In any economy, there exists no less than one commodity or security of inelastic volume which is overvalued due to reservation demand. I.e.: one scarce good which is money.
To me the gold price takes the form of a very uncomplicated formula, and all you have to do is divide one by ‘n.’ And ‘n’, I’m glad you ask, ‘n’ is the world’s trust in the institution of paper money and in the capacity of people like Ben Bernanke to manage it. So the smaller ‘n’, the bigger the price. One divided by a receding number is the definition of a bull market.
You’ll notice that this had nothing to do with security analysis. This is conceptualizing, brainstorming, nothing to do with price/earnings ratios, other valuation methods like cash flows. It is a proposition or a hypothesis on what is driving the gold market. So the gold market is necessarily a speculative piece of business. It’s not to be confused with the kind of investment that Ben Graham wrote about.
UR is much cheaper than Grant’s Interest Rate Observer. We too conceptualize and brainstorm. We try to be rigorous, however, at least where rigor seems called for. We were also on this five years ago—just so ya know.
For instance: why gold? Why not silver? Or silver and gold? Or, gosh, the good old dollar? It’s certainly true that Messrs. Graham and Dodd have nothing to add on the subject. But I feel we can get considerably past Mr. Grant’s “uncomplicated formula”—roughly correct though it is.
Why gold, not silver? This collective choice is a standard—a persistent group decision. Why does your computer speak IP, not IPX? The Internet, or something much like it, could have been built on IPX, a perfectly good internetworking protocol. Gold works as money. So does silver. So does nicely engraved government paper. Before the 19th century, we see a patchwork of gold and silver standards around the planet. In the late 19th, gold emerges as a global monetary standard, displacing and demonetizing silver. In the 20th, paper (mostly) displaces gold.
Normal economic calculation, macro and micro, assumes a stable monetary standard. But monetary standards change. Why and when? What happens when they do? What is the effect on traditional macro indicators—interest rates, GDP, CPI?
First, let’s review the basic material.
There are two schools of thought on monetary standardization. One assumes that monetary standardization is inherently a sovereign function: the monetized good in any economy is what that economy’s government wants it to be. Alas, we live in an age of state-sponsored economics, whose state-sponsored economists easily assume this chartalist theory. Chartalism by definition precludes spontaneous restandardization. If the gold standard is considered, which it generally isn’t, it’s considered only as a policy option. A bad one, needless to say.
Economists in the Austrian tradition (i.e., legitimate economists) believe that monetary standardization is a normal market process—though, like all market processes, subject to government intervention. Clearly, the market today has selected dollars (USG liabilities) as a global monetary standard. Austrians agree that dollars and other fiat currencies are money. They also agree that the omnipotent state can compel its citizens to save in fiat currency. They disagree, however, that fiat currency is in all cases compatible with a free market—especially a free market in the precious metals. So for Austrians, restandardization is not only a policy, but also an event.
It’s worth arguing for a moment with the modern super-chartalists or Moslerites, who have awarded their system the pretentious caption of “Modern Monetary Theory” or “MMT.” I take the acronym as a personal insult: it conflicts with my own Moldbug Monetary Theory (MMT). Indeed, the same “modern” ideas are found in the great ’30s inflationists Silvio Gesell and C.H. Douglas, not to mention Attwood a century earlier—butt of John Stuart Mill’s immortal essay, “The Currency Juggle.” The Juggle, indeed, has never been zanier.
But every juggle is based on some fundamental truth. It’s important to recognize the fundamental truth behind this new outbreak of Ezra Pound economics, which is that fiat currency is sovereign equity. Dollars are best defined as shares of stock in USG.
These shares convey no corporate control and pay no dividends, but this does not make them worthless—the same could be said of Google’s A shares, or even of Delta SkyMiles. USG redeems its paper for concrete benefits at its pleasure, as with any and all equity instruments.
Even USG’s “debts” (such as Treasury notes) are not debt but equity, because they are denominated in equity (dollars). A Treasury STRIP or zero-coupon bond, for instance, is a form of restricted stock—financially equivalent to a dollar with a “not valid until” date.
Thus it is sheer nonsense (as Mosler will tell you) to talk of USG being unable to repay its “debt,” because its “debt” is not debt but equity. If USG had contracted to deliver 20,000 tons of gold in 2020, it would have debt. If it had contracted to deliver 20 trillion euros in 2020, it would have debt. If it had promised to wash 20 million cars, it would have debt. Its promises to deliver its own shares, however, are no more than restricted shares. Of course, any corporation may issue any number of shares at any time. No sweat!
So the reality, unbelievable as it seems, is that USG has no debt at all. (This does not mean its financial condition is healthy: it is not healthy to fund continuing operations by issuing new equity.)
That fiat currency is sovereign equity, the Moslerite gets. It is his one big hedgehog truth. But what the hedgehog misses is that the dollar is not just USG equity. It is monetized USG equity. It can lose this status—and if USG follows Mosler’s advice, it probably will. Alas, this would produce substantial purchasing-power decreases in your USG securities.
Given that 30% of USG’s revenue is generated by issuing new equity, the dollar operation is already pretty far into the Ezra Pound spectrum. It is the incumbent standard, however, and this represents a form of capital—one fast being dissipated. Also, not a small thing, USG is sovereign—perhaps the only true sovereign on the planet.
(USG’s financial status is better than it seems, not only because its sovereignty is so secure, but also because a meaningful financial analysis of USG consolidates the entire “private” banking system onto USG’s balance sheet. If the banks are (not formally, but in reality) part of the government, bank debt is government debt; your securitized mortgage is a government security, your mortgage payment is government revenue. This “private” debt is at present expanding slowly and actually contracted in 2009. On the other hand, many projected future expenditures do not appear as debt in the Z.1 report.)
Securities, sovereign or not, are just like precious metals. They can be monetized (overvalued), or demonetized (Ben Graham valued). In a sense, the naive chartalist is like the naive goldbug, who believes that gold and silver prices represent “intrinsic value.” In fact we can easily imagine a pure platinum standard, under which gold and silver trade at industrial prices. Since gold and silver are already slightly monetized, we’d expect these prices to be much lower than today’s.
Is USG both able and willing to force its subjects, not to mention the rest of the planet, to save in its own securities? If so, its securities will never be demonetized. If not, we must consider the possibility that Americans and/or foreigners will move their savings to another currency, such as gold. Regardless of how we calculate USG’s market capitalization, at present exchange rates its total liabilities are well over a million tons of gold—10 times as much as has ever been mined. This seems a bit rich, especially for an enterprise so deep in the red.
USG is an awesome operation. Its nuclear aircraft carriers are pimped beyond belief. Its fighter planes are the best fucking fighter planes in the world, and it owns California. Its paper is certainly not without value. But, just as with gold, we need to distinguish between the hypothetical intrinsic or “Ben Graham” price (set by non-monetary demand, and immeasurable while the good is monetized) of USG shares, and the monetary price of USG shares.
For which the denominator is, of course, gold. Anyone can practice gold accounting—whatever country they live in. How many USD do you have? How many milligrams Au does a USD run you these days? Multiply and get your net worth, in gold. It’s a weight, which is actually kind of cool.
(Of course (having upgraded to gold accounting), if you keep your entire portfolio in USD—or USD-denominated securities—it may fluctuate alarmingly. And, more alarmingly, generally in a downward direction. That’s a good indication that you should diversify out of this marginal and unstable soft currency. What next, naira? Baht? Imagine you’re a reasonably wealthy person—a retired cardiac surgeon, for instance. Imagine you admitting to your new accountant: "Oh, yes. Of course. I keep all my money in baht." Even if you lived year-round in Chiang Mai.)
Under gold accounting, consider the effect of new dollar issuance on dollars priced in gold. In the intrinsic or “Ben Graham” analysis, issuing new shares dilutes all existing shares, while leaving the market capitalization unchanged. A share is always defined as a fraction of shares outstanding. By issuing new dollars, USG effectively expropriates existing dollar-holders, salami-style, to pay its ongoing expenditures. Ben Graham doth frown.
But this intrinsic analysis is not in fact relevant to dollar prices, because dollars are monetized. Consider a gold standard in which all gold is in a central repository, and the medium of exchange is warehouse receipts denominated in fractions of this grand vault. Now suppose the gold is radioactive; 5% of it decays every year, resulting in a corresponding decrease in industrial utility. Will this affect the monetary system (assuming it remains the standard)? Not at all, as the gold is never used. The industrial price of a monetary good is purely hypothetical. Likewise, a securities analysis of the dollar yields no relevant results.
Not that issuing new dollars does not, ceteris paribus, increase the price of goods in dollars. But this is monetary inflation, not stock dilution; it plays by different rules.
For instance, if USG delivers $5 trillion in pallets to Bill Gates, and Bill stores the cash in a hole in the ground, the Ben Graham dilution is considerable, but no price inflation whatsoever can be expected—an extreme reverse Cantillon effect. Conversely, if the $5 trillion goes to Chinese peasants with a high marginal propensity to consume, we can expect considerable increase in the prices of noodles and soy sauce, but perhaps less in luxury yachts (except inasmuch as a soy-sauce tycoon or two needs a luxury yacht).
When restandardization is a possibility, the intrinsic value of a monetary good still matters. Intrinsic value represents a put option against the horrific possibility of demonetization. Hence, if gold, at present lightly monetized, becomes fully demonetized, your gold will still make pretty earrings and excellent electrical contacts. If dollars, at present heavily monetized, demonetize, they remain Federal Brownie Points which USG may choose to redeem for valuable goods and services. Ben Graham would be happy to snap them up, of course at a low, low price, and install a new CEO who can turn the operation around.
Should this influence your desire to save in dollars and/or gold? It should, but as a relatively minor factor. The intrinsic price is generally much lower than the monetary price, for both metals and securities.
So much for dollars. Fiat currency, though historically evanescent, is no exception to any valid theory of money. But the enormous cognitive complexity of existing fiat financial systems makes for poor thought-experiments. Therefore, we’ll consider only restandardization between metallic currencies. If we need to create these metals, we’ll need alchemists. As a convention, we’ll suppose that silver is collapsing (due to excessive alchemy), and the new standard is gold.
Let’s answer the question again. Why and when does monetary restandardization happen?
Moldbug Monetary Theory (MoMT) is a post-Austrian theory of money. It is a minor refinement of Mises’ standardization theory, which asserts that money is standardized by the demand for a standard medium of exchange. Rather, I assert, the demand is for a standard medium of saving.
In a pre-industrial or even pre-electronic age, it’s easy to understand the standardization of media of exchange. If Thag the axe-maker wants silver for his axes and all you have is gold, you have to go fetch Drog the money-changer, which is a pain in the ass. However, on a modern (or at least future) trading platform, translating commodities is a matter of milliseconds. Thus it would appear that the demand for a monetary standard is epsilon. You can buy axes with pork bellies, no problem.
Or consider an economy in which the daily medium of exchange is silver, but all significant silver accounts are converted to gold overnight. This economy demands a very small amount of silver (petty cash) and a very large amount of gold (savings and other long-term positions). Hence, it is one in which silver is substantially demonetized—yet the medium of exchange.
But in a modern economy, anyone can save in anything. Retiring in 2030? You can put your entire retirement portfolio in 2030 pork-belly futures. If you don’t want to spend your entire old age gnawing on pork bellies, you can trade these for other goods.
So it’s clear why the whole world needs one standard for Internet packets. It’s also clear why it might want one standard for payments. It’s not as clear why it needs a standard commodity (or security) of saving.
Probably the easiest way to understand monetary standardization is to forget about Thag, Drog, and the historical origin of money, and consider only the problem of restandardization: selecting a new standard when the existing standard collapses.
The fundamental phenomenon of monetary restandardization is Mises’ “flight to real values,” which sounds better in German: Flucht in die Sachwerte. You will often hear of consumers buying gold, land, foreign currencies, etc., to “preserve their savings” against “inflation.” This intuitive understanding, though roughly correct, must be tuned before we can proceed.
The goal of a rational economic actor in the Flucht is not in fact to preserve the purchasing power of his assets, but to maximize it. The alchemists have figured out to turn lead into silver. Silver, as a currency, is toast. You hold silver for your retirement in 2030. Run away!
You need to sell your silver and buy some new medium of saving X, which you will sell in 2030, in exchange for pizza, cruises and wine. What X should you choose? What X will get you the maximum pizza, cruises and wine? (Yes, instead of buying spot X, you should probably buy X futures maturing in 2030. You still need to choose X, as there are no pizza futures.)
The trick to understanding this decision is understanding its collective nature. Whatever X you choose, others will choose that same X. This will affect the market for X—ceteris paribus, driving up its price. If “real value” means Persian rugs, the Persian-rug market will boom. If this price increase is sustainable, you are buying into the next monetary standard. If it is not sustainable, you are buying into a bubble.
Thus, the goal of the rational actor is to choose the X that everyone else will choose (assuming they choose right), but choose it first. In standards terms: pick the winner, be an early adopter.
Value investors often describe a commodity or security already popular with other investors as a “crowded trade.” This is by definition an overvalued good. When a crowded trade un-crowds, a bubble pops.
The pons asinorum to success in the Flucht is to reverse the normal investor psychology of avoiding the crowded trade, and crowd instead into the most popular trade, finding the most overvalued good. This will become the standard trade: money, which is the bubble that never has to pop. The strategy is a Nash equilibrium: the correct strategy for everyone to follow, if everyone follows it. It needs some refinements, of course, discussed below.
When the Flucht is finished and the restandardization process is complete, instead of a large number of somewhat overvalued storable commodities, we see one extremely overvalued storable commodity—again, money. As for the runners-up—goods that became overvalued, then returned to industrial price equilibrium—they look like popped bubbles. They are popped bubbles. Tulip bulbs, for instance, are almost like a monetary good, but not quite.
One metaphor for monetization is that of a storage vessel, like a battery for electricity or a tank for compressed gas. When people buy into the currency, they are charging the battery and compressing the tank. When they sell out, they are discharging the battery. When new currency is created (perhaps by alchemists) without a buy-in, the tank has sprung a leak. Etc. The charge, or the pressure, is simply the market capitalization of the entire present (and discounted future) monetary good.
But wait. Why did we have this Flucht in the first place? What happened to silver? We know intuitively—too many alchemists around. Let’s try to make it a little more rigorous. What is the correct, rational, Nash-equilibrium strategy for the flight to real values?
To pick between silver and gold, we need two variables: interest rates in silver and gold. An interest rate in any good can be restated as the price of the future good in the present good—a discount rate. Most people are used to interest rates, but I like discount rates better—I feel they are more intuitive. However, the two are equivalent and can be used interchangeably.
If there is a 20% one-year interest rate in silver, you can exchange one gram of present silver for 1.2 grams of one-year-later silver, which means the price of a gram of one-year silver is 0.83 grams of present silver. Of course, there is not a single interest/discount rate within any good, but an entire yield curve—the price of four-year silver cannot be computed from the price of one-year silver. But we’ll forget this important fact.
Of course, there is a discount rate in gold as well. There is also a current exchange rate between gold and silver. Since we can calculate the price of future silver in present silver, the price of present silver in present gold, and the price of future gold in present gold, we can compute a rather interesting number: the price of future gold in future silver, or future gold-silver ratio (FGSR), for any instant after now.
In short, the interest rate in each of these currencies, combined with the present exchange rate, defines a prediction market for the future exchange rate. On January 1, 2012, it is possible to compute an FGSR for January 1, 2013—at least, if you know the current GSR, the gold lease rate, and the silver lease rate. Over time, this FGSR will converge on the actual GSR for its date. The prediction, while not guaranteed to be correct, is arbitrageable: if you know your prediction is better than the market’s, you can profit.
This equivalence is an accounting identity. What do identities tell you? Murray Rothbard once parodied Irving Fisher’s quantity theory of money, MV=PQ, by saying “the volume of water that hits the ground is the same as the amount of rain that falls from the sky.” A statement which, while true, does not enable you to predict the weather. We know the identity; what is the causality?
The causality in this identity is particularly peculiar. The future exchange rate is decided by interest rates within each currency—the supply and demand between present and future gold, and present and future silver. Therefore, the predictors are not moneychangers; they are not people who know anything about exchange rates. Therefore, although the prediction market is correctly defined, its players are not generally informed about the question it predicts.
We’ll return to this interesting paradox. But first: to decide between silver and gold, what do we need to know? Simply the ratio between gold interest rates and silver interest rates. This will tell us the extent to which silver is expected to depreciate against gold.
If gold interest rates are 20% and silver interest rates are 10%, which would you prefer to hold? Would you say: look at those juicy gold rates, I should be in gold? You mean not “hold” but “invest in”—a very different concept. If you can invest in gold at 20% or silver at 10%, whichever currency you start from, the decision is neutral: the increased return in gold will be canceled by the expected currency depreciation.
Are you willing to exchange present money for discounted future money? In other words, to lend? Bear in mind that lending does not decrease the set of currency holders. If you lend money to someone, it’s because he either wants to hold it himself, or lend it to someone else who will hold it. Thus, we cannot evade the contest for holders. The true saver is the “hoarder,” not the lender.
If gold rates are higher than silver, everyone should (ceteris paribus) prefer to hold gold rather than silver—simply because silver is depreciating against gold. Thus, we see exit pressure out of silver and entry pressure into gold. The silver battery is much taller than the gold battery, because silver is the monetary standard and gold is the upstart. However, money is leaking out of the silver tank into the gold tank, as rational hoarders obey incentives.
But there is worse ahead for silver, because this tendency is self-accelerating. As silver holders bail out in favor of the harder currency, gold, they create pressure on the spot exchange rate, which of course is set by supply and demand. Thus, gold goes up and silver goes down. This tendency can continue until gold is fully remonetized, silver fully demonetized.
Our first-order strategy (not, of course, to be construed as financial advice) to game players is thus: of any two competing currencies, hold the appreciating one: that is, the one with the lowest interest rate. As everyone else follows this strategy, the appreciating currency will appreciate even more, until eventually there is only one. Gold is money, silver is stuff.
This strategy has some obvious deficiencies—or at least, raises some obvious questions.
Why doesn’t this happen all the time? How hard is it for a non-monetary commodity to exhibit interest rates lower than those of the present monetary standard? Does this process really have to run to termination once it begins? Is epsilon sufficient to initiate the chain reaction, or can a current standard sustain its dominance given some mild exit pressure?
But first, we have a causal inconsistency to resolve. Earlier, we said that the gold-silver ratio is predicted by interest rates within each of these currencies. But now, it seems, the ratio is set by supply and demand to exchange gold for silver. These seem like very different economic activities, so perhaps it’s puzzling that they would produce the same number.
In fact, both statements are true. The GSR is predicted in the future by interest rates, and set by supply and demand in present. If supply and demand sets a different number than past interest rates predicted, all that means is that the prediction was wrong. Yes, Virginia, this happens.
I promised not to say anything about dollars. But in fact, the gold-dollar ratio (GDR) has been rising by about 20% a year for the last decade. Was this predicted by interest rates? No. Do interest rates predict a continuation of this trend? No. Does this mean that you could walk down the street right now, and find a $20 bill on the sidewalk? Wouldn’t preclude it at all.
In fact, it is impossible for loan markets in dollars and gold to predict this result, because there is no such thing as a negative interest rate in a loan market—the transaction is meaningless—and dollar interest rates, at least official rates, are well under 20%. Nonetheless, over the last 10 years, simply holding gold has produced a better return then almost any real capital activity. In other words, the gold futures market’s prediction of future gold prices has been reliably wrong, in the same consistent direction, for the last decade. A puzzle for Professor Hanson!
What is the problem here? Where is the misprediction coming from? It is coming from the fact that the lending market, since it does not understand the monetary standardization game, cannot play it. If it could play this game, we would see its prediction rapidly converge with the reality of the exchange market.
How would this work in practice? If gold predictably appreciated by 20% against silver, but the loan markets predicted only 5% appreciation, lenders would drive up silver interest rates to 15%, by offering lucrative investments in “enterprises” whose only activity was to hold gold—hedged by the market’s modest and incorrect prediction of appreciation. Bonds issued by these ventures would drive all other bonds off the market. Of course, in reality, no such bonds can be offered, because a bond is a fixed-income instrument and the exchange market is inherently unpredictable.
The interest-rate signal can also be disrupted—for instance, by lending alchemists who create present silver to buy future silver. By increasing the supply of present silver at any time, this can be expected to increase the price of present silver in present gold. But it certainly does tend to lower interest rates. The alchemists, of course, should be careful that they don’t find themselves buying future silver that is generated by the profits from holding gold. This would leave them pouring silver into an infinitely deep hole.
If the signal is absent or disrupted, speculators can speculate—and they do. In all cases, this involves being short silver and long gold. Thus we see the cycle again: predictable appreciation of gold over silver, generates exit pressure in silver and entry pressure in gold, which generates predictable appreciation of gold over silver.
(In the dollar-gold market of the past decade, although we cannot see gold’s rise predicted in the the futures market, we can see it reflected in a market of generally savvy speculators: gold miners. Miners can choose between selling future production forward into the futures market (hedging), which they will do if their own price predictions are equal to or lower than the market’s prediction; or selling the gold when they produce it. Sure enough, the global gold hedge book rises in the ’90s as gold is falling, and drops (to almost zero) in the last decade as gold rises. This indicates an accurate perception of market inaccuracy by expert speculators.)
We see the fundamental instability of monetary competition. Stable systems are buffered—they experience negative feedback. But this is very much a positive-feedback story. Whoever starts winning, can be expected to keep winning. A tiny breath of air, and the pencil, balanced on its point, falls over.
This explains some facts—for instance, why bimetallic standards are historically unstable. Across the millennia, governments are always trying to fix gold-silver ratios, and always failing. One money drives the other out by Gresham’s law. But even if no one is so foolish as to fix this unfixable price, in the end there can be only one.
As natural market fluctuations push one metal above the other, the rational saver will rebalance into the rising standard and de-diversify away from the falling. As gold rises and silver falls, he will exchange silver for gold. Or at least, the sooner he figures out this strategy, the more gold he will end up with. The collective behavior of all rational savers results in an industrial silver market and a gold standard. Thus, the bimetallic standard is like a pencil standing on its point: stable only as a perfect mathematical abstraction.
The instantaneous feedback is positive. But is there any negative feedback? As the pencil falls, is there a magnet that catches it and stands it back up?
Consider the case of competition between ordinary 20th-century fiat currencies. These predictably depreciate against each other all the time—that is, different currencies exhibit different interest rates. Why doesn’t all international currency competition collapse, as our gold-and-silver model has? Why didn’t everyone in America in 1979 switch to D-Marks?
Good old forex has a very powerful buffer mechanism: the balance of trade. If country A starts to adopt country B’s currency, country B’s currency rises versus country A, which gives country B (ceteris paribus) a trade deficit relative to country A. This implies a flow of money from B to A: negative feedback. This feedback is absent from our gold-silver model because, and only because, we’ve assumed that gold and silver users are homogeneously distributed.
There is another negative feedback, however: monetary production. This is probably the strongest stabilizing element in metallic currencies.
The ideal currency is perfectly inelastic in volume: no new money can be created. Elasticity is defined as a percentage of the stockpile: how much work does it take to create 10% more gold than exists at present? Or to put it more precisely: how much gold per annum, as a percentage of gold already mined, will be mined at the present price?
We can look at monetary elasticity through two lenses: interest rates and exchange rates. We should expect higher interest rates in an more elastic currency, because more elasticity implies production of more future money, whose price will therefore drop. We should also expect this currency to depreciate, because we can compute exchange demand not in unadjusted physical terms, but in relative terms—not as grams of metal, but as percentages of the entire market capitalization of that metal.
Suppose the silver battery is neither being discharged into the gold battery, nor the gold battery into the silver battery. Priced in either metal, the ratio of total gold stockpile capitalization to total silver stockpile capitalization remains constant. However, gold is being diluted by new production at 5% a year, whereas new silver is 10% of the silver stockpile.
Thus, in relative prices, the GSR remains constant. But in grams of metal—which is the actual GSR—gold appreciates by 5% against silver. Again, this appreciation will be magnified by positive feedback.
So where is the negative feedback? Remember, in our model, silver starts out as money, and gold as an industrial metal. Alchemists, however, have figured out how to make 5% more silver a year than gold. So silver energy starts to flee into gold, and gold starts to go up.
But wait! As gold’s price increases—perhaps stratospherically—its elasticity changes. At the original, industrial price, gold was less elastic than silver. But to win the monetary game, its price in silver must rise by a factor of (let’s say) 100. This is because silver falls, of course, but let’s say gold’s price in a neutral commodity—like wheat, a grain often eaten by gold miners—rises by a factor of 10.
Moreover, because gold was not a monetary metal, it has a small stockpile. Therefore its old elasticity experiences a brutal double whammy: much higher prices, much smaller base. Gold rises under its own power until its elasticity equals that of silver; possibly it rises on momentum, after that; and then the feedback becomes negative. The gold bubble pops. The old standard, silver, which was stable after all, reasserts its unquenchable will to monetary power.
Our goal, remember, is not to select the X ahead at present, but the X who will win the game: finem respice. With our first-order strategy, money rushed into gold not to correct a supply-demand imbalance in the industrial gold market, but to speculate on a monetary transition from silver to gold. But if that transition cannot actually occur, it has no reason to happen in the first place, and the rational herd will stay in their present standard money—silver.
Thus a correct, second-order strategy to pick a winner has to consider the monetary pressures across the whole path to complete monetization. If the leak will reverse direction halfway through the process, the process cannot complete and should never start. If large price increases in a commodity would cause a stockpile blowout, the walls of the tank are too thin. The whole premise of monetary restandardization is that the new currency will be stable and permanent.
Note in general the social effect of a total restandardization. The result is nothing less than a general redistribution of wealth—or at least, money. When silver goes down the toilet and gold becomes king, all the silver in the world has to pass through the gold-hole. This is Grant’s “1/n.” He who exits first is a mogul. He who exits last finds his portfolio has turned into a small stockpile of industrial metal—a metal the world has enough of right now. Similarly, if he has any Semper Augustus tulips, he can always plant them in his garden.
Indeed, the political effect of this transition is hard to understate. But that’s a separate post. Ideally, a well-run political system will not let such a chaotic, spontaneous wealth redistribution happen, but will bend to reality and orchestrate an orderly liquidation. This is especially straightforward when the transition is from a fiat to a metallic currency. It is not especially difficult to establish a liquidation price at which all fiat obligations can be repaid in metal. The main problem is that any such ordered liquidation involves a large discontinuous transition in the exchange rate, which makes it a difficult policy in practice to plan and implement.
What will happen to interest rates, inflation and growth during a spontaneous remonetization? We’re finally in a position to answer the question we started with.
Demonetizing silver in favor of gold means a striking fall in the silver-gold ratio, which normally implies inflation in the silver price of all goods, deflation in the gold price of all goods.
But wait: we have another causality problem. This one is a frequent bugaboo of arguments between goldbugs and deflationists. Prices are set by supply and demand. If the price of bacon in silver is to increase, where does all the extra silver to bid up bacon come from? One deflationist writes:
My argument is simple, and I will not yield ground to any hyperinflationist who fails to explain, if the system collapses, where the money will come from to bid tangible assets skyward.
In other words, inflation means more money chasing the same goods. Where’s the more money?
There are two ways to answer the question. The first is to point to the enormous stockpile of monetary silver that built up while silver was money. Previously, this metal was hoarded by savers; gold has displaced it in that role; Gresham’s law pushes it onto the market, increasing velocity as people try to spend their silver on bacon while silver can still buy bacon.
This is an accurate answer, but it is confusing, because it answers the question from the opposite direction. A better way to say it is to say that prices in silver are a function of purchasing power in silver, which is a function of everyone’s net worth as measured in silver.
After the restandardization from silver to gold, everyone’s net worth in silver has massively increased. Why? Not because there is much more silver in the world—because everyone’s portfolio has been converted to gold, which has been revalued in silver. Thus, their purchasing power in silver, by the end of the transition, can and should considerably exceed the amount of silver in the world.
This is a little tricky to understand, so let’s go back to the real-world players. It is not silver but the dollar which is the falling incumbent currency. To holders of gold, this is of course deflation—a most salubrious phenomenon. Holders of gold (and dollars) likewise had a blast during the Weimar experience. Their wallets turned into fountains of money.
It is these fountains which bid up prices. The new purchasing power comes from the exploding portfolios of gold’s “early adopters.” As this effect spreads from a few Internet nutcases and daring hedge funds, out across the broader global economy, that economy (still on the dollar standard for most prices) experiences a gold-driven wealth effect. Consumer spending rises; the same sort of broad economic boom as the ’90s tech-stock boom is seen.
On the dollar’s last day as a meaningful unit of account, total dollar net worth is at its historical peak. If there is a free market in future dollars (unlikely), future dollars in an expanding dollarsphere will be cheap relative to present dollars, and interest rates therefore high.
Best of all, unlike theglobe.com, this boom is sustainable. Ideally, it terminates in an allocated gold standard with no debt—the American and European economies at present, of course, being brutally overcapitalized. The dollar debt will be largely inflated away—along with any dollar savings which tarry too long in that currency. Can we imagine a debt-free world? Yes, we can.
(Except by actual gold-generating ventures (such as gold mines), gold debt will not be generated until remonetization completes. With gold rising like a rocket, there is simply no practical venture that can exchange discounted future gold for present gold at a profit—at least, not a venture that operates a business in a dollar economy, for in dollars this venture would be wildly profitable. Thus, gold interest rates will be low, and forward sales restricted to gold producers—if the futures market can match the producers’ predictions of appreciation. Otherwise, producers will not hedge, and there will be no gold lending at all.)
Thus remonetization should be welcomed by political authorities, because it promises reflation—or, in other terms, national bankruptcy and a general restructuring of public and private debt. The Moslerites are certainly right that the world carries too much debt, and that this debt needs to be restructured. Where they err is only in suggesting that this restructuring should be carried out as an ongoing process of massive deficit spending in classic Argentina style.
Remonetization, spontaneous or orderly, is a one-time restructuring event. The smart rich will profit, of course, by early adoption of the new standard in a spontaneous remonetization. It is the stupid rich who will suffer, and perhaps deserve to. Who can defend the stupid rich? Still, as a general friend of order, I prefer an orderly remonetization in which every dollar is equal.
(Another way to state the effect of remonetization: Arnold Kling’s recalculation. All prices and positions are new, not just quantitatively but qualitatively. New prices cannot be computed from the old ones; they must be computed by the market.)
USG as an economic entity has two problems. One: it is overcapitalized (has too much debt). Two: it loses more money every year. Both these descriptions are accurate for both the conventional public-sector balance sheet, and the national balance sheet (consolidating public and private). (On the national balance sheet, only foreign transactions appear; the annual loss is the trade deficit, the capitalization is the foreign debt.)
Why do we see an oncoming storm of commodity-price inflation? When America runs a trade deficit and exports net dollars to the rest of the world, it sends those dollars to places with a high marginal propensity to consume commodities. More money chases the same goods, and prices rise. Moreover, as new dollars are being produced but not staying in America, we see an inflationary boom in reserve-accumulating nations (China) but stagnation here. Stagflation is inflation without the fun, like liquor that only gives you a hangover.
In its present operating structure, America leaks cash, like a Soviet car factory. The Soviet car factory may also be overcapitalized; a haircut will maximize the return to its creditors. If it remains unprofitable after the haircut, however, there is no point in continuing operations. The factory might as well be sold as scrap metal.
This is what’s so frightening about a money-losing country: the rational option is to terminate all economic activity. In the human dimension, unprofitability disconnects an enterprise from all economic discipline, which is often the only discipline it has left. It becomes depressed and psychotic—especially in the long run. Would you want to eat in a money-losing restaurant? Why would you want to be governed by a money-losing government?
Remonetizing gold, and restoring USG to an allocated-gold balance sheet, fixes both these problems (if the gold price of the dollar is set correctly—about a milligram is my wild guess). It both annihilates past debt, and enforces future financial discipline.
So much for the theory. Let’s take a quick moment to apply it to present-day reality. Where should you store your money? This analysis is anything, of course, but financial advice.
First, the incumbent: dollars. All liabilities issued or guaranteed by USG, even informally, are dollars—such as all bank liabilities. All investments whose price is calculated by Ben Graham as a structure of future dollars are also dependent, of course, on the value of the dollar.
The basic problem with the dollar is that new dollars are winding up not in the hands of Bill Gates, but in the hands of Chinese peasants, who use them to bid against global commodities. If USG adjusts its fiscal and monetary policy so that it is not exporting dollars, it winds up with net dollar destruction domestically, which means politically unsustainable deflation. If it eases to avoid this, it bleeds dollars. In the worst case, it is quite capable of both inflating foreign dollars and deflating domestic dollars. The problem is structural: the whole enterprise is unprofitable.
The dollar alchemists are constantly buying future dollars with new present dollars, effectively concealing the high interest rates inherent in a hemorrhaging balance sheet. This need not fool exchange-rate predictors, however. Increasing dollar supply in the hands of commodity consumers produces an upward bias in all commodity prices, kicking off the Flucht in die Sachwerte and creating demand for a new monetary standard. The question, therefore, is whether the dollar has any plausible competitors.
It’s worth considering non-dollar currencies. While these may rise against the dollar, their appreciation is constrained by the balance-of-trade buffering mechanism described earlier. Fiat currencies are managed by central banks. Central banks are political actors. Political actors do not like to see industrial destruction, which is what happens when currencies become overvalued. The Swiss central bank, for instance, has to work very hard to keep Swiss army knives affordable to non-Swiss buyers.
The obvious competitor, and almost certainly the final winner: gold. Gold can be revalued to whatever level is necessary to liquidate the dollar system. The high price of a milligram is no obstacle, even if physical gold needs to circulate as cash. A modern gold currency should not have exposed metal surfaces! If a milligram coin is needed, wrap a disc of gold leaf in Lucite. Or simply circulate token coins as warehouse receipts to allocated gold.
The wild card in the gold market, as I hasten to remind readers, is the existence and/or new creation of synthetic or “naked short” gold, presumably by central banks (no one else could hide the losses). If dollar liabilities can be transformed to gold liabilities, currency issuers (central banks) can create infinite synthetic gold to neutralize all monetary demand.
Perhaps this is a crime. If so, the CBs exhibit motive, opportunity, and propensity. The official gold market, including bullion banks, is a riddle wrapped inside a mystery inside an enigma. I would like to see the gold books of all governments, exchanges, and banks. Who is naked? Who is transforming maturities? It won’t happen.
Especially if gold longs are indifferent to the exact nature of their holdings—synthetic and backed by hot air, synthetic and well-collateralized, synthetic and government-guaranteed, present backed by future (maturity-transformed) gold, or allocated present gold— “paper gold” is a potent weapon against restandardization. Public service message: insist on allocated or physical gold. If it matters, you’ll be glad you did. Fortunately, Chinese peasants do not buy a lot of Comex futures.
There is little real financial activity in the gold market, aside from gold-miner forwards. Gold interest rates are derisory. There is no stock market denominated in gold, though there should be, if only for gold producers. With gold appreciating at 20% a year, this matters very little.
We turn to silver, which has exploded recently. The short story on silver is that silver is the perfect bubble. Silver at $50? Silver could go to $500. It would not surprise me in the slightest. It would surprise me considerably, however, to end up with a new silver standard. If gold and silver defeat the dollar, gold will almost certainly defeat silver.
Eric Sprott, a rare trustworthy source (Bron Suchecki is another rare trustworthy source), outlines the present silver market. It is no surprise that silver is appreciating rapidly relative to gold, because comparable quantities of saving are pouring into each metal. However, because silver was fully demonetized in the 20th century and gold was not, the market capitalization of the gold stockpile is 60 times the capitalization of the silver stockpile. Thus, comparable volumes of gas are pressing in to the gold tank and the silver tank, but the silver tank is 60 times smaller. It is actually surprising that silver has not risen faster and harder.
But this present advantage is also silver’s long-term Achilles heel. The silver tank, being so much smaller, cannot take this kind of pressure. It will almost certainly explode. I have personal advice for those playing the silver market: bring your steel balls. If you buy into a bubble when it’s small, and get out before it pops, you can do quite well.
How will gold defeat silver? If silver wins, it will go to $500 and well beyond. But consider the dilution with silver at $500! First, it will draw every last silver fork out of the attic. Secondly, today’s silver mines are the silver mines which are profitable with silver at, say, $12. The set of silver mines profitable at a price an order of magnitude higher: a considerably larger set.
Because the present stockpile of monetary silver is so small in relation to productive capacity, even present productive capacity, that stockpile is easily diluted. In contrast, because gold was never demonetized, gold is much harder to dilute even if it revalues by orders of magnitude. By Sprott’s figures, annual silver production: 50% of the present stockpile. Annual gold production: 2%. As you see, gold is a much harder currency than silver.
Therefore, when gold competes against silver, rational actors choose gold, because silver will dilute much faster ceteris paribus. The secondary feedback loop is dependent on the primary depreciation analysis. Silver, because of its small stockpile, is easy to dilute. Because easy to dilute, it is not a plausible monetary metal at all—it is barely more than industrial metal. And this though “money” and “silver” are synonyms in half the languages in the world. All that silver has going for it is tradition, and this is not enough—not when gold retains so much of its Victorian monetary structure.
Finally, we examine a new contender—the mysterious and awesome Bitcoin.
I’ll be frank with you, dear reader. When I came up with the MoMT, my first thought was: how can I, Mencius Moldbug, make some damned money from this? As system software is my first love, it was not that hard to think of an answer. In some ways Bitcoin is actually much better designed than my design, which was not distributed. The use of Lamport hash chaining is particularly elegant. I did not wind up building my design, however, because I sensed a problem. Bitcoin has the same problem, but worse.
But the basic economic design is the same: an artificial currency of limited supply. What is the currency backed by? Nothing but speculation and hot air. Note that this (contrary to its exponents’ claims) violates Mises’ classical “regression theorem.” MoMT has no problem with an unbacked monetary candidate, because the required epsilon can be provided simply by the probability that the monetary system is adopted.
If Bitcoin becomes the new global monetary system, one bitcoin purchased today (for 90 cents, last time I checked) will make you a very wealthy individual. You are essentially buying Manhattan for a quarter. There are only 21 million bitcoins (including those not yet minted). (In my design, this was a far more elegant 24, with quantities in exponential notation. Just sayin’.) Mapped to $100 trillion of global money, to pull a random number out of the air, you become a millionaire. Wow!
So even if the probability of Bitcoin succeeding is epsilon, a million to one, it’s still worthwhile for anyone to buy at least a few bitcoins now. The currency thus derives an initial value from this probability, and boots itself into existence from pure worthlessness—becoming a viable repository of savings. If a very strange, dangerous and unstable one.
I think the probability of Bitcoin succeeding is very low. I would not put it at a million to one, though, so I recommend that you go out and buy a few bitcoins if you have the technical chops. My financial advice is to not buy more than ten, which should be F-U money if Bitcoin wins. Or, of course, you can invest in those alpaca socks.
Here is the problem with Bitcoin: the tank, I think, will pop. This is not due to any technical fault in Bitcoin’s algorithms or economics. It is due to a political fault in our society, which is that we’re governed by dumb people.
Because we’re governed by dumb people, here is what I think will happen with Bitcoin. Stage 1: Bitcoin does not exist. Stage 2: Bitcoin exists, but is worthless. Stage 3: Bitcoin exists, and is used by strange and desperate weirdos and geeks. Stage 4: Bitcoin is used by Slashdot readers, perhaps slightly less desperate. (You are here.) Stage 5: Bitcoin is used by criminals. Stage 6: All Bitcoin exchanges are shut down by USG. Stage 7: Bitcoin exists, but is worthless. Stage 8: Bitcoin does not exist.
At least on the surface, Bitcoin exchanges violate the critical know-your-customer rule which USG enforces on all money-transfer businesses. As a money-transfer business, you are essentially an agent of the government—a spy. To a regulator, Bitcoin seems like a way to transfer arbitrary quantities of money anonymously. This is a nonstarter, and the regulator knows exactly whose necks he has to squeeze—the spies who are not doing their jobs.
He cannot shut down Bitcoin itself. He can trivially shut down Bitcoin-dollar exchanges, or even Bitcoin-gold exchanges. Probably seizing all their dollars, etc. He probably can’t seize their bitcoins, but it doesn’t really matter.
To save in a currency is to place your trust in that currency. If you put energy into this great collective battery, you have to be able to get it back out. If that trust can be convincingly damaged, the currency has no chance. If people lose money in bitcoins, the currency can never recover. No one will ever again exchange it for dollars, or even alpaca socks. It will be dead. Its chances, now and forever, will be zero—not even epsilon.
If Bitcoin was centralized—sacrificing all real coolness—it could deal with this problem, perhaps, by applying KYC to all dollar transactions. But Bitcoin is not centralized, so there is no way the development team can prevent exchanges from operating. These exchanges are obvious targets for numerous predatory authorities. When they are destroyed, the currency dies.
What is Bitcoin’s only chance? Perhaps that Bitcoin is not really anonymous. In fact, it is anything but. All transactions, though pseudonymous ( named by a random key), are public and can be tracked by anyone, including said authorities. There is no financial secrecy in Bitcoin—it’s a completely transparent system.
Which means that, if money launderers try to launder money through Bitcoin, they are actually doing the authorities a massive favor. It is very easy to track dirty bitcoins. If you know Pablo, a drug dealer, is using Bitcoin address X, you can download the entire graph of parties that X trades with, and roll up Pablo’s whole network. Instead of shutting down the real-money exchanges, you can secretly force them to send you their entire customer database. That way, the terrorists, drug dealers, etc., are not hiding their transactions at all—they are sharing their most intimate details with the government. Heck, the DEA probably understands Pablo’s finances better than Pablo’s own people. That’s what he gets for using Bitcoin.
But, as I said, we are governed by dumb people. Or, worse, committees of smart people. Therefore, I reiterate my target price on bitcoins: epsilon. Nonetheless, it probably wouldn’t kill you to go buy five or ten—not that this is financial advice.