XMFSinchiruna (28.54)

An Interesting Proposal to Remobilize Gold and End USD Price-Fixing

July 20, 2009 – Comments (14)

The following open letter to former FED Chairman and Obama advisor Paul Volcker comes to Fooldom courtesy of economist Antal Fekete.

My regular readers will recall Fekete's comprehensive explanation of the gold backwardation event that we saw early signs of back in December, or this gem excerpted from a MarketOracle post:

Thirty-five years ago gold, symbol of permanence, was chased out from the Monetary Garden of Eden , replaced by the floating irredeemable dollar as the pillar of the international monetary system. That's right: a floating pillar. The gold demonetization exercise was a farce. It was designed as a fig leaf to cover up the ugly default of the U.S. government on its gold-redeemable sight obligations to foreigners. The word ‘default' itself was put under taboo even though it punctured big holes in the balance sheet of every central bank of the world, as its dollar-denominated assets sank in value in terms of anything but the dollar itself. These banks were not even allowed to say ‘ouch' as they were looking at the damage to their balance sheets caused by the default. They just had to swallow the loss, obediently and dutifully join the singing of the Hallelujah Chorus of sycophants in Washington praising the irredeemable dollar and the Nirvana of synthetic credit.

Well, Professor Fekete is at it again, this time with an urgent message for his seasoned colleague: get the physical gold supply flowing or face unthinkable consequences as bondholders run from dollar exposure like the plague. It's an interesting premise, and one I had not considered before ... discussion has typically included some form of modified gold standard, but it's interesting to consider that the same outcome might be attainable without going that far. According to Professor Fekete, access to physical bullion is the key (and in referencing this he is of course alluding to the gross undersupply of physical bullion that supposedly backs COMEX and global futures markets). Anyway, this is my first exposure to this particular idea, and I wanted to toss it out there to get your perspective on its merits. I do agree with him that a sort of permanent (or very prolonged) backwarddation event could easily arise if risk aversion were to suddenly return to the broader market amis heightened concern about U.S. sovereign debt. Before I go writing a novel about my thoughts on the topic, though, let's just consider Fekete's letter to Paul Volcker and see what we all think:

http://www.professorfekete.com/articles/AEFRemobilizeGoldToSaveTheWorldEconomy.pdf

Dear Paul,

In 35 years our paths have crossed for the second time. In 1974/75 you and I were Visiting
Fellows at Princeton University. Now, in 2009, both you and I are attending the Santa
Colomba Conference on the present debt crisis at the invitation of Bob Mundell.

In 1975 you conducted a seminar on the international monetary system and invited me to
contribute a paper on gold which I did. Those were halcyon days by comparison. The United
States, after the turbulence of 1971, successfully consolidated the international position of the
dollar and could confidently lift the 42-year old ban on the ownership and trading in gold. On
December 31, 1974, trading of gold futures contracts started in New York and Chicago. It
showed a robust contango at full carrying charge, that is to say, the gold basis (the spread
between the futures and the cash price) was at its peak. It indicated that monetary gold was
available in great abundance to meet any demand for any reason. It showed that the gold
futures markets could serve as the fulcrum in seeking out the equilibrium between the supply
of and demand for gold. They could act as a safety valve, releasing occasional pressures that,
in the absence of paper gold, may be a threat to the monetary system. It looked as if the gold
problem has been solved for once and all.

But as I feared, and as the intervening 35 years have proved, rather than moving towards
equilibrium we have been constantly moving ever farther away from it, as measured by the
gold basis. The secular vanishing of the gold basis is a most ominous danger signal. It
indicates that monetary gold is increasingly unavailable, and in case of a crisis it can no
longer be relied upon to come to the rescue. Basis started out at 100 percent of the prevailing
interest rate, but has been steadily eroding all the way to zero percent today. Permanent gold
backwardation (negative gold basis) is staring us in the face. The gold basis is trying to tell
you something. It heralds the greatest monetary crisis of all times. It warns about the possible
collapse of the international monetary and payments system.

Let me explain. Gold is the only ultimate extinguisher of debt. Other extinguishers do, of
course, exist but they are not ultimate in that they have a counterpart in the liability column of
the balance sheet of someone else. Gold has no such liability attached to it. Gold is where the
buck stops. It is this property that makes gold unique as a financial asset. Historically, gold
discharged its function as the ultimate extinguisher of debt through the gold clauses written
into the bonds of the U.S. government before 1933. Gold could also discharge this function,
albeit rather imperfectly, under the gold exchange standard of 1934 with gold redeemability
limited to foreign holders. Still more imperfect was the system of fluctuating gold prices introduced in 1971, thanks to the availability of paper gold. Imperfect as though these
stratagems were, they served as a pacifier to the bond market. But as the threat of permanent
backwardation indicates, all offers to put monetary gold at the disposal of the international
monetary system could be abruptly withdrawn. In that event there would be no ultimate
extinguisher of debt. The world is totally unprepared for such a momentous development. I
ask you: are there contingency plans in the U.S. Treasury and in the Federal Reserve what to
do if backwardation makes monetary gold unavailable for the indirect retirement of debt?

The message to debt holders would be: suave qui peut. There would be a rush to the exit doors
and people would trample one another to death in trying to get out. The debt crisis of 2008
was a dress rehearsal. It gave the world a foretaste. This crisis is a gold crisis. It is a crisis
indicating the threat of a shortage of the ultimate extinguisher of debt, without which our
runaway debt tower is doomed. When it topples, it will bury the world economy under the
rubble, as the Twin Towers buried the people working inside in 2001.

All kinds of ad hoc explanations have been offered for the debt crisis. But the real explanation
is that under the threat of gold backwardation creditors are scrambling for liquidity. There will
be no recovery unless provision is made for the orderly retirement of debt through a
mechanism using gold as the ultimate extinguisher. The alternative is a Great Depression
worse than that of the 1930’s. To understand this we have only to contemplate the shock to
the world if it was revealed that the debt of the U.S. government was in fact irredeemable.
The Emperor is naked. As long as bonds carry a gold clause, or the bond market is supported
by the trading of paper gold, bonds are deemed redeemable. But once permanent
backwardation makes gold unavailable, debt becomes irredeemable in the eyes of the
bondholders. Paying U.S. bonds at maturity in F.R. notes does not establish redeemability.
The latter is just evidence of debt secured by the former as collateral revealing that bonds are
not really redeemable at all. An interest-bearing bond is replaced by a non-interest-bearing
bond, that is, by an inferior instrument. All you do is shuffle various forms of irredeemable
debt. When the world wakes up to this prestidigitation, the international monetary system will
not be able to survive the shock-waves. The chaos that will engulf the world is appalling.

The solution is relatively simple. The world’s monetary gold should be remobilized. This can
be accomplished by opening the U.S. Mint to the free and unlimited coinage of gold. There
should be no attempt to fix, cap, or otherwise control the dollar price of gold. The gold coins
of the United States ought to be made available to bondholders in order to provide for an
orderly retirement of debt, if that is what the bondholders want. When they become convinced
that this avenue is open to them through the unlimited availability of gold coins of the realm,
the scrambling for liquidity will peter out and stability return. If other great nations wanted to
join opening their Mints to the free and unlimited coinage of gold, so much the better. It
should not be beyond the power and the wit of the U.S. government to rein in this crisis and
make a decisive move in the direction of full recovery through opening the U.S. Mint to gold,
as demanded by the Constitution.

Gold is a great world resource. It would be foolish if, for parochial or ideological reasons, we
failed to enlist it in the cause of economic development — even in the absence of a great
crisis. But given the present crisis situation, remobilization of gold is imperative.

Thoughts? Reactions? Counter-proposals? Thanks in advance. :)