Permanent Gold Backwardation: The Crack Up Boom

Professor Antal Fekete has written several pieces discussing gold backwardation, and arguing that this is the red alert signal for the coming financial Armageddon, when the tower of unpayable debts collapses.  In this paper, I delve deeper into this topic.  My goal is to make this topic approachable by the layman and describe what I think will happen when backwardation in gold futures becomes permanent.

Most people define “backwardation” for a commodity as when the price of a future contract is lower than the price in the spot market. But since there are two prices for everything, we must look at the bid and the offer.  They are more meaningful than the last cleared price (which is what people think of as “the price”).  So we must refine the concept of backwardation slightly, as I will show below.

In backwardation, one can sell a physical good for cash and simultaneously buy a future contract to make a profit.  Note that in doing this trade, one’s position does not change in the end.  One begins with a certain amount of the good and ends (upon maturity of the contract) with that amount of the good.

So let us examine the actual trade that any arbitrager in the market could do.  To sell the physical commodity, one must take the bid.  And likewise, to buy the future one must pay the offer.  With this arbitrage in mind, we define the term:

Backwardation is when the bid in the spot market > offer on a future

Why is this important?  What does it mean?

Many commodities, like wheat, are produced seasonally.  But consumption is much more evenly spread around the year.  Immediately prior to the harvest, the spot price of wheat is normally at its highest.  This is because wheat stocks in the warehouses are very low.  People will have to pay a higher price for immediate delivery.  At the same time, everyone in the market knows that the harvest will be in one month.  So the price, if a buyer can wait one month for delivery, is lower.  This is a case of backwardation.

Normally, backwardation is a signal that a commodity is scarce.  This is because if anyone had a quantity of it, they could make a risk-free profit by delivering it and getting it back later.  Markets do not normally offer risk-free profits, and in the case of backwardation there is not normally a real opportunity to make a risk-free profit because the good really is scarce—no one actually has a lot of it to sell at that time.

It is worth delving into arbitrage briefly to complete the point about backwardation.  Arbitrage is, in essence, an attempt to make a profit on a spread (usually by buying one thing and selling another).  The important thing to note is that the arbitrager pays the offer on what he buys, thus lifting said offer, and takes the bid on what he sells, thus depressing said bid.  The arbitrager, alone or with many others doing the same trade, will usually force the spread to narrow to the point where further arbitrage is no longer profitable.  If it is possible to make a risk-free profit someone will do it, and another, and so on until it is no longer to make a risk-free profit.

I said “usually” because in the case of a shortage of wheat it is not possible to make a risk-free profit unless one has physical wheat in one’s warehouse.  In the case when there is not enough grain remaining in stock to compress this spread, backwardation persists (or grows) until the harvest.

Earlier, I said backwardation “normally” means there is a shortage.  But what if backwardation happens to gold?  There is more gold in human possession than any other commodity by a factor of 100 or more (abundance or scarcity must be measured as a ratio of stocks or inventories to flows or annual production—the absolute amount is not important).  Given gold’s massive accumulated inventories, a “shortage” of gold is impossible.

So what does gold backwardation really mean?

For ordinary commodities, the lower price on the future contract vs. spot signals the relative scarcity available for delivery today vs. delivery in the future.  But what would a lower price on gold for future delivery mean compared to a higher price on gold to be had in one’s hand today?  Well, mechanically, it means that gold delivered to the market is in short supply.

The meaning of gold backwardation is that trust in future delivery is scarce versus trust in the gold in one’s hands today.

In an ordinary commodity, scarcity of the physical good available for delivery today is resolved by higher prices.  At a high enough price, demand for wheat falls until existing stocks are sufficient to meet the reduced demand.

But how is scarcity of trust resolved?

Thus far, the answer has been via higher prices.  However, when backwardation becomes permanent, then trust in the gold futures market will have collapsed.  Unlike with wheat, millions of people and some large institutions have plenty of gold they can sell in the physical market and buy back via futures contracts.  When they choose not to, that is the beginning of the end of the current financial system.


Think about the similarities between the following three statements:

  • “My paper gold future contract will be honored by delivery of gold.”
  • “If I trade my gold for paper now, I will be able to get gold back in the future.”
  • “I will be able to exchange paper money for gold in the future.”

I submit that it will not take gold holders a long time to arrive at the inevitable conclusion.  If some holders of gold do not agree, then they will sell (at higher prices, probably) to those who do.  Soon enough, there will not be sellers of gold in the physical market.

With an ordinary commodity, there is a limit to what buyers are willing to pay based on the need satisfied by that commodity, the availability of substitutes, and the buyers’ other needs that also must be satisfied within the same budget.  The higher the price, the more that holders are motivated to sell and the less that consumers are motivated (or able) to buy.  The cure for high prices is high prices.

But gold is different. Unlike wheat, it is not bought for consumption.  While some people hold it to speculate on increases in its paper price, by the logic above, they will be replaced by people who are holding it because they do not trust paper and want to hold gold because gold is money.

Gold does not have a “high enough” price that will discourage buying or encourage selling.  No amount of price change will bring back trust in paper currencies once said currencies decline past the threshold where it is obvious to a critical mass of people.  Thus gold backwardation will not only recur, but at some (hard to predict) point, it will not leave its backwardated state.

In looking at the bid and offer, one other fact is germane to this discussion. In times of crisis, it is always the bid that is withdrawn; there is never a lack of offers. Another way of looking at permanent gold backwardation is as the withdrawal of gold’s (i.e. money’s) bid on irredeemable government debt paper (e.g. dollar bills). But paper’s bid on gold is unlimited.

The remainder of this essay addresses what will happen to non-monetary goods when gold goes into permanent backwardation.  Note that it is possible that silver will go into backwardardation prior to, concurrently with, or following gold.  I make no prediction about the sequence.  In the following discussion, everything should be interpreted to apply to silver as well as gold.

Many people who hold paper but who desire to hold gold will buy (e.g.) crude oil for paper, and then sell it for gold (I will call buying a commodity for paper to sell it for gold “gold arbitrage”). This will drive up the price of crude in terms of paper, and drive down the price of crude in terms of gold.  Even if this “window” were to remain open indefinitely, it is obvious that larger and larger amounts of paper will buy dwindling amounts of gold. This is because of the twin rising prices of crude-in-paper and gold-in-crude.

For example, if today the price of a barrel of crude in terms of paper is $100 and gold priced in crude is 15 barrels, then $1,500 can be traded for one ounce of gold this way.  But if the price of crude in paper rises to $2,000 and the price of gold in crude rises to 150 barrels, then one would need $300,000 to trade for one ounce of gold this way. There will always be a gold bid on crude, but it need not necessarily be high.

Of course, this window will shut sooner or later (I suspect sooner), as I show below.

To summarize, what I have outlined above is the logical outcome of permanent gold backwardation. With an understanding of Austrian economics, particularly the ideas of Carl Menger and Antal Fekete, one can see that in permanent gold backwardation the following steps are inevitable:

  • Withdrawal of offers to sell physical gold for paper money.
  • Skyrocketing price of liquid commodities in terms of paper.
  • Falling price of commodities in terms of gold.

Gold is not officially recognized as the foundation of the financial system. Yet it is still a necessary component, without which the system will collapse. As I will show, it is impossible to divorce gold and paper without also divorcing commodities and paper.

Earlier, I gave three equivalent statements:

  • “My paper gold future contract will be honored by delivery of gold.”
  • “If I trade my gold for paper now, I will be able to get gold back in the future.”
  • “I will be able to exchange paper money for gold in the future.”

My point was to show that these statements are all false. They are false for the same reason. This is what is discovered by the market, when it goes into permanent backwardation. Paper currencies are backed by debt, and the debt has grown far past the point where it could possibly be repaid. It is rapidly approaching the point where the interest cannot be kept current. So governments and other borrowers seek to borrow ever more money to pay the interest on their debt and to cover their permanent deficits.  This cannot continue forever, or indeed much longer.

There is a fourth statement that is equivalent to the other three above:

“My paper money will be accepted in trade for the goods I need in the future”

If the first three are false, this one is also necessarily false.

The commodity producers will eventually be forced to do business by buying their inputs for gold and selling their outputs for gold. To validate this, let us use the technique of assuming the opposite is true, and see if that leads to a contradiction. Let us assume that commodity producers will continue to operate by buying their inputs for paper and selling their outputs for paper. As discussed above, paper prices for their output products will be skyrocketing. At first, this would seem to be good for them.

However, we must consider that each business needs to keep the appropriate balance of its capital in cash, ready to pay for inputs, wages, etc.  Under conditions of rapidly rising prices for inputs, cash is rapidly losing purchasing power. One cannot keep cash for more than a day (if that), without losing precious capital. Every business will spend its cash as quickly as possible. Now someone has to hold it, as the cash does not go out of existence when one spends it—it just goes into someone else’s hands. So this will be a period of rapidly accelerating capital decumulation. Second, most businesses will have a suboptimal allocation of cash which is determined, not by rational analysis, but by this game of “hot potato.”  This leads to another consequence: shortages.

Ordinarily, the businessman does not want to keep excess inventory of his output product. This is because the marginal utility of oil or tires or whatever declines rapidly, but the marginal utility of money (even paper money) does not.  But in the condition of gold backwardation, the marginal utility of paper is declining faster than any real product.

So the commodity producer would be wise to keep its output in inventory, and only sell his products as he needs the cash to buy another input. This is inefficient, and tantamount to losing the benefit of indirect trade. It will cause supply disruptions to businesses that use this commodity as their input. It will also cause much wider spreads, as the market becomes less liquid, and rapidly changing prices add the risk that a normally profitable spread could become unprofitable. Narrow spreads are a sign of increasing economic coordination; widening spreads are a sign of collapsing coordination.

In gold backwardation the next problem for commodity producers to (somehow) address is: how can a business use a rapidly diminishing currency as its unit of account? How is one to even determine whether production is profitable or unprofitable? Hint: if a business is decumulating capital, it is making losses.

One must also consider real demand (as opposed to the demand for a medium for the gold arbitragers). As the paper price rises, most buyers don’t have unlimited amounts of paper to pay. How many people can fill their car with gasoline every week at $100 per gallon? How about $1,000? Real demand for commodities is collapsing in this environment (going back to the analysis above, recall that the prices of commodities in gold are falling).  But the prices are rising in paper terms. Regardless of the value of paper money, in real terms most businesses that produce a good with rapidly falling demand do not make a profit.

Another challenge comes from the fact that not all prices rise equally. As discussed above, the primary driver for liquid commodity prices is the arbitrage to get into gold, because there will always be a gold bid for food and energy. But what about specialty manufactured products?

Machine parts and truck tires do not make a suitable vehicle for the gold arbitrage, and so their prices may not rise to the extent of oil and wheat. The spread (i.e. profit margin) for manufacturers of these items, who need to buy oil as their inputs, may very well become permanently negative. While there will be some demand from commodity producers to provide a bid, such thinly traded markets could see enormous volatility. The nature of a business who makes a specialty product for a thinly traded market, especially a business which is thinly capitalized, is that it must make a profit every month or at least every quarter or else close its doors. Even if the spread reverts to the mean, an inversion lasting one or two months could be enough to destroy such a company.

And even if the spread does not collapse, think of the behavior of their customers. Unlike oil drillers whose output product is in constant demand (especially by the gold arbitragers), who can choose exactly when they sell their products, specialty manufacturers are not sovereign. They must sell when buyers want to buy. But their buyers, the commodity producers, are going to be controlling their buying and selling in larger batches rather than the steady buying of “just in time” that was operative when the currency was stable.

So a summary of (some) consequences suffered by all commodity producers who try to do business in terms of paper money after permanent gold backwardation:

  • Capital decumulation due to the necessity of holding some cash at some times while said cash is rapidly falling in value.
  • Supply shortages, including failure of critical vendors, causing production disruptions and lost time/money.
  • Hoarding of produced goods.
  • Collapsing real demand.
  • Skyrocketing prices do not perfectly compensate for skyrocketing costs.
  • Rising volatility and widening spreads across the board.
  • No usable unit of account for one’s books, so losses will (temporarily) look like gains.
  • As currency devolves, efficiency of transactions devolves also to become more like direct (barter) trade, requiring coincidence of wants or at least timing.

Without even addressing strikes by workers, failure of critical infrastructure like the electrical grid, or the breakdown of law and order (how will the government collect and use taxes to employ police and firefighters?), it should be clear that businesses who use paper money will not be able to operate profitably for long.

Thus it is safe to conclude that the gold miners will not continue to provide gold to the paper market. The same holds true for all other commodities. By temporarily assuming that commodity producers could continue to supply goods to sell for paper, the opposite has been proven.

While no one can predict the timing, and I think that it will be years away, my conclusion is that Von Mises’s “Crack Up Boom” is an inevitable consequence of permanent gold backwardation.

© Keith Weiner May 10, 2011


55 comments to Permanent Gold Backwardation: The Crack Up Boom

  • Fantastic piece! We are working on its Spanish version. We are certain that our readers will appreciate your insight in layman terms–although the conclusion is quite alarming.


  • Fantastic piece! We are working on the Spanish version. We are certain that our readers will appreciate your insight in layman terms–although the conclusion is quite alarming.


  • Charles Pace

    Great Article! Since we live basically in a cashless society, the process to bartering might be quick and decisive. So, where might be the trigger point? Funding our federal debt?

    • Keith Weiner

      I am not sure how much difference it would make if we used physical slips of paper vs. electronic credits. Perhaps there could be a period of (maybe) weeks when paper bills will be worth something and electronic credits are not accepted. I dunno.

      I think the trigger will be defaults or fear of defaults. Like fall of 2008 (when gold went into a major backwardation). The whole monetary system is based debt on top of debt on top of more debt. When defaults begin to occur, it threatens the whole system as the creditor who is screwed on one debt is a debtor struggling to pay its creditors, etc.

  • How long has the current backwardation in gold persisted, and can we find such a pattern in history?

    • Keith Weiner

      Sorry, I should have stated it in my paper. Gold is not currently in backwardation. Interestingly, silver is in backwardation for futures contracts dated May or Jul 2012 and beyond. Spreads jitter around a bit–it does flicker into backwardation for Jul of 2011 as well but it doesn’t persist at the moment.

  • Austrian

    As usual, your argument has enough holes for a year’s supply of Swiss Cheese.

    You confuse and muddle two senses of “trust” – “trust” in the fiat currency, as opposed to “trust” in the credit-worthiness of a counterparty who is legally bound to deliver physical gold. Loss of faith in ‘paper’ currency is a completely different issue from concern that a counterparty may not be able to deliver contractually promised physical gold.

    Note that credit fears and debt defaults, which could cause backwardation in futures, lead (and led) to *deflationary* pressures and a strong *revaluation* of the fiat dollar. See 2008.

  • Austrian

    And how can ‘permanent backwardation’ in gold be the canary in the coal mine that you and Fekete claim? We’ll only know ex post facto whether any particular episode of backwardation *was* ‘permanent’ or not, and by then it’s too late. If people are losing faith in the financial system, it will be obvious enough from the newspaper headlines. Absent this, how will you be able to tell whether any particular episode of gold backwardation is ‘permanent’ as opposed to being due to other transitory factors? Purporting to read the tea leaves of ‘gold backwardation’ is simply useless.

    Moreover, if gold backwardation arises due to credit fears and distrust of counterparties – then *all* futures contracts are going to go into backwardation (and *all* financial claims will become discounted). This will hardly be a phenomenon unique to gold.

  • Keith Weiner

    Austrian: you don’t seem to be here to make a point, but to attack me. Consequently, I will give you the response that you deserve.

  • Austrian

    You write: “Abundance or scarcity must be measured as a ratio of stocks or inventories to flows or annual production—the absolute amount is not important. Given gold’s massive accumulated inventories, a “shortage” of gold is impossible.”

    Concepts of ‘shortage’ or ‘scarcity’ *in economics* do not pertain to *physical* quantities such as inventory-to-annual-production ratios, but to the relation of available supply to *demand*.

  • Austrian

    You write: “With an understanding of Austrian economics, particularly the ideas of Carl Menger and Antal Fekete…”

    It’s almost intellectual sacrilege to mention a money crank like Fekete in the same breath as a genius like Menger. But at least now I get where you’re coming from. Carl Menger did indeed lay the groundwork for Austrian monetary theory, but you continue to ignore that it was *Ludwig von Mises* who developed the ‘meat’ of Austrian monetary theory. As you admitted in another comment thread, you have no familiarity with the fundamentals of Mises’ theory (hence your continued repeated assertions that gold does not have declining marginal utility). Go ahead and promote your own pet monetary theories, but you should stop promoting them under the ‘Austrian’ label, when you admit unfamiliarity with the core Austrian theory of money and when you continue to write things that contradict it (apparently without compunction).

    Is it part of Fekete’s teachings that, as you wrote in an earlier piece, “demand for money” is equivalent to the decision of how much to save and how much to consume? My opinion of Fekete wasn’t so low as to expect such a basic and fundamental error from him. But I’m happy to revise my opinion if necessary.

  • Austrian

    Keith: Actually, I thought I’d made *several* points — attacking *your points*. If you have no answer to them, I fully understand.

    • Merv

      Austrian, you obviously have an ax to grind, and it is impossible for me to tell what you are even talking about. If this article is not up to your ego-centric expectations or has offended your self-important sensibilities, no one cares. Instead of attacking this piece, why don’t you try writing an article yourself that makes a set of cogent points and predictions based on a potential future event, as Keith Winer has done here?

  • Californio

    Great Article! Easily Understood.

  • Jeff/Keith:

    As we finished polishing the Spanish version of this piece we realized that it wasn’t Jeff’s– whose writings are being featured on our blog…

    Keith: do you mind us publishing this article under The Daily Capitalist section in our blog?

  • Wow, who is Austrian lol and what on earth is he talking about? I always hark back to when FDR asked for all the Gold to be turned into the Federal Reserve (I would have kept mine) and to Nixon ending the Gold Standard. I’m not sure I understand where the term backwardation came from. But your article is certainly noteworthy and easy to understand.

    • Keith Weiner

      Thanks Leslie. Contango and backwardation are words used in the futures trading markets.

  • Elmo

    This article suggests that future delivery of gold may not occur when a futures or options contract matures.

    Can you site one example in the history of US commodity trading when contracts were not honored? That is delivery was not possible due to the absence of supply?

    I enjoyed the article but its relevance hinges on your answering the above question for gold.

    • Keith Weiner

      I am not aware of such an occurrence. I don’t think that will prevent it from occurring. And in any case, you have to ask why has gold (and silver) had several backwardations in the past few years?

    • Austrian

      Elmo – yes, there is a ‘force majeure’ clause for futures contracts. As one example, it was invoked against the Hunt Brothers (when they tried to corner the silver market) releasing the sellers of futures from having to deliver physical silver, and instead allowing for cash settlement of all contracts for that particular month. Gold is far too big a market for anyone to try to ‘corner’ though, so we won’t see that scenario with respect to gold.

    • Keith Weiner

      And yet, gold has had several backwardations in recent years.

      The question anyone who rejects my thesis must answer is: why?

      • Austrian

        Keith: Given your thesis that gold backwardation portends Armageddon, I would think rather that the onus is on *you* to explain why we have had backwardation episodes that *haven’t* led to Armageddon. On the face of it, such episodes suggest that there are other forces at work — other than the one indicated by your thesis — that need to be investigated.

        Here are some factors that cause backwardation:

        - Credit fears and counterparty risk concerns: these can and would cause backwardation, as they did in 2008, as I indicated above. But those are *deflationary* forces, not forces that portend the end of fiat currency.

        - Heavy forward selling by mining companies: This was likely the cause of the recent silver backwardation. Mining companies saw the spike for what it was – temporary – and were eager to lock in such high prices (especially since silver production is fairly easy to ramp up). Heavy gold forward hedge sales by mining companies was a common feature of the late 90s / first part of 2000′s.

        (Should such backwardation automatically be arbitraged away? No. If it’s slight, it’s not worth the hassle and it won’t clear trading costs. Even if it’s moderate, it’s not something hedge funds will rush into until it gets rather large. Since the timing of the mean-reversion is uncertain, and since the spread can always widen before it narrows (causing mark-to-market losses), the risk is non-trivial, hence the reward has to be large enough to compensate for the timing uncertainty and the mark-to-market price risk.)

        - Gold and silver each have (and have always had) their own “in-kind” interest rates, which is completely distinct from the dollar interest rate. The “fair value” futures calculation for gold is: the future will trade at a price differential to spot equivalent to the difference between the gold interest rate and the dollar interest rate. (You can look up this sort of futures fair value calculation in any good finance textbook. There are also storage costs and insurance costs that factor in, but I’ll leave those aside for the sake of simplicity.)

        For example: if the gold interest rate is 1% and the dollar interest rate is 5%, then the fair value for a 1 year gold future is 4% higher than spot gold. In contrast, if say we’re in a deflationary period for dollars when monetary policy is very loose, we might see the dollar interest rate at e.g. 0.25%, and the gold interest rate at 1%. In that case, the “fair value” for gold futures *is* backwardation to the tune of 0.75%. Yes, that’s right – *correct fair value* would be backwardation.

        So – those are the explanations for past episodes of gold backwardation.

        • Keith Weiner

          I did not say that all backwardations are necessarily permanent. Obviously there are multiple forces at work. By the way, backwardation is not a force at all. It is a state of the market.

          Perhaps we’re not on the same page regarding the meaning of deflation. From your comment, I take it you mean falling prices and rising value of paper money. But deflation is a decrease in credit. Which means defaults in credit. With that concept, one can see that “too much” deflation means the end of the paper currency. This is because paper currency is nothing more than someone’s debt obligation.

          The recent backwardation in silver (which still persists for contracts beyond 2012) preceded the rise in the price and persisted most of the way up. Perhaps heavy forward selling by mines caused the rise in price from the 20′s to the 40 or so? That is not my view.

          Remember that annual mine production is a tiny fraction of the total gold or silver stocks. The miners don’t have enough production to move the price like that in any case.

          The definition of backwardation is when Spot(bid) > Future(offer). This is because there is an actionable arbitrage that a trader could take. Backwardation could be caused, as you note, by massive selling of futures. But the price was rising. So the more likely explanation is that there was massive buying of physical metal. This is confirmed by a number of sources, such as the US Mint.

          Someone with the handle “Austrian” should understand marginal analysis. The trader at the margin is the one who takes the profit of the gold decarry operation. There is no way to say that “this doesn’t happen until the decarry > $X” (or X%)–how do you calculate X? A differential equation? If someone can hold to maturity (a few months–these are not 30 year bonds!), it is a guaranteed risk-free profit, except for the risk of default. A trader who holds gold, perhaps pooled client accounts, and who is a member of the LBMA, could do such a trade for nearly zero cost–probably fractions of a basis point. Both a carry and decarry operation end up with the same position on contract expiration, but for the duration mismatch that could occur if the accounts are demand deposits and the future contract maturity date is more than 30 days in the future (banks don’t care about this little “formality” today).

          The one thing that can be said if the basis is rising is that more carry trades are being put on, and if the cobasis is rising more decarry trades are being put on (or carry trades are being unwound).

          By the way, the backwardation in Dec 2008 was not slight.

          For someone with the handle “Austrian”, your reliance on arbitrary formulae is inexplicable. You actually offer an equation to *derive* “fair value” of a spread?? Was that Mises who offered that or Menger??

          • Austrian

            “Arbitrary formulae”?!? Keith, the fair value formula for futures prices is Finance 101 / CFA Level I type stuff! You are the denying the existence and/or validity of this formula, and writing an essay on the backwardation of futures prices!?

            Of course neither Menger nor Mises wrote about this. Yes, both held that math is not useful for elucidating fundamental economic principles. But the field of Finance is different, and neither wrote about that.

            So am I to understand that you reject all the mathematical formulae of Finance theory as “arbitrary” then? Bond pricing formulae, present value formulae, option pricing formulae, etc.

          • Keith Weiner

            Am I to understand that you think the Austrian School sanctions and supports a formula that dictates the “fair price” of gold in the futures markets? That money should be paper, and gold should be a commodity that trades like cattle and pork bellies? And that it has a “fair” price in terms of government debt paper?

            And that this “fair” price could very well dictate a negative spread?

          • Austrian

            “Am I to understand that you think the Austrian School sanctions and supports a formula that dictates the “fair price” of gold in the futures markets?”

            The formula dictates the fair price of gold futures *relative to spot prices*. I.e. given a spot price, there is a precise fair value formula for the futures price. Yes. Why wouldn’t the Austrian school sanction this finance theory?

            “That money should be paper, and gold should be a commodity ”

            Umm, who said anything about whether money ‘should’ be paper? Currently, yes, money *is* paper. That is the system we have now. And currently gold still *is* largely a commodity (though increasingly taking on monetary properties in recent years). The definition of money is “a generally accepted medium of exchange”. Paper dollars are a medium of exchange and they are generally accepted. Gold is neither. It is not currently money. (Should it be money and do I hope it will be? Of course.) Gold is not used as a means of exchange nor as a unit of account. So long as the paper dollar continues to be money and used as the unit of account – then yes, the futures fair value formula applies perfectly well to gold as to anything else.

            Yes, so long as people continue to accept paper money, then there is a fair value price for gold futures relative to spot. If people stop accepting paper dollars, then yes, *at that point in time*, there will be little meaning to the spread between gold futures prices and gold spot prices in dollar terms. *But there will also be no gold spot price in dollar terms*.

            Since you are asking me to explain *past* episodes of gold backwardation, when the paper money system is/was still firmly entrenched, that is what I am doing. Come the apocalypse, that might change; but past episodes of backwardation were not the apocalypse.

            Could the fair value price dictate a negative spread? Absolutely – as I indicated and as has happened in the past. The formula is elementary finance theory.

          • Austrian

            Keith wrote: “Remember that annual mine production is a tiny fraction of the total gold or silver stocks”

            True for gold. Not true for silver.

            Keith wrote: “The miners don’t have enough production to move the price like that in any case.”

            What matters for the price is not the total above ground supply but the *demand at the margin*. If miners were supplying to the forward market more than was being demanded, the price would fall (as it did). And in any case, the quantities over time are not trivial. Let’s say gold production is 3% of existing stocks a year. Over 10 years, that’s a 30% increase in total gold supply – not trivial. Hedgers like Barrick were hedging as much as 10 years forward.

          • Austrian

            “The trader at the margin is the one who takes the profit of the gold decarry operation.”

            Yes, you merely assert that someone would, but who *specifically*? The vast majority of financial funds are invested under circumstances where institutional arrangments or investment mandate or legal/fiduciary restrictions prohibit futures trading. Even most hedge funds are not set up to do futures trading. Even smaller is the number of such funds (who are able to trade futures) who *actually hold some physical gold* that they could swap against futures. (Especially earlier in the last decade.) There will be some speculators who might try to arb the spread, and against this was the combined hedging might of global mining firms.

            “There is no way to say that “this doesn’t happen until the decarry > $X” (or X%)–how do you calculate X? A differential equation?”

            Why do you need a precise number? The arb happens when someone decides the risk-reward is favorable. There is no precise number, but it is also false to say that the first appearance of any tiny spread differential will automatically and immediately be arbitraged away. There are plenty of examples in the financial markets of arbitrageable spreads that persist for years.

            “By the way, the backwardation in Dec 2008 was not slight.”

            … and was caused by mass fears of counterparty defaults, as I indicated before. There were *all kinds* of wonky things going on in 2008, juicy arbitrageable spreads I never thought I’d see in my life. Like: negative yields on t-bills; AA-credit spreads trading less than the yield on government paper; 29.75 year treasury bonds trading at yields 50bps higher than 30 year treasury bonds. The common denominator was: no one trusted anyone else to be solvent, so no one was willing to transact to arb these spreads.

            And – contrary to your and Fekete’s “red alert” thesis about gold backwardation – we didn’t need gold backwardation to tell us the the financial system was about to collapse in 2008.

          • Austrian

            Keith wrote: “I did not say that all backwardations are necessarily permanent.”

            Right – which speaks to the second point I originally posted, way up near the top. How can “permanent backwardation” serve as the “red alert” or canary in the coal mine that you claim it to be, when we can only know *long after the fact* whether it was “permanent” or not? By the time we’re in a position to ascertain that it is indeed “permanent” – there will be plenty of very obvious signs that the world is coming to an end.

          • Austrian

            Keith wrote: “Perhaps we’re not on the same page regarding the meaning of deflation.”

            Agreed, that could be part of the issue.

            “But deflation is a decrease in credit. Which means defaults in credit”

            Yes, which since it reduces the broadly-defined money supply, will tend to result in prices falling and the value of *cash* rising. Paper cash is not credit – it is not callable or redeemable into anything else. Debt defaults result in a mad scramble for *cash*, which results in a revaluation of the dollar *upwards* against all else (as happened in 2008). Why would that portend the end of the dollar system? The opposite is true. Rather than ‘abandoning’ the dollar, people were scrambling to sell anything and everything in order to *acquire* paper dollars in order to be able to pay off their debts. Because if they didn’t, they’d lose everything and go bankrupt. Exactly the same thing happened in the Great Depression.

      • Keith, have you considered producer hedging in the out years as a cause of backwardation? Junior gold miners may have financiers who require that be done.

        • Keith Weiner

          DoctoRX: If there was no issue of trust, then selling of futures would be responded to by decarrying. Decarrying is selling physical and simultaneously buying a future to end with the same net position. Decarrying will tend to eliminate backwardation. The $64T question is: when backwardation has been happening (most notably in Dec 2008 but there have been other instances) why have gold owners not responded by decarrying?

          Also, the forward selling argument does not address why prices shortly thereafter rallied strongly.

          The same happened with the silver backwardation that led up to the rally that temporarily ended at $49.

  • Austrian:

    Thank you for your many comments and interest in our articles. I assume from your name that you do follow and understand Austrian theory economics. I appreciate that fact and urge you to comment. However, you are getting to be a flamer on this site because of the nature of your commentary. I and my readers would appreciate a less antagonistic approach to your comments and come up with something more constructive. The purpose of this site is to promote free market, Austrian, classical liberal ideas. Perhaps we don’t always live up to that ideal, but we try. By being antagonistic instead of constructive, you actually do more to harm our goals. Instead of just saying Keith is wrong, I would appreciate it if you would build an argument that is supported by theory, demonstrating why you think he’s wrong, rather than the cheap shots you are taking.

    Jeff Harding

  • [...] and arguing that this is the red alert signal for the coming financial Armageddon. Permanent Gold Backwardation: The Crack Up Boom | The Daily Capitalist __________________ At high tide fish eat the ants, at low tide ants eat the fish. [...]

  • Craig Cheatum

    For the simple minded, does your article suggest a continued upward price movement on gold and silver?

    • Keith Weiner

      The article does not say anything about price in the short term. In the long term, it says gold will not be offered for paper dollars at all.

      I suspect that the price in dollar terms will go a lot higher before that happens.

  • Craig Cheatum

    Ok, that’s what I thought, but wanted to ask directly. That scenario really would be armageddon. Thanks, Craig

  • Austrian

    I thought I’d made two very cogent arguments (not cheap shots) right at the beginning, criticizing the heart of Keith’s thesis. Keith said they were not points but just an attack, and refused to answer. Were my points forcefully and colorfully stated? Yes, perhaps. (I’ll be happy to tone down the ‘forcefulness’ and ‘color’ if you wish.) Did I make a personal attack on Keith? No – I only criticized his ideas, and provided reasons why.

    I am indeed a long-time student of Austrian economics. I am indeed *very* concerned about doing harm to our goals of promoting free-markets, etc. That’s why I do get a bit upset if I see someone making statements that flatly contradict fundamental Austrian monetary principles, while calling his theories ‘Austrian’ — and continuing to do so even after this is pointed out. It just makes it all the more difficult for those of us who want to spread Austrian ideas, to get the message out and be heard and taken seriously. I haven’t just been saying “Keith is wrong”, I’ve been providing arguments in most cases, and in other cases pointing to the positive, constructive theory which is contained in the writings of von Mises, for the correct views – views which I would have thought should be mandatory reading for anyone wanting to write about Austrian monetary theory. Is that wrong for me to point out? If our side is going to make any headway, we have to ‘do our homework’ and know our ideas thoroughly. Should I recapitulate Mises’ arguments here, in my own words? It seems more efficient to just read Mises’ works directly.

    • Austrian:

      Perhaps you perceived your commentary to be fair criticism, but I will stand by my comment, because I thought it was getting personal. I noticed that your following comments have been more on point than what I believe were “cheap shots.” More explanation and less sarcasm is appreciated. The style should be as if you were sitting across from the other person at coffee. Thus, would you say the same things to him/her in person that you would in print.

      For the record, there are three other writers for this blog that I regularly publish: Keith Weiner, DoctoRx, and David Stockman. I like what they have to say but I don’t always agree with everything they say. The only one I agree with 95% of the time is myself, and I usually admit when I am wrong. Each of them is a valuable supplement to add to my commentary and I appreciate them for that. But, when they publish commentary here they are on their own to defend their positions.

      • Keith Weiner

        Jeff: This is beyond agreeing or disagreeing. And it’s beyond taking a cheap shot or two. “Austrian”, bravely using a pseudonym, was clear in his comments to my other posts and this one that he wants me to stop writing altogether. Or at the least stop writing under the banner of the Austrian School.

        I don’t mind taking controversial positions. While I wouldn’t say my objective is controversy per se, I am writing about areas of Austrian thought that are not well understood and lead to conclusions that are counterintuitive. Too many “Austrians” like Schiff, for example, implicitly accept the Monetarist nostrum that rising money supply = rising prices. It is not a simple or linear process (or indeed something that can be modeled with equations).

        Think of a race car cornering at 1.4g and a defective weld in the suspension is failing. The failure will be dynamic, non-linear, and catastrophic. In the last few milliseconds or tens of milliseconds, G forces could oscillate wildly in opposite directions. It would be wrong to measure the rate of change in the level of the gas tank to try to predict the next change in the state of the vehicle–no matter how many times there was a correlation in the past (drivers must lift off the throttle and push down the throttle in a certain sequence and timing to enter and exit a corner–but if the suspension is shearing off then past correlations will not predict the future!)

        Anyways, I expect all sorts of responses and questions and I am happy to entertain them. This is still a learning experience for me, and in being forced to think about a question I may have to clarify my own thoughts. But what I don’t need to tolerate is someone who is not here to exchange ideas, but to gun me down (intellectually speaking). He has a right to his opinion, but I don’t have any reason to respond to him at this point.

      • Austrian

        Strong criticism of someone’s ideas is “gunning [him] down”?!?

        “Or at the least stop writing under the banner of the Austrian School.”

        Yes, I think it is only fair that if someone denies a fundamental, core tenet of the Austrian school, he shouldn’t call himself an adherent of Austrian theories.

        The principle of “marginal utility” is *the* fundamental explanatory principle of *all* price theory, according to Austrian economics. Menger and Bohm-Bawerk showed how it provided a unified explanation of wages, rents, and all goods prices(whereas classical economists had *separate* theories for each of these.) Mises showed how marginal utility also explained the value of money, thus completing the theory and demonstrating its universality. Mises theory is accepted by the community of Austrian scholars as “the” Austrian theory of money. The marginal utility principle is universally accepted by Austrian scholars as the basis of price theory.

        Keith advocates the idea that gold/money does *not* have declining marginal utility. This contradicts Austrian monetary theory *at the very root*. Why call yourself an Austrian then? Why not simply say: I disagree with the Austrian theory of money, and have my own theory to offer instead?

        • Sundar

          Keith -

          I disagree that marginal utility of money does not decline. Sure it does, the very reason more printed dollars means the paper is worth lesser.

          Austrian -

          You are correct that all goods, including money (be it gold or fiat currency) have declining marginal utility. But the interesting fact about gold is that it has the slowest decline relative to all other goods. This means that it can be used as a barometer to measure the value of all these other goods, therefore makes an excellent choice for medium of exchange purpose.

          Instead of picking an argument on a semantic point, please provide a cogent reasoning on why you think gold backwardation *does not* matter. If gold is accepted as money universally, it definitely matters to monitor the gold basis.

          • Austrian

            Sundar –
            You are confusing the purchasing power of money (which does *tend* to decline with increased supply, ceteris paribus) with the *marginal utility* of money (i.e. *cash*) to an individual person. The concept of declining marginal utility only pertains to an individual person. And the marginal utility of *cash* means how much the person values the next unit of *cash* that comes into his possession (i.e. how much he values *keeping it as cash* as opposed to spending it to acquire consumption goods or investment goods). Unless you like to carry your net worth around with you as cash in your wallet (or alternatively keep it as cash in a vault in your home), I would venture to say that your marginal utility for money (i.e. cash) falls quite rapidly. (The above principles apply whether money is paper or whether money is gold. Again, I refer people to von Mises’ Theory of Money and Credit for a full fleshing out of the relevant concepts and principles.)

            “Instead of picking an argument on a semantic point…”

            It’s not a semantic issue regarding what is, or is not, part of the body of thought called Austrian economics.

            “please provide a cogent reasoning on why you think gold backwardation *does not* matter…”

            Did you not read my posts above? I provided several reasons to explain past episodes of backwardation, and that could perfectly well explain future episodes. I also explained why these episodes are not necessarily arbitrageable. (Keith simply assumes that they are and that they must be.)

            I also argued that ‘permanent’ backwardation is meaningless as the ‘leading indicator’ that Keith and Fekete claim it to be (see the very first sentence of Keith’s essay above) since you can only know it was indeed “permanent” long after the fact. As Keith admits, there were plenty of episodes of gold backwardation that *weren’t* permanent. Ok fine – so now you need to give me *another* indicator that will tell me “real-time” whether any given episode of backwardation is “permanent” or not. Otherwise how will I know whether the *next* episode is indeed the “red alert” or just another normal “impermanent” episode? And if I can’t know in real-time whether any episode of backwardation is “permanent” or not – why bother monitoring gold backwardation?

          • Sundar

            Backwardation is simply a state in which the good is presently in. The fact that gold is in backwardation, is an alert signal in itself because the stock to flow ratio of gold is as high as 80:1. Backwardation of gold indicates that the holders of gold are unwilling to participate in making risk-free dollars as profit, by selling their gold at spot and replacing it with a lower cost future.

            Sure there’s no way to say if gold went into backwardation, whether it is permanent — you are asking an indicator for an impossible question, because you are seeking an answer for the future state of gold which no one can answer correctly. Can you tell me where S&P will be one month from now?

            However we can ‘monitor’ the present state of the gold market using basis and contra-basis — thereby giving us clues on which direction the market is headed. Are the participants more bullish or bearish on gold? These questions can be answered. There will also be other major indicators that show the poor health of the economy, but gold basis is a significant and an early indicator of the financial health.

          • Austrian

            Sundar -
            “The fact that gold is in backwardation, is an alert signal in itself because the stock to flow ratio of gold is as high as 80:1. Backwardation of gold indicates that the holders of gold are unwilling to participate in making risk-free dollars as profit, by selling their gold at spot and replacing it with a lower cost future.”

            Sundar, I addressed all these points above. TO REPEAT: Only a small fraction of total financial wealth is managed in a legal/regulatory/fiduciary structure that allows for the trading of futures. On top of that, the “arbitrageurs” would not only need the ability to trade futures *but also* the present ownership of physical gold — which is an even *tinier* fraction of the financial market community.

            Moreover, you simply cannot assume that the very existence of an arbitrage opportunity necessitates that arbitrageurs will immediately close it. Anyone who’s been professionally involved in the financial markets for any length of time realizes that arbitrage opportunities regularly abound and can persist for a variety of reasons. (E.g. see: closed-end fund discount ‘paradox’; share-class arbitrage; etc., etc.) Also: trading is not costless for an institution. Besides transaction costs there are: risk-monitoring costs; reporting costs; and so on. The arbitrage spread has to be large enough to be profitable even *after* the extra hassle and costs involved.

            Also as I wrote above: backwardation can occur for a lot of other reasons. It can occur completely normally *and correctly* depending on the relationship between the dollar interest rate and the gold interest rate. In this scenario – *profitable arbitrage would CAUSE backwardation*. It can occur due to heavy forward selling by mining companies (which can more than swamp potential arbitrageurs). It can occur because of counter-party risk fears (as in 2008). That is not arbitrageable.

            “you are seeking an answer for the future state of gold which no one can answer correctly”

            Exactly my point. So how then can it be a “red alert” to financial Armageddon?

  • Keith, Not to simplify this, but is the point essentially just that they (US Treasury) will not buy back with paper dollars because there is no value perceived in “backwardian” markets?

    I don’t usually listen to all these e mails that are speaking of a “Financial Armageddon, but maybe I should have been. I am wondering what is going on with Fiat Money if this is a projection in the future. If I am asking for a repeat explanation, it’s only because it’s hard to focus if you aren’t an expert with all the words flying around here and I want to be advised and understand a new trend without being “taken in”

  • back to reality

    This article makes wild assumptions and conjecture that have nothing to do with reality. If gold was not sold for paper money it would not have a monetary value. Turning this on its head saying that paper money would then not have a gold value and so paper money would be worthless, or spiral into hyper inflation is laughable. The paper money supply is not dependent on people accepting money for gold.

    • Sundar

      back to reality -

      paper money supply is in the control of the Federal Reserve, which is engaged in injecting massive amount of liquidity (in the form of electronic dollars) into the system now. These just exist as credit presently (potentially increasing consumption/spending, thereby providing economic growth) but when they are extended to the people, it would drive the prices of everything that people need, higher.

      If QE continues to infinity, why would people accept worthless dollars in exchange for real goods? They need to turn to real money, which is gold. Has been for the entire existence of human civilization, will continue to do so in the future.

  • Chip Joyce

    I think it is lousy that “Austrian” is being accused of flaming Keith Weiner. He is making cogent and well reasoned points and, in my estimation, is very well versed in both Austrian economics and finance.

    If this site and its readers have any regard for the truth, the baseless accusations against “Austrian” for flaming should cease. Strong, well-reasoned challenges to articles should be encouraged if truth is valued. Otherwise, this site will end up being a place for vanity publishing for authors seeking flattery.

    • Keith Weiner

      Mr. Joyce: Well *I* think it’s lousy that someone tells me I shouldn’t blog, or if so I should not call myself an Austrian. I think it is particularly lousy to call Professor Antal Fekete a “crank”. “Austrian” has a right to think that, and I would fight to defend his right to think it and say it, but if you’re going to try to judge people here you shouldn’t overlook that in your haste to find him reasonable and reject the charge of flaming me. I am studying economics under Professor Fekete, and I have a right not to engage with people who (anonymously, no less!) take cheap shots at him.

      But I’ll bite. If you can go through his posts and extract what you think are the legitimate questions and points he raised, and post them in a simple list here (devoid of pejoratives, condescension, etc.) I will respond.

    • Austrian

      Incidentally, my charges are never gratuitous or spurious, but always with a solid intellectual point to them. “Money crank” is a common term in economics, used to refer to people who advocate long-ago discredited monetary theories – such as the Real Bills doctrine, which Fekete does advocate.

    • You should look at Austrian’s earlier postings. They were not in the spirit of this blog. Since then, I believe his comments have been better.