9 December 2008


Imagine my surprise when I learned that mainstream economists have also discovered gold as the only instrument to give teeth to time preference that would otherwise remain but a pious wish. See in particular the joint paper of Barsky and Summers. The correlation between the rate of interest and the price level under a gold standard was named 'Gibson's Paradox'. Paradox, because monetary theory according to Keynes would call for a correlation between the rate of interest and the rate of change (rather than the level) of prices. Gibson's, because Irving Fisher named Gibson as the first author to make this observation. Keynes stated in 1930 that two centuries of data failed to confirm that a correlation existed between the rate of interest and the rate of inflation. Instead, between 1730 and 1930, the rate of interest and the price level showed a positive correlation which Keynes described as "one of the most completely established empirical facts in the whole field of quantitative economics". No one has been able to come up with a full theoretical explanation. Friedman and Schwartz in 1976 concluded that "the Gibsonian Paradox remains an empirical phenomenon without a theoretical explanation". It was not for want of trying, either. Irving Fisher wrote in 1930 that "no problem in economics has been more hotly debated". Barsky and Summers also state that "Gibson's Paradox has proven to be an especially stubborn puzzle in monetary economics".

Yet to find the key to the 'paradox' we have only to observe that suppression of the rate of interest will intensify gold hoarding by the marginal bondholder which, under a gold standard, squeezes bank reserves and leads to a falling tendency of the price level. Conversely, we observe that when the rate of interest rises the marginal bondholder will, in buying the gold bond, release hoarded gold. Increase in the quantity of monetary gold increases bank reserves, and leads to a rising tendency in the price level. The 'Gordian knot' finds its 'snap solution' in Menger's concept of marginal utility.

The regime of the irredeemable dollar

The validity of Gibson's Paradox clearly extends to the regime of the irredeemable dollar with a variable gold price. It varies directly with the price level. In particular, as the irredeemable dollar loses purchasing power, the price of gold will rise for the stronger reason. In terms of Gibson's Paradox, the price level rises less if the rate of interest is suppressed; otherwise it rises more.

Properly interpreted, there has never been an episode in history when Gibson's paradox failed to operate. It is the empirical description of the apodictic truth that suppression of the rate of interest brings about increased gold hoarding, subject to leads or lags. Every ounce of hoarded gold is a testimony to the fact that somebody, somewhere, has found the quality of savings instruments, and their yield, inadequate. By making the regime of irredeemable dollar non-negotible, the U.S. government has foolishly deprived itself of the possibility to channel people's savings into 'socially more useful' applications. Therefore it is the government, not the people, that is to be blamed for the present negative savings rate in the United States.

Government manipulation

In Part 1 I advanced the hypothesis that the U.S. Treasury and the Federal Reserve have been manipulating both the rate of interest and the price of gold. In more details, they encourage bull speculation in bonds and bear speculation in gold. They do it by making unlimited quantities of bonds available for the speculators to buy, and unlimited quantities of paper gold available for them to sell in the derivatives markets. Lures, in the form of risk-free profits, are planted along the path of the speculators.

Clandestine government policy to manipulate the bond and gold markets is revealed by statistics on the number of outstanding contracts in derivatives, showing an inordinate open interest in bonds on the long and in gold on the short side. Neither has any rhyme or reason to exist, in view of the underlying economic reality. What is more, the long interest in bond and short interest in gold derivatives are increasing exponentially, far outpacing the amount of bonds in existence, and the amount of gold available for delivery. Significantly, there is an extreme concentration of derivatives in the hands of three or four firms on the long side of the bond market, and on the short side of the gold market.

A most alarming development occurred recently as observed by Pinank Mehta on (October 6). The net long open interest of the 10-year US bond contract, as reported by Morgan Stanley Research, has increased explosively and is now greater than six standard deviations. This level is unprecedented.

The Twin Towers of Babel

In Part 1 I explained why the government was interested in manipulating speculators so that they compulsively construct such uneconomic Twin Towers of Babel. The purpose of Part 2 is to show that, in view of Gibson's Paradox, there is a conflict involved in the dual manipulation. In fact, the two desiderata in the agenda of the government: the propping up of the bond price and the suppression of the gold price, are contradictory. In encouraging bull speculation in bonds the government prompts more gold hoarding, making gold scarcer and the gold price more buoyant still. On the other hand in encouraging bear speculation in gold, in so far as it is effective, gold hoarding is reduced pushing interest rates higher. Rather than canceling out, the two effects could ratchet up both the gold price and the rate of interest simultaneously. As a result, the Twin Towers will self-destruct in due course.

The regime of the irredeemable dollar is subject to the 'sudden death syndrome', a malady afflicting all fiat currencies with a 100 percent fatality rate. Creditors know this, and add a risk-premium to the rate of interest they charge on their loans. If it weren't for bond derivatives, the dollar would have gone the way of the assignats and mandats already in the twentieth century. But the government plants lures, to induce speculators to buy the bonds. This keeps interest rates low, and props up the dollar.

However, in terms of Gibson's Paradox, the suppression of the rate of interest means increased gold hoarding. To counter that threat, the government has to have recourse to a devious scheme to induce speculators to sell unlimited amounts of gold through the gold derivatives market. In Part 1 I described an imaginary mining concern, Sarrick Gold, with a phony hedge plan involving forward selling, to the exclusion of forward buying, of gold. Speculators are offered risk-free profits on the short side of the market. All they have to do is to pre-empt Sarrick's forward selling strategy, that is, sell before Sarrick does.

Thus the Twin Towers of Babel, the long-bond pyramid and the short-gold pyramid, are interdependent. Neither one will prosper without the other prospering. Conversely, if one topples, so will also the other. It follows from standard theory of speculation that, in commodities, a short position constitutes unlimited risks, as opposed to a long position the risk of which is limited as the price cannot fall below zero. This suggests that the inordinate, fast-increasing and extremely concentrated short interest in gold is vulnerable and will act as a trigger when it gets wounded (that's what the word 'vulnerable' makes you expect to happen). Delivery may encounter difficulties, backwardation may develop in gold futures, and the weakest link in the short chain may snap. Some shorts may default. That would cause other short positions cascade and defaults spread. The collapsing gold basis will accurately gage the development leading to the toppling of the short gold pyramid. In an earlier paper entitled: The Last Contango in Washington I conjectured that the collapsing silver basis may act as an 'early warning system' to herald the coming collapse of the gold basis.

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