References
Robert B. Barsky and Lawrence H. Summers, Gibson’s Paradox and the Gold Standard, The Journal of Political Economy, vol.96, no. 3(June 1988) p 528-50.
A. E. Fekete, Gold and Interest, Monetary Economics 102, The Gold Standard University, , January 1, 2003
A. E. Fekete, Gold Fever Trumps Gold-Hedge Fever,
, January 13, 2003
A. E. Fekete, The Bubble That Broke the World,
, June 30, 2003
A. E. Fekete, The Last Contango in Washington,
, June 3, 2006
A. E. Fekete, When Atlas Shrugged..., Part One, ,
August 24, 2006
Milton Friedman and Anna J. Schwartz, From Gibson to Fisher, Explorations Econ. Res. 3 (Spring, 1976) p 288-91.
Copyright © 2006 by A. E. Fekete
Part Two: Gibson’s Paradox and the gold price
Antal E. Fekete
Professor, Intermountain Institute for Science and Applied Mathematics
E-mail: aefekete@hotmail.com
My approach is different from that of other monetary scientists in that I take speculation into full account. The theory of speculation is conspicuous only by its absence from mainstream economics. (Keynes’ attempt to create one was a dismal failure.) But it is not a strong side of Austrian economics either. I reach back to Carl Menger and construct a theory of interest directly on his economic principles.
Faux pas of Mises
My theory of interest is centered around the constant marginal utility of gold. It is this property that makes gold ‘most hoardable’. That there is a limit to gold hoarding is due solely to the institution of interest. The opportunity cost of hoarding gold is just the lost interest. This is a distinctive property of gold. The hoarding of all other goods is limited by declining marginal utility. Mises missed this fundamental connection between gold and interest. (This is not to mention David Ricardo. If Mises missed by inches, Ricardo’s ‘bullion plan’, adopted by Britain in 1925 and the by U.S. in 1934, missed by miles.) All this is fully worked out in my Gold Standard University lecture series, which has been in the public domain for many a year.
It follows that the rate of interest is just the rate of marginal time preference*. In practical terms this means that the agent to regulate the rate of interest is the marginal bondholder**. He is doing arbitrage between the gold market and the bond market. As the rate of interest falls below the rate of marginal time preference, he takes profits in selling his overpriced gold bond and puts the proceeds into gold. This action makes the rate of interest turn around. As it rises above the rate of marginal time preference, the marginal bondholder will buy back his gold bond at a lower price.
It is interesting to note that Mises explicitly referred to this particular arbitrage (although without using that word) so he was actually pretty close to discovering the force driving the rate of interest. Yet he went astray because, for him, paper currency was a present good no less than the gold coin -- a faux pas.
Should the marginal bondholder accept paper currency in exchange for his gold bond, he would take zero in exchange for a positive income. Thus his protest against low interest rates would be counter-productive. In effect, he would jump from the frying pan into the fire.
This irrefutably shows that the action of the marginal bondholder aims at hoarding gold, and not currency in general. Under contemporary conditions the meaning of the term ‘time preference’ is not the preference for an apple available today as against two apples available ten years from now. It is, rather, the preference for holding the gold coin, a present good, as against holding the gold bond, a future good -- unless the rate of interest is sufficiently high to compensate for the unequal exchange.
Gibson’s Paradox
Imagine my surprise when I learned that mainstream economists have also discovered gold as the only instrument to give teeth to time preference that would otherwise remain but a pious wish. See in particular the joint paper of Barsky and Summers. The correlation between the rate of interest and the price level under a gold standard was named ‘Gibson’s Paradox’. Paradox, because monetary theory according to Keynes would call for a correlation between the rate of interest and the rate of change (rather than the level) of prices. Gibson’s, because Keynes named Gibson as the first author to make this observation. Keynes stated in 1930 that two centuries of data failed to confirm that a correlation existed between the rate of interest and the rate of inflation. Instead, between 1730 and 1930, the rate of interest and the price level showed a positive correlation which Keynes described as “one of the most completely established empirical facts in the whole field of quantitative economics”. No one has been able to come up with a full theoretical explanation. Friedman and Schwartz in 1976 concluded that “the Gibsonian Paradox remains an empirical phenomenon without a theoretical explanation”. It was not for want of trying, either. Irving Fisher wrote in 1930 that “no problem in economics has been more hotly debated”. Barsky and Summers also state that “Gibson’s Paradox has proven to be an especially stubborn puzzle in monetary economics”.
Yet to find the key to the ‘paradox’ we have only to observe that suppression of the rate of interest will intensify gold hoarding which, under a gold standard, shows up in a falling tendency of the price level. Conversely, we observe that when the rate of interest rises, the marginal bondholder will, in buying the gold bond, release hoarded gold. The increase in the quantity of monetary gold shows up as a rising tendency in the price level. The ‘Gordian knot’ finds its ‘snap solution’ in Menger’s concept of marginal utility.
The regime of the irredeemable dollar
The validity of Gibson’s Paradox clearly extends to the regime of the irredeemable dollar, under which the gold price is variable. It varies directly with the price level. In particular, as the irredeemable dollar loses purchasing power, the price of gold will rise for the stronger reason. In terms of Gibson’s Paradox, the price level rises less if the rate of interest is suppressed; otherwise it rises more.
Properly interpreted, there has never been an episode in history when Gibson’s paradox failed to operate. It is the empirical description of the apodictic truth that an increase in gold hoarding and a fall in the rate of interest are linked (subject to leads and lags), and conversely. Every ounce of hoarded gold is a concrete testimony to the fact that the quality of savings instruments, and the yield on them, are inadequate. By making the regime of irredeemable dollar ‘untouchable’, the U.S. government deprives itself of the possibility to channel people’s savings into ‘socially more useful’ applications. To this extent it is the government, rather than the people, who is responsible for the present negative savings rate in the United States.
Government manipulation
In Part 1 I advanced the hypothesis that the U.S. Treasury and the Federal Reserve have been manipulating both the rate of interest and the price of gold. In more details, they encourage bull speculation in bonds and bear speculation in gold. They do it by making unlimited quantities of bonds available for the speculators to buy, and unlimited quantities of gold available for them to sell through the derivatives markets. Lures, in the form of risk-free profits, are planted along the path of the speculators.
Clandestine government policy
to manipulate the bond and gold markets is revealed by
The Twin Towers of Babel
In Part 1 I explained why the government was interested in manipulating speculators so that they compulsively construct such uneconomic Twin Towers of Babel. The purpose of Part 2 is to show that, in view of Gibson’s Paradox, there is a conflict and, for this reason, the Twin Towers will self-destruct in due course.
The regime of the irredeemable dollar is subject to the ‘sudden death syndrome’, a malady afflicting all fiat currencies with a 100 percent fatality rate. Creditors know this and add a risk-premium to the rate of interest they charge on their loans. If it weren’t for bond derivatives, the dollar would have gone the way of the assignats and mandats already in the twentieth century. But the government plants lures to induce speculators to buy bonds. This keeps interest rates low, and props up the dollar.
However, in terms of Gibson’s Paradox, the suppression of the rate of interest means increased gold hoarding. To counter that threat, the government has to have recourse to a devious scheme to induce speculators to sell unlimited amounts of gold through the gold derivatives market. In Part 1 I described an imaginary mining concern, Sarrick Gold, with a phony hedge plan involving forward selling, to the exclusion of forward buying, of gold. Speculators are offered risk-free profits on the short side of the market. All they have to do is to pre-empt Sarrick’s forward selling strategy, that is, sell before Sarrick does.
Thus the Twin Towers of Babel, the long-bond pyramid and the short-gold pyramid, are interdependent. Neither one will prosper without the other prospering. Conversely, if one topples, so will also the other. It follows from standard theory of speculation that, in commodities, a short position constitutes unlimited risks, as opposed to a long position the risk of which is limited as the price cannot fall below zero. This suggests that the inordinate and fast-increasing short interest in gold is more vulnerable and will act as a trigger. Delivery may encounter difficulties, backwardation may develop in gold futures, and the weakest link in the short chain may snap. Some shorts may default. That would cause other short positions cascade and defaults spread. The collapsing gold basis will accurately gage the development leading to the toppling of the short gold pyramid. In an earlier paper entitled: The Last Contango in Washington I conjectured that the collapsing silver basis may act as an ‘early warning system’ to herald the coming collapse of the gold basis.
Insatiable Appetite
The purpose of this paper is to establish another ‘early warning sign’: Barrick’s share price, showing a profound shareholder disillusionment. It significant that Barrick has insatiable appetite for further acquisitions. One might have expected that, having become No. 1 in the world, Barrick would want to catch its breath and rest on its laurels. Not so. Barrick is still looking for other gold producers to gobble up.
This looks like a sign of desperation. As long as you are No. 2, appetite for acquisitions is understandable. You try harder. But when you are No. 1, it no longer makes sense. However, Barrick is in the limelight. The share price as compared with assets is lamentably low. It would be more fitting for the last than the first in the business. The reason is the curse of the hedge book. It just won’t go away. Barrick will neither repudiate nor repair its faulty policy of forward selling of gold, in spite of dire warnings that it may eventually be the cause of its downfall. The hedge book is deep under water. It shows only forward sales, no compensating forward purchases.
Barrick has been challenged to mark its hedge book to market. The challenge was ignored. For all we know, there may be a good reason for that. Perhaps the rumors are true and, when liabilities are marked to market, all the assets of Barrick are wiped out. Barrick would be seen to be bankrupt. Could this be the very reason why Barrick is so desperate to acquire other gold mining assets? If it could buy badly needed time before share value declined more relative to assets, the worst could be averted.
Barrick loves to pay for its acquisitions with its own shares. From the point of view of the shareholders, this policy is disastrous. Not only does it mean further dilution of their share, but so low is the value of shares relative to assets that Barrick’s shareholders see in it another attempt by the management to fleece them. On the other hand, shareholders of the company targeted for hostile takeover are increasingly reluctant to accept Barrick’s ‘stained’ shares in exchange for their ‘clean’ (read: not stained with forward sales) shares.
One wonders why targeted companies could not force Barrick to mark to market its existing commitments to sell gold forward. After all, the seller has the right to ask whether the check offered in payment by the buyer is backed as represented. Maybe they did try, whereupon Barrick decided to come up with the cash rather than make the revelation.
Atlas Shrugged
One can only guess that the urgency with which Barrick acquired Placer Dome is explained by the 2006 surge in the gold price. We may take it for granted that Barrick anticipated the surge but could not close out the deal in time before it happened. At any rate, the two events are connected and their concurrence has materially changed the course of history. First, the utter futility of the short gold pyramid has convincingly been demonstrated. Speculators no longer take the bait: they no longer mindlessly short gold on the first sign of strength. Second, Barrick has changed its strategy from forward selling to unlimited acquisitions. This is symptomatic of the problems Barrick is going to face in the future. The new battle cry is: “Acquire or die!” However, in doing so Barrick will be racing against a buoyant gold price.
This is the unpredictable part. Can Barrick acquire gold properties fast enough to win the race against a rising gold price no longer fettered by forward sales? If it can, this may be a set-back for the gold price. Atlas may be able to carry the $300 trillion derivatives market on its shoulder awhile longer.
But if it could not, and Atlas shrugged, then the short gold bubble would burst triggering the bursting of the $300 trillion derivatives bubble. We could then expect to see the ruination of the credit of the United States and the close of the dollar system.
Endnotes
* In Human Action Mises treats time preference as if it were the same for everybody, paupers and nabobs alike. As I have found this too crude, I refined it by introducing the concept of the rate of marginal time preference, that is, the rate of the time preference of the marginal saver. He is the first to add to his bond holdings on the next upwards move of the rate of interest.
** Strictly speaking, there are two agents: the marginal bondholder regulating the floor, and the marginal entrepreneur regulating the ceiling of the range to which the rate of interest is confined. The ceiling is the rate of marginal productivity of capital as it is regulated by the marginal entrepreneur in doing arbitrage between the bond market and the capital goods market. As the rate of interest rises above the rate of marginal productivity of capital, he sells his capital goods and invests the proceeds in the bond market. This action will make the rate of interest turn around. As it falls below the rate of marginal productivity of capital, the marginal entrepreneur takes profits and sells his overpriced bonds. With the proceeds he re-equips his productive enterprise and starts production once more. For full details, see my Gold Standard University lecture series.
In this paper I have, for the sake of simplicity, assumed that the rate of interest is the same as the rate of marginal time preference, and the agent to regulate it is the marginal bondholder.
References
Robert B. Barsky and Lawrence H. Summers, Gibson’s Paradox and the Gold Standard, The Journal of Political Economy, vol.96, no. 3(June 1988) p 528-50.
Antal E. Fekete, The Gold Standard University, Monetary Economics 102:
Gold and Interest, , January 1, 2003
Antal E. Fekete, The Last Contango in Washington, June 3, 2006
Milton Friedman and Anna J. Schwartz, From Gibson to Fisher, Explorations Econ. Res. 3 (Spring, 1976) p 288-91.
DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS ARTICLE IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE TAKEN AS THE AUTHOR’S OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT, IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
September 1, 2006