The current financial crisis may progress to a phase where people demand and hoard dollar bills but take electronic deposit credits only at a discount which increases until electronic deposit credits are repudiated entirely. The Federal Reserve would be powerless to solve the problem, because while they can create unlimited electronic deposit credits they can’t create unlimited paper dollar bills, “money you can fold” as Professor Antal Fekete calls it. There would be a glut of electronic deposits, but a shortage of dollar bills.
Before the financial crisis metastasized in 2008, Fekete wrote a paper that I think is underappreciated and under-discussed. “Can We Have Inflation and Deflation at the Same Time?” In his paper, he discussed the “tectonic rift” between paper Federal Reserve Notes (i.e. dollar bills) and electronic deposits. By statute the Federal Reserve cannot print dollar bills without collateral (e.g. Treasury bonds). Also, they have limited printing press capacity that is insufficient to keep up with a catastrophic crisis.
He discussed the inverted pyramid of John Exter. Gold is the triangle at the bottom, and then above is silver, dollar bills, and then the various kinds of electronic deposits, stocks, real estate, etc. In a crisis, people want to move from top to bottom of the pyramid, but of course there isn’t enough of the stuff at the bottom.
In a scenario in which desperate, panicky people are trying to cope with the enormity of a collapse that they don’t and can’t understand, I think this split between “physical” dollars and “electronic” dollars is very plausible.
Just as there is nothing to be accomplished by selling an underlying security as it becomes worthless, only to buy a derivative of it, selling Treasury bonds and buying dollars is equally nonsensical. The dollar is the Federal Reserve’s liability, backed by the Treasury bond as the asset. If you believe the Treasury bond is worthless, then you ascribe no value to the dollar either. This is why gold will go into permanent backwardation. Holders of dollars will provide an unlimited bid for gold that will not be reciprocated by holders of gold. The latter own the only safe asset, and the only monetary asset that is not ultimately backed by the Treasury bond or the dollar, and they will have no desire to give it up.
The concept of backwardation is simple. It is when people accept a future promise to deliver only at a discount to physical stuff handed over right now. This could be when there is a shortage, such as wheat before the harvest. Or in the case of gold, backwardation signifies a collapse in trust. But isn’t this the same phenomenon of a tectonic rift between paper dollars and electronic deposits?
In a certain sense, the “money you can fold” behaves like a physical commodity, a present good (I realize I am stretching the concept here more than a bit). The electronic deposit credit is most definitely a future promise. In my gold backwardation thesis, the action begins with the offer on the futures contract falling below the bid on spot gold. The bid-ask spread on spot gold widens, as the offer is relentlessly advancing, pulling the bid behind it. The bid-ask spread on the futures contract also widens, as the offer remains stubbornly high, but the bid withdraws and retreats as gold buyers don’t trust futures and buy physical gold instead. Eventually, there are no more sellers of physical gold and that is that (except for the dollar-commodities-gold arbitrage, a backdoor way for dollar holders to get a little gold before the end of the game).
If this split occurs in the dollar, I think it will play out the same way. At first, sellers of real goods may accept electronic credit money, but demand a higher price. The spread on the electronic dollar widens, with the bid from real goods falling. At the same time, virtually unlimited demand for the “real” paper you can fold causes the bid on the paper dollar to rise.
Who knows how long it could last? People could go on accepting paper dollars out of long habit. Obviously, this is an unstable situation that must necessarily collapse. Unlike gold, the paper dollar has no value other than the broken promises that back it.
I dub this “dollar backwardation”.
Keith Weiner is the founder DiamondWare, a VoIP software company, and is a PhD student at Antal Fekete’s New Austrian School of Economics in Munich. He is now a trader and market analyst in precious metals and commodities. He is also president of the Gold Standard Institute USA.
© 2012 by Keith Weiner
Keith,
Very interesting piece.
Here are some more thoughts to ponder, along the lines of what you have said:
Price and value are entirely different things. For gold, which has the highest stock-to-flow ratio, price is determined by flow at the margin whereas value is determined by the existing stock. The value of gold does not have any objective metric, so I think the existing stock holders of gold value it more than those who don’t hold it yet. Therefore, the explosion in price of gold will potentially come from the existing stock holders unwilling to sell gold, more than new savers stampeding into gold. (stocks to flow ratio tending to infinity).
If and when the dollar backwardation happens as you suggest, there is going to be a rush of dollars from future-dated debt to here and now T-bills and more preferably physical cash as well. What is this going to cause for the price of gold in dollars? That’s right, it is actually going to fall. There will be tremendous volatility in the price of gold in dollars because of the rush to physical cash. Traders and weak hands could dump all gold (paper/physical).
When the owners of physical gold stop bidding for dollars, that is when gold price in dollars will explode to unimaginable levels. If gold stops bidding for dollars (low gold velocity), the price (in gold) of a dollar falls to zero.
Jesse: Thanks for your comments and questions.
The price of everything is set at the margin. Those who own a good but do not offer it value it more highly (typically a lot more highly) than the current market price. Those who don’t own it and do not make a bid value it at a lower level. What gold’s uniquely high stocks to flows means is that there are vast amounts of gold not at the margin compared to the gold which is at the margin. A high stocks to flows also means a high stocks to margin (if that ratio makes any sense). All of that gold *could* be offered, but for whatever reason isn’t. All of the stocks are potential “supply” (a term I don’t prefer).
Incidentally, two of my next lectures at the next course of the New Austrian School are “Can value be measured?” and “Is constant marginal utility of gold contradictory?” We shall have to wait to see what I say. :)
I agree 100% when you say that the gold price in dollar terms will be driven by the withdrawing gold bid on the dollar, rather than by the dollar’s aggressive bid on gold. In crisis, it is always the bid that is withdrawn. When the dollar crisis comes, gold will withdraw its bid.
I would not be so confident that the price of gold will fall in the liquidity crunch of the dollar crisis. It could. I am confident that volatility will be rising, perhaps exponentially. I agree gold will move from the hands of traders to the hands of hoarders.
You make some good points! :)
Keith,
/* The price of everything is set at the margin.*/
Agreed, but my main point was to note the difference between gold and other things such as stock or real estate. For example, there are objective metrics like cash flow statements, operating margin etc. for a stock like MSFT which can determine the value of the stock. Overvaluation happens when too much dollars bid for MSFT and the shares dry up.
The difference between MSFT and gold is that dollars bid for MSFT, but gold bids for dollars. Gold is the sun in the monetary cosmos, so to speak.
/* I would not be so confident that the price of gold will fall in the liquidity crunch of the dollar crisis. */
What happened in 2008?
Gold went down less than other things, and went on to new highs fairly quickly. Then, subsequently, central banks stepped up their purchases and a much larger number of people certainly in the US learned about gold and made the connection to “currency risk.”
While I would not be surprised to see gold fall, I would not be surprised to see it hold steady, nor surprised to see it jump higher.
Is it correct to assume that physical circulating coinage falls into the same category as the physical “money you can fold”? From my understanding, Federal Reserve Notes are obligations of the Federal Reserve, and physical US coins are obligations of the US Treasury. Does this matter?
Terry: Yes, I think coins will fall into the same category. No, I don’t think the fact that coins are minted by Treasury will matter. Both paper and coins are a “present good” (I wince again saying that as I winced when I wrote it in this article). But they are both a tangible thing you can hold, unlike an electronic credit.
Dollar bills are not dollars, and since 1933, have no par value (worthless). They are legal tender on obligated parties, such as the Federal government, (see Title 12 USC sec. 411) -and- “contributors” who are signed up with FICA/Socialist Insecurity.
Hoarding dollar bills is ludicrous and tragic. They are IOUs emitted from a Congress that repudiated ever redeeming them (see: House Joint Resolution 192, in June 1933).
And seeking a solution with gold is equally flawed. Based on the 5.3 billion ounces (2007 est.) versus 7 billion people, there’s less than one ounce per capita – far too little to function as a medium of exchange to facilitate trade of surplus usable goods and services.
And then there is the usury, an abomination, denounced for “only” 3500 years. How else did America rack up a 15 trillion DOLLAR debt that can never be paid? (The debt computes to 750 billion ounces of gold, stamped into coin.) At current mining rates, it would only take 87,000 years to mine enough gold – if the debt and interest were frozen right now.
Yup, we’re [expletive deleted] !