Strange rumblings in Dollarstan

I disappear into the garage for a while, and what happens? Wall Street types rm -rf *, Europe melts down, and Harvard kicks off the midget race war.

And now, we hear, JP Morgan is being investigated for evil deeds in the precious-metals markets—more or less confirming, or at least rendering plausible, the longstanding charges of GATA, Ted Butler, etc. Frankly, this doesn’t surprise me. But the converse would not have surprised me, either. These markets are extremely opaque.

When I first hypothesized the spontaneous remonetization of gold, way back in 2006, I remember clearly how wacky an idea it was. While not exactly conventional, these days it is not at all hard to find, not even in the official press. (I have no joke—I just like saying “the safest of all investments, gold.” I have been telling my mother this for quite some time, but I am still surprised to see it in the Times.) And the basic idea of remonetization was not at all unusual in those days, at least in the goldbug media. Completely unfiltered, this stream contains all good ideas about gold, and all bad ones too.

Remonetization is pretty simple: you have two neighboring countries, Goldenstein and Dollarstan. If Dollarstan systematically dilutes its currency, its savers will move their savings to Goldenstein, whose currency will therefore deflate. If Dollarstan is relatively large relative to Goldenstein, Goldenstein’s currency will deflate relatively a lot.

There is no Goldenstein today, but that doesn’t mean people can’t use gold as money—i.e., buy it now for the purpose of selling it later. (If there was a Goldenstein, and capital flight to gold meant capital flight to Goldenstein, all Goldenstein’s industries would disappear and its citizens would just be rich for a living, like Kuwaitis. But fortunately, there is no Goldenstein.)

So people move their savings to Goldenstein because gold is going up. And gold goes up because people are moving their savings to Goldenstein. At the end of this cycle, gold is the standard medium of saving and dollars are a kind of soft, hot-potato currency—a North American Peso.

But while this effect—perhaps best simply described as capital flight to gold, or CFG—now appears to be occurring to some extent, it is occurring much less than my evil theory would predict! And it has not yet devoured the entire financial universe. Although that’s certainly one of the things that could happen on Monday. But all this talk of gotterdammerungs does leave one a bit blase—does it not, Maurice?

The problem with my evil theory, as of 2006, is that it predicted that either (a) the dollarsphere had already exploded, or (b) would explode, spontaneously, as soon as the theory was properly stated. (a) was inherently false; (b) did not happen.

Therefore, there was some unknown variable in my evil equations. Ha ha! I would have to try again. Egg again, on Dr. Lizardo’s face. But surely, any day now, the universe will end! (And it will come, to Dr. Lizardo it will come, and ask him to rule. Laugh while you can, monkey-boy.)

In fact it turns out that whatever JPM was alleged to be doing, it has a considerable resemblance to one good candidate for the missing variable. That is: the gold price is (or was) being managed by the production of artificial gold.

Since the price of all goods is set by supply and demand, the price of any good can be managed down by the creation of arbitrary supply. Who would buy artificial gold? Simple—someone who wanted to make a dollar when the price of gold went up a dollar. Who would sell it? Simple—anyone willing to lose a dollar when the price of gold went up a dollar.

In other words: to a gold investor, i.e., someone betting on the gold market, artificial gold is just as good as regular gold. Actually, this is not quite true. But at a crude level, it is true. And to all conventional financial analyses, it is true. Thus, you can expect there to be a fair amount of artificial gold (“paper gold”) around.

Even (perhaps especially) among the goldbugs, there is a considerable confusion between two kinds of artificial gold. Let’s call them virtual gold and synthetic gold. Moreover, the (now highly suspect) London gold market itself does not distinguish between these types of claim, considering both unallocated.

Virtual gold (VG) is artificial gold that’s backed, on the balance sheet of the issuer, by some kind of future gold receivable—e.g., a gold forward. This is typically maturity-transformed, a stupid and dangerous practice, but one that is conventional in both bullion and regular banking. So, for instance, Buns & Buns of London might have written a promise to deliver gold in 3 months, backed by a Barrick promise to deliver gold in 36 months.

Again, if this seems dangerous, that’s because it is dangerous. In a gold maturity crisis, as all holders of artificial gold demand allocated gold, gold interest rates spike—gold now is much more desirable than gold later.

But gold interest rates are tied by arbitrage to dollar interest rates. So what happens when this irresistible force meets that immovable object? Come on. In nature, what happens when an irresistible force meets an immovable object? What happens is a giant sucking financial death-vortex singularity, that’s what. Don’t ask these kind of things if you don’t want the answer.

And even if it wasn’t, that’s probably still what I’d predict! But that’s virtual gold—artificial gold backed by future gold production. Dangerous—but not lethal. At least, not especially lethal.

Now we turn to synthetic gold. This is also described as a speculative or naked short. A writer of synthetic gold is willing to lose a dollar for every dollar that gold goes down, and has collateral to back it up. Unlike the writer of virtual gold, who gets that dollar back when future gold rises (assuming gold interest rates do not decouple from dollar interest rates), the synthetic alchemist by definition has no gold to back his Mephistophelean paper.

The creation of synthetic commodities and/or securities is a normal aspect of a modern financial market. There is nothing inherently unhealthy about it. However, derivatives are not as safe as conventional theory would make them.

First, it is a fallacy to assume that collateralization can render any loan, however short-term, risk-free. There is no such thing as a risk-free loan. The possibility that the price of the collateral will fall faster than it can be sold, resulting in negative equity, always exists. This is especially the case when the collateral protects, or purports to protect, the lender against systemic risk. Collateral cures systemic risk like a good hot shower cures AIDS.

(The same is true of “clearinghouses.” The modern term “clearinghouse” is actually derived from the Old German klarenhaus, a bit of Hamburg wharf argot meaning “too big to fail.”)

Suppose you buy a CDS that pays you 1 euro if Greece defaults. Greece defaults. What do you have? A euro? No—a piece of paper, saying someone is supposed to pay you a euro. Who wrote this piece of paper? Who does it obligate? Do they even still exist? You didn’t used to have to worry about this stuff. You didn’t used to have to worry about Greece! Idiot. Or at least: if you mark this piece of paper at 1 euro on your balance sheet, you’re fooling either yourself or someone else. Its expected value may not be much less than 1 euro; it is certainly less.

The government, of course, could pay off on private credit-default swaps. Typically this is the implicit solution—better mathematical finance, through fiat currency! And it has been done before. But not so much again, I think. What saved the world, or purportedly saved the world, in 2008 was a lot of one-off tricks—emergency authorities that could not possibly become routine. This time, things will have to get worse. The old emergency powers are dissipating rapidly, as emergency powers do.

And more practically, if you are one of the people who bet on the collapse of Greece, the people who are going to pay off on that bet are under the thumbs of the people you bet against! No one in Brussels wants to print a bunch of euros, just to pay off speculators and Jews like you.

But this is a minor quibble, compared to the real problem with synthetic gold.

The real problem with synthetic gold is: gold is not wheat. Demand for gold is monetary demand, i.e., reservation demand. It is not consumption demand, as in wheat. Therefore, the creation of synthetic wheat by wheat traders should not have a substantial and predictable effect on wheat prices. This is not the case for gold.

Assuming for simplicity that all gold is held as monetary gold, the gold-dollar exchange ratio is set by the size of the gold stockpile and the marginal desire of gold and dollar holders to exchange their loot. If you expand the gold stockpile, you dilute the demand for gold. If you create synthetic gold, you lower the price for gold—just as if you were minting it in a nuclear reactor in your basement. Since your synthetic gold is (almost) just as good as physical gold, it passes perfectly well for the stuff.

A more sophisticated game can be played by minting arbitrary amounts of synthetic gold to move the physical market around, then buying it back to manage the size of the short position. As far as I can tell, this is what is alleged in the case of JPM. This is probably not profitable unless there is some external way to profit by manipulating the price. But here, great opacity descends.

The short takeaway is that in principle, synthetic gold can manipulate the gold market down, so long as the creator of the synthetic gold either (a) profits asymmetrically from success, or (b) is willing to accumulate a large naked short position. Whether (a) or (b), is the case in the case of JPM (or even whether this announcement is real) we cannot say at this time.

What remains puzzling, however, is the existence of any synthetic gold at all, in a world in which gold prices have been rising more or less steadily for a decade. Over this time, everyone who has issued these derivatives has been, on average, losing money. So why do they still do it? How can they still do it? It is not clear to me that quantitative finance can make money flow upstream. But then again, there is the government to consider.

In any case, if JPM has large naked short positions in gold and silver, and now is forced to close them, there will probably be trucks of chanting, machete-waving militia driving through your neighborhood by Wednesday or so. Short, dark men—speaking something that isn’t Spanish. Arabic? Mayan? Kenyan? Have the Bilderbergers have been breeding them, in camps in the Sierras? Is this the New World Order, as Rush foretold? Alas, the television is already off. Arm yourself. Go to the window. Soon, the midget race war will begin.

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