Wednesday, August 26, 2009

Remobilize gold to save the world economy!

An open letter to Paul Volcker, Chairman of the Board of Governors of the Federal Reserve, 1979-1987;
Chairman of President Obama's Economic Recovery Advisory Board.

by Antal E. Fekete
San Francisco School of Economics

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indicates, all offers to put monetary gold at the disposal of the international monetary system could be abruptly withdrawn.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 momentuous 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? FULL STORY

The vanishing of the gold basis

and its implications for the international monetary system

A paper presented at the Santa Colomba Conference on the
International Monetary System at the Palazzo Mundell, July 2009

by Antal Antal E. Fekete
San Francisco School of Economics

Gold futures trading started on the Winnipeg Commodity Exchange in Canada in 1971 at a time when ownership and trading of gold was still illegal in the United States. Upon becoming legal the bulk of gold futures trading moved to New York and Chicago.

For all these 35 years the gold markets have been in contango (with minor exceptions due to temporary friction in the delivery mechanism). The basis cannot theoretically exceed the carrying charge (the lion's share of which is interest, usually calculated on the basis of LIBOR). If it did, speculators would be able to pocket risk-free profits in buying the cash gold and selling the futures contract against it. This arbitrage would quickly push the basis back to the level of carrying charge. By contrast, should the market ever go to backwardation, there is no theoretical limit below which a negative basis could not fall. One should see clearly the economic significance of gold backwardation. It is an unmistakable indication of shortages of deliverable supplies.

On the face of it, backwardation in gold would be a rank aberration of the world economy as most of the gold produced throughout the ages is still in existence in marketable form. For this reason profit is to be made by selling cash gold while replacing it through buying the much cheaper futures contract. If people hesitate to do it, there must be a reason. Indeed, the reason is the lack of confidence that paper gold can be exchanged for physical gold at maturity as specified by the futures contract.

The basis for agricultural commodities shows a clear annual cyclical pattern that closely follows the crop year. It starts with contango just after harvest, and ends with backwardation when supplies are drawn down just before the new crop is brought in. FULL STORY

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