Backwardation

If I understand Fekete correctly, "backwardation" (in gold) is the signal the market gives us that the sellers of gold (the CB's, the BB's, the shorts, and the naked shorts) have realized that there truly is a shortage of physical gold. And they have realized it will be more beneficial to them in the near future if they keep their physical gold and settle any outstanding contracts in dollars.

This development is evident right now in the European CB's recent statements about reducing gold sales, other region's buying of gold, rising gold lease rates, and the reduction in short positions on the COMEX. And then Friday morning it showed up as a backwardation in the basis.

The scary part of this is that A.E. Fekete says that backwardation in the monetary metals market will usher in hyperinflation. He says that hyperinflation is not simply a function of the quantity of money, it is also a function of shortages.

Think about that while you read this. It is well worth the effort to read the whole thing. But here are some snippets to get you going:

As the regime of irredeemable currency threatens to crumble under the weight of the inordinate debt tower of Babel, people increasingly take flight to gold. Supplies will get tight and the gold basis will fall. The gold futures market may even go to backwardation briefly at the triple-witching hour, i.e., the hour when gold futures, as well as call and put options on them expire together. Later, flirtation with backwardation may occur even more often, at the end of every month when gold futures expire. Gold will get caught up in a storm.

Backwardation in gold has a perverse effect. In the case of agricultural commodities backwardation provides a most powerful incentive for traders to sell the cash commodity and buy the futures. Not so in the case of gold. Rather than bringing out deliverable supplies of gold, backwardation tends to remove them. The more the gold basis falls the less likely it becomes that owners will exchange their cash gold for futures. Please remember that you have seen it here first. This perversion of the gold basis constitutes the self-destroying mechanism of the regime of irredeemable currency. The longs tend to take delivery on their gold futures contracts in ever greater numbers, and refuse to recycle cash gold into futures, regardless how low the gold basis may go. As it is not set up to satisfy demand for delivery on 100 percent of the open interest, the gold futures market will default. Exchange officials will declare a “liquidation only” policy to offset long positions in gold. At that point all offers to sell cash gold will be withdrawn. Gold is not for sale at any price. The shorts are absolved of their failure to deliver on their gold futures contracts.

Previous descriptions of hyperinflation purporting to explain the descent of a currency into the abyss of worthlessness do so in terms of the quantity theory of money. My explanation of the hyperinflation that is staring us in the face is very different. I dismiss the quantity theory of money as a linear model that is not applicable. Every previous episode of hyperinflation took place in the context of a war replete with shortages caused by the destruction of stockpiles and productive facilities. In this situation it is not possible to sort out the effects of an increasing demand (due to a flood of printing-press money) and a decreasing supply (due to the destruction of stockpiles and production facilities). We want to show that prices may also explode in the presence of unsold stockpiles and ongoing production.

Moreover, previous episodes of hyperinflation affected isolated countries which had embraced the regime of irredeemable currency out of desperation, while the rest of the world stayed the course of monetary rectitude. In the present situation the entire world has been inflicted with irredeemable currency. There are no gold standard countries around that could lend a helping hand to countries that want to stabilize their currency. My description of hyperinflation is not in terms of the quantity theory of money, but in terms of a model where the relentlessly declining gold basis leads to backwardation destroying the gold futures market. When all offers to sell cash gold are withdrawn, producers of essential commodities such as grains and crude oil refuse payments in dollars, and demand gold in exchange for their product. The dollar and other irredeemable currencies will go the way of the assignat.

Backwardation in gold should therefore be considered the self-destroying mechanism for the regime of irredeemable currency that “only one man in a million may identify and understand” (my thanks to Keynes for the felicitous phrase). This is where supply/demand analysis is utterly useless. The huge stocks of monetary gold are still in existence, yet zero supply confronts infinite demand.

The only way to fend off this outcome is for the government of the U.S. to come up with a credible plan to stabilize the dollar in terms of gold. Presently there is no hint that contingency plans for the rehabilitation of the gold standard exist. It doesn’t matter. Any country, e.g., China, India, Iran, could do it through the back door by opening the Mint to the free and unlimited coinage of gold and silver. The alternative may be mass starvation in the midst of plenty as world trade comes to a halt for want of a universally acceptable medium of exchange.

Here is a question for the U.S. President and Treasury Secretary to contemplate: How many innocent lives are they willing to sacrifice on the altar of doctrinaire purity in defense of their untenable gold policies?

How many indeed. The following is a good podcast which discusses hyperinflation. It is an interview with Steve Hanke of Johns Hopkins and the Cato Institute. He is an expert on hyperinflation and is currently studying Zimbabwe.

He says that our current deflation could switch very quickly to inflation and catch most people off guard.

The statement that caught my attention was that once hyperinflation starts, there is no tax base for the government to subsist on. So the only tax they can take at that point is the inflation tax. This forces them to accelerate the inflation to suck a constantly shrinking amount of value out of the population.

And if Fekete is correct, we may only be a few months away from hyperinflation.

All I can say is... got gold?

FOFOA