"Ah, but a man's reach should exceed his grasp, or what's a heaven for?" Robert Browning, Andrea del Sarto, 1855
Gold and Interest Rates. The gold standard may be, as Lord Keynes suggested, a "barbarous relic," but gold itself remains permanent natural money. The notion that gold does not earn a return is a canard. Neither does cash in your wallet or hidden under your mattress. Like currencies, gold can be loaned or placed on deposit to earn interest. Gold lease rates are interest rates. Gold prices are exchanges rates.
Gold is produced for accumulation, not consumption. The above-ground supply of readily available gold is many multiples of annual new production. Accordingly, its inherent supply and demand characteristics are more like those of currencies than of commodities produced for consumption, where short-term shortages can cause large increases in current prices.
Futures prices for currencies and the monetary metals -- gold and to a lesser extent silver -- are a function of their spot prices and their relative interest rates. In this respect, the monetary metals differ fundamentally from other commodities, where futures prices are principally a function of future expectations about supply and demand. Everyday, in spot and forward markets around the world, gold is arbitraged against the major currencies based on relative interest rates. See The Golden Sextant (1991).
Arbitrage places currencies with lower interest rates in contango against those with higher rates, meaning that one unit of the lower interest rate currency will buy more units of the higher interest rate currency for future delivery than at spot. Gold is in contango against all currencies because it carries the lowest interest rates. In dollar-denominated markets, the contango or forward rate on gold -- "GOFO" in the lingo of the London Bullion Market Association -- generally equates to US$ LIBOR minus the lease rate.
This figure must stay positive if gold prices for future delivery are to remain higher than spot. Although in few recent instances the LBMA's derived lease rates have actually turned marginally negative at the shortest maturities, GOFO has remained well into positive territory and would have done so without the help of negative lease rates.
Since November 2006, the LBMA has also provided corresponding statistics for silver. On a number of occasions in recent months, forward rates on silver (SIFO) at the shorter maturities have turned negative, putting silver into modest backwardation at these maturities and tending to confirm anecdotal reports of delays and shortages in effecting physical delivery.
Nick Laird, the proprietor of www.sharelynx.net, has graciously provided some charts depicting gold lease rates, including derived one-year lease rates as calculated by the LBMA from the GOFO rates quoted by its Market Making Members, i.e., the rates at which they will lend gold on a swap against US dollars for 1-, 2-, 3-, 6- and 12-month periods.
As these charts illustrate: (1) sharply falling dollar interest rates appear to have forced down gold lease rates in the 2001-2004 period; and (2) since 2004 and notwithstanding a period of higher dollar interest rates lasting into 2007, gold lease rates have remained at very low levels and far below their historic norms of 1% to 2%.
Gold relates to interest rates in another important respect. Under the classical gold standard, the yield on British consols (government securities issued at a fixed rate of interest but with no redemption date) moved in close correlation with wholesale prices but almost no correlation to the inflation rate. According to Lord Keynes, this phenomenon -- Gibson's paradox -- was "one of the most completely established empirical facts in the whole field of quantitative economics." J.M. Keynes, A Treatise on Money (Macmillan, 1930), vol. 2, p.198. It was a paradox because contemporary monetary theory, largely associated with Irving Fisher, suggested that interest rates should move with the rate of change in prices, i.e., the inflation rate or expected inflation rate, rather than the price level itself.
Gibson's paradox deals with the relative purchasing power of gold. Under the gold standard, higher prices meant that an ounce of gold purchased fewer goods. That is, the relative price of gold fell, moving inversely to higher long-term rates. Modern economic research suggests that Gibson's paradox will operate in a truly free gold market just as it did under the gold standard. That is, gold prices will move inversely to real long-term rates, falling when rates rise and rising when they fall. See Gibson's Paradox Revisited: Professor Summers Analyzes Gold Prices (8/13/2001); Gold Derivatives: Da Goldman Code (6/21/2006); and Gibson's Paradox and Rising Rates (7/20/2007).
To illustrate this principle, Nick has kindly updated some charts that he provided for prior commentaries. The charts track real interest rates against gold prices, inverting the latter so that assuming operation of the paradox, both measures move in roughly the same direction. Real rates are represented by the 30-year T-bond yield less the government's consumer price index. In the second chart, gold prices are adjusted by the CPI.
Gold and Central Banks. Official institutions, principally central banks, claim to hold in excess of 30,000 metric tonnes of gold, or about one-fifth of all the gold that has ever been mined. They are the principal lenders of gold, ostensibly to earn a modest return on their otherwise "sterile" reserves. Most of these loans are made to large bullion banks, which then sell the borrowed gold into the market in connection with activities designed to profit on the spread between low lease rates and the higher interest rates available on other financial assets.
At the same time, prudence dictates that the bullion banks hedge against the risk of higher bullion prices when they must repay/return the borrowed gold to the central banks. From this perspective, facilitating forward sales by gold producers, making gold loans to finance new gold mines, and financing gold inventories of jewelry manufacturers represent the least risky and most attractive lines of business for bullion banks.
Probably the best measure of the full extent of their activities, however, are the figures on over-the-counter gold derivatives reported semi-annually by the Bank for International Settlements. See, e.g., Gold Derivatives: Options Galore (11/30/2007), and prior commentaries cited. The following chart, which includes the most recent data from the BIS, shows total OTC gold derivatives converted to metric tonnes at period-end gold prices since December 2000. As of June 30, 2007, total forwards and swaps, which peaked at around 12,000 tonnes in 2002, were a little under 7000 tonnes, most of the decline reflecting the near elimination of forward sales by gold producers.
Reading between the Chart Lines. Taken together, these charts help to elucidate the current monetary situation, including how we got here and where we are likely headed.
As to the past, note that gold forwards and swaps peaked and began to decline at right around the same time -- end of 2002 -- that Gibson's Paradox began to reassert itself after half a decade of anomalous behavior. Coincidental? Hardly, as anyone who has followed GATA's work, including the Gold Price Fixing Case (2000-2002) that it supported, will know.
Turning to the current situation, gold lease rates remain at abnormally low levels. Falling short-term interest rates in 2002-2003 forced lease rates far below their historic ranges. What is perhaps even more significant, lease rates failed to return to normal levels despite rising interest rates from 2004 to 2007. Why would central banks loan gold at such derisory levels, and why would bullion banks borrow it in the face of strongly rising prices? The most logical answer is that central banks are rolling over prior gold loans to large bullion banks at subsidized rates, thereby avoiding both the recognition of any losses on these loans and a run on gold by bullion banks faced with demands for repayment.
As to the future, Gibson's Paradox suggests either further strength in nominal gold prices or a substantial hike long-term real interest rates. At the shorter maturities, a more intriguing question is presented: Could gold go into backwardation? What happens if the central banks stop lending gold at less than normal lease rates but the U.S. Federal Reserve moves U.S. short-term rates to near zero? My guess is that U.S. dollar futures prices on gold would not go into backwardation. Rather, gold futures would likely be quoted in a different currency with a more normal interest rate structure -- one that does not command the belief that paper is better than gold.
Gold and the Supremes. Today we hear that the Fed is in uncharted waters. From a constitutional perspective, it has been in uncharted waters since President Nixon closed the gold window in August 1971. Unlike the other transformative events in the nation's monetary system, this action is has never undergone review the Supreme Court.
Indeed, the Supreme Court has declined or dodged every opportunity presented to it to address the constitutionality of the post-1971 monetary system, including not only the absence of any link to gold or silver but also the role of the Fed in a wholly fiat system. See, e.g., Walter W. Fischer v. City of Dover, N.H., et al., Petition for Certiorari, Supreme Court of the United States, No. 91-221 (1991).
With the phrase "Not worth a Continental" still echoing across the land, the monetary provisions of the Constitution were adopted to assure the nation sound money based on gold and silver. Prior to the Civil War, Daniel Webster described the nation's monetary system (Speech on the Specie Circular, U.S. Senate, Dec. 21, 1836):
Currency, in a large and perhaps just sense, includes not only gold and silver and bank bills, but bills of exchange also. It may include all that adjusts and exchanges and settles balances in the operations of trade and business; but if we understand by currency the legal money of the country, and that which constitutes a legal tender for debts, and is the standard measure of value, then undoubtedly nothing is included but gold and silver. Most unquestionably there is no legal tender, and there can be no legal tender in this country, under the authority of this government or any other, but gold and silver, either the coinage of our own mints or foreign coins at rates regulated by Congress. This is a constitutional principle, perfectly plain and of the highest importance. The States are expressly prohibited from making anything but gold and silver a legal tender in payment of debts, and although no such express prohibition is applied to Congress, yet, as Congress has no power granted to it in this respect but to coin money and to regulate the value of foreign coins, it clearly has no power to substitute paper or anything else for coin as a legal tender in payment of debts and in discharge of contracts. Congress has exercised this power fully in both its branches; it has coined money, and still coins it; it has regulated the value of foreign coins, and still regulates their value. The legal tender, therefore, the constitutional standard of value, is established and cannot be overthrown. To overthrow it would shake the whole system.
The Civil War "Greenbacks" represented the federal government's first attempt to make paper money a legal tender. Originally struck down by the Supreme Court in 1869, a year later following changes in the composition of the Court, their issuance at least as a war measure was upheld. Then, in a much criticized 1884 decision, the Court held that the government could make paper a legal tender in peacetime as well as war. However, that decision had little contemporary effect since the nation was already well on track to return to the gold standard. For citations, see id. or Money in Court: Paving the Road to Ruin (5/23/2002).
Congress created the Federal Reserve in 1913 to strengthen the nation's banking system. The Fed's miscues during the Great War and the Roaring Twenties contributed to the Great Depression, leading Congress to enact substantial changes in the Federal Reserve Act and to centralize power in the Federal Reserve Board in Washington. For a more detailed discussion of the modern Fed at least prior to the events of this year, see Fiat's Reprieve: Saving the System, 1979-1987 (RKL) (8/21/ 2004).
The New Deal also brought nationalization of gold, interdiction of gold clauses in private contracts and government bonds, and devaluation of the dollar from $20.67/ounce to $35/ounce. By 5-to-4 majority, the Supreme Court upheld the measures effectively invalidating gold clauses, but did not directly address gold confiscation. That 1934 decision represents the Court's latest word on the monetary provisions of the Constitution. As to the constitutionality of closing the gold window and delinking the dollar from gold or silver, the opinions of the nation's highest court contain no more instruction than the songs of The Supremes.
The Supreme Court is understandably loathe to place itself at the center of a debate on a subject of as immense consequence as the underlying shape of the nation's monetary system, particularly when not a scintilla of support for the existing system can be found in the Constitution. But that system is now in crisis and in need of reform. See The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure (March 2008). It has "failed the test of the marketplace" says former Fed chairman Paul Volcker, adding: "The implications of the [Fed's recent] decisions, and the lessons from the unfolding crisis itself, surely deserve full debate and legislative review in the period ahead.'' See J. Brinsley et al., Volcker Says Fed's Bear Loan Stretches Legal Power (Update4) (Bloomberg, April 8, 2008).
Good Cop; Bad Cop. That debate should start with the Fed's place under the Constitution. Here the editors of The Golden Sextant are not of one mind. Bob Landis regards the Fed as a constitutional abomination that should be killed outright. Yours truly thinks this might be case for application of Voltaire's maxim: "The perfect is the enemy of the good" (< Le mieux est lennemi du bien >).
As a practical matter, if we are stuck with the Fed, maybe we should give it and its unlimited fiat currency a proper constitutional basis, but only as part of a larger constitutional bargain. The Fed's constitutional respectability should come with a quid pro quo -- one that is fully consistent with the language and intent of the Framers: recognize and protect the people's right to use sound money of gold or silver. See Gold Is Money. Pass It On. (RKL) (5/31/2006). As the Austrian economist Ludwig von Mises wrote (The Theory of Money and Credit (Liberty Classics, 1980), p. 454):
It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights.
Accordingly, to reconcile these competing constitutional interests, I propose a package of three constitutional amendments:
(1) Amend Article I, Section 8 ("The Congress shall have Power...") by adding: "To establish a National Bank with exclusive Authority to emit Bills or Notes on the Credit of the United States; To make Bills or Notes issued by the National Bank a Tender for Debts of the United States."
(2) Amend Article I, Section 10 ("No State shall...make any Thing but gold and silver Coin a Tender in Payment of Debts") by adding: ", but a State may make Bills and Notes issued by the National Bank a Tender for Public Debts."
(3) Amend the the Fifth Amendment by adding: "; nor shall Congress or any State make any law abridging, taxing, or otherwise restricting the right of the people to use gold or silver Money as a Tender for Private Debts."
Under these provisions, which are reproduced in fuller context in the table below, Congress could reform the Federal Reserve as it wishes, but the Fed would no longer have a monopoly over the national currency. The federal government and the states could mandate use of the Fed's scrip for all public debts and transactions, but that currency would face real and effective competition from sound money in all private transactions. Indeed, that competition would be far more likely than any reforms Congress might enact to improve the Fed's actual performance.
Gold and UFOs. Admittedly, the odds of my proposed amendments being debated in Congress, let alone enacted, are remote. Chris Powell, GATA's indefatigable treasurer, likes to say that what GATA has unearthed about the gold market is akin to discovering the secret knowledge of the universe. The metaphor is apt, maybe more so than Chris intended. Congress has been about as receptive to hearings on gold as on UFOs. Fox News, Pilots Urge Government to Investigate UFOs (Nov. 14, 2007); Reuters, Former pilots and officials call for new U.S. UFO probe (Nov. 12. 2007).
But the current presidential campaign is challenging much what formerly passed for political wisdom. Ron Paul, the gold bugs' favorite candidate, did astonishingly well in the Republican primaries. On the Democratic side, the debates produced an almost other worldly instance of political candor. In response to a "serious question" by Tim Russert, Dennis Kucinich confirmed what Shirley MacLaine reported in her recent book: He did see a UFO.
Almost as quixotic at the outset was the campaign of the currently leading Democrat, who promises fundamental change in the way Washington does business. The promise has obvious allure against the background of an unpopular and ill-advised war and a banking and credit crisis more severe than any since the Great Depression. Predictably, with respect to the latter, Washington's business as usual solution to is to give still more power and responsibility to the Fed notwithstanding that it bears heavy responsibility for creating the very conditions that led to the crisis.
The two remaining Democratic candidates -- both very able lawyers -- aspire to take the presidential oath of office next January: "I do solemnly swear (or affirm) that I will faithfully execute the Office of President of the United States, and will to the best of my Ability, preserve, protect and defend the Constitution of the United States." Shouldn't we ask them whether the Fed is operating within the Constitution, and if not, what he or she as president would do to rectify the situation?
Proposed Amendments in Bold
Section 8. The Congress shall have Power:
To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States;
To establish a National Bank with exclusive Authority to emit Bills or Notes on the Credit of the United States;
To make Bills or Notes issued by the National Bank a Tender for Debts of the United States;
To borrow Money on the credit of the United States;
To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes;
To establish an uniform Rule of Naturalization, and uniform Laws on the subject of Bankruptcies throughout the United States;
To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;
* * * * * *
Section 10. No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts, but a State may make Bills and Notes issued by the National Bank a Tender for Public Debts; no State shall pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.
Bill of Rights, Amendment V. No person shall be held to answer for a capital, or otherwise infamous crime, unless on a presentment or indictment of a Grand Jury, except in cases arising in the land or naval forces, or in the Militia, when in actual service in time of War or public danger; nor shall any person be subject for the same offence to be twice put in jeopardy of life or limb, nor shall be compelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use without just compensation; nor shall Congress or any State make any law abridging, taxing, or otherwise restricting the right of the people to use gold or silver Money as a Tender for Private Debts.