large Russian depositors have found ways to make withdrawals even though the banks have been closed, using branches located outside the country).

We hope that if the reader gets nothing else from this article, at least he now understands that the Cyprus banks lost their depositors’ money over a long period of time. They used leverage to buy assets that collapsed and now they are insolvent. External parties are providing a bailout (which Cyprus will never be able to repay). For the first time in this crisis, the bailout does not cover depositors in full. Losses are to be suffered by not only shareholders and bondholders, but even by depositors. We expect future bailouts to incorporate this feature.

It is good that Eurozone leaders are beginning to assert that banks should fix themselves. In a free market, there is no such thing as a bailout that takes money from taxpayers to give to those who made a mistake. Hopefully they will take this to the next logical step and realize that bank solvency is impossible under the regime of irredeemable paper currency wherein the government bond is defined as the “risk free asset”. Gold is the risk free asset. Everything else has a non-zero risk of default.

We will continue to monitor and publish the gold basis to see when world markets begin to shift away from trusting the banking system, when people are willing to forego a yield to avoid having to trust a counterparty. When this happens, we expect gold to move more significantly towards gold backwardation.

Compared to the first proposal last week, this bailout is less unfair (we can hardly call any bailout fair)—at least shareholders go first, then bondholders then depositors.

After markets closed on Friday, it was announced that Cyprus worked out a deal with the European Central Bank, European Commission, and the International Monetary Fund (“the Troika”). Here is a typical article reporting on the story.

Cyrpus has been in desperate need of a bailout, and was in discussions as early as June last year. They asked for an amount of money roughly equal to their annual GDP (for comparison, this would be about $15 trillion in the US!) The question is how did Cyprus arrive at this end of the road?

The root of the problem is the manufacture of counterfeit credit. Examples of counterfeit credit include Greek government bonds, sold by Greece to finance their social welfare state, Cyprus government bonds, sold by Cyprus to finance their social welfare state, and Cyprus bank debt, including deposits, used to finance the purchase of said Greek and Cyprus government bonds. To a bank, a deposit is a liability and it owns loans and bonds as assets.

As the world now knows, Greece is unable to pay. Greece is now mired in so-called “austerity”, a package-deal of falling government spending, rising tax rates, and no relief from crippling regulations. The result has been falling tax revenues, rising unemployment and social unrest. Holders of Greek government bonds (and Greek bank bonds) have taken losses already and will take more.

I define inflation as an expansion of counterfeit credit. Bond prices may rise for a time, making participants feel richer. But eventually, all debt borrowed without means or intent to repay is defaulted, and this is deflation. Default can come in many forms, and the imposed loss on depositors in Cyprus is no less a default than other forms. Deflation is now imploding in Cyprus.

In the initial proposal, depositors in Cyprus banks are to be stripped of 6.7% of deposits under €100,000 and 9.9% of amounts over that. Electronic bank transfers have been blocked and cash machines have run out of cash. A bank run is the inevitable reaction to the threat of loss of deposits in a bank.

Subsequent to the initial story, news is now coming out that the Cyprus parliament has postponed the decision and may in fact not be able to reach agreement. They may tinker with the percentages, to penalize smaller savers less (and larger savers more). However, the damage is already done. They have hit their savers with a grievous blow, and this will do irreparable harm to trust and confidence.

As well it should! In more civilized times, there was a long established precedent regarding the capital structure of a bank. Equity holders incur the first losses as they own the upside profits and capital gains. Next come unsecured creditors who are paid a higher interest rate, followed by secured bondholders who are paid a lower interest rate. Depositors are paid the lowest interest rate of all, but are assured to be made whole, even if it means every other class in the capital structure is utterly wiped out.

As caveat to the following paragraph, I acknowledge that I have not read anything definitive yet regarding bondholders. I present my assumptions (which I think are likely correct).

As with the bankruptcy of General Motors in the US, it looks like the rule of law and common sense has been recklessly set aside. The fruit from planting these bitter seeds will be harvested for many years hence. As with GM, political expediency drives pragmatic and ill-considered actions. In Cyprus, bondholders include politically connected banks and sovereign governments.  Bureaucrats decided it would be acceptable to use depositors like sacrificial lambs. The only debate at the moment seems to be how to apportion the damage amongst “rich” and “non-rich” depositors.

In Part II (free registration required) we discuss the likely impact to the markets outside Cyprus, such as the euro, the dollar, gold and silver, and the US stock market.

When writing about economics (as opposed to trading), one does not expect to be proven right within days of publishing something. Things can take years to play out. On Monday, February 25, we published What Drives the Price of Gold and Silver? In that article, I wrote:

If there is a credible rumor that the Fed is planning to further extend its “Quantitative Easing”, how would you expect the monetary metals to react? Typically, the gold price would rise and the silver price would rise even more. The question is why.

Traders read the headlines and they know how the price “should” react to such news, and they begin buying. For a while, the prophecy fulfills itself. But then what happens next? It may take an hour or a month, but sooner or later some of the new buyers begin to sell. What can be bought on speculation using leverage must eventually be sold.

On Tuesday, Fed Chairman Bernanke testified before the Senate. Sure enough, the prices of gold and silver rose sharply. The next day, the prices were back down. By Thursday the price of silver was lower than it had been prior to his announcement.

On March 3, we published a video asking Is Bitcoin Money? While I appreciate many aspects of the cool technology behind it (being a software developer in a previous career), and noting that it has several features that uniquely suit it for certain markets, I concluded that it is an irredeemable currency, but not money (i.e. the most marketable commodity). I received much feedback on the video, some of it negative, though mostly thoughtful and engaging.

At the time of the video, Bitcoin was trading around under $40. Since then, it rose to about $48. 

I was surprised to read that yesterday it fell to a low of $37. It has mostly recovered though it is now a few dollars below its high of $49. What happened?

The technical term is that the “blockchain forked”. In the video, I was very careful not to criticize the digital currency on technical grounds such its cryptographic technology, peer-to-peer networking, its data formats, methods of validating transactions, or communications over Internet Protocol, etc. I wanted to keep the discussion about monetary science. There is a point that I could have made, and will now make here.

If a currency is subject to Internet availability or other technological considerations, it simply is not money. It may still be useful for enabling commerce that would otherwise not be feasible—this is not an attack on Bitcoin as such. But (at least) one key characteristic of money is missing. Money must be beyond question by everyone and at all times. By nature, gold never becomes “unavailable” (though one could entrust it to an institution that suffers from unavailability of course).

When its “blockchain forked”, Bitcoin’s essence was called into question. Suddenly there were possible competing claims to the same coin, possible loss of coins, and certain lack of availability of the currency at least until engineers fixed the problem.

It has crashed before, too. On August 17, it moved from about $15.50 to $10.50 in a few hours. There were previous crashes before that, and there will likely be more (no this is not a prediction for next week!)

Technology aside, there is another factor that contributes to so-called “flash crashes”. If there is a wide bid-ask spread and/or the stack of bids is sparse, then it does not take much selling pressure to cause the price to collapse. For purposes of this discussion, let’s focus on the. While it is possible for the price to rise explosively, there is an important asymmetry between bid and ask: in times of extreme stress, it is always the bid that is withdrawn, never the ask.

Imagine if the US Geological Survey said that there would be a massive earthquake in Los Angeles, estimated to be 15 in the Richter Scale and which would not leave anything taller than a fire hydrant standing. There would be no lack of offers to sell real estate. What would be gone would be the bids. Anyone who needed to sell would have to accept peanuts, if he could even get that.

As I pen this, late Tuesday evening, I see a bid of $45.02 and an ask of $45.1377. This does not seem that bad, $0.1177 spread or about 26 basis points. But the bid looks thin to me! At $45.02, there is around 600 bid.

This is a screen capture I just took from Bitcoincharts.