9 July 2009

THE VANISHING OF THE GOLD BASIS and its implications for the international monetary system

THE VANISHING OF THE GOLD BASIS and its implications for the international monetary system A paper presented at the Santa Colomba Conference on the International Monetary System at the Palazzo Mundell, July 2009. Antal E. Fekete San Francisco School of Economics The basis for agricultural commodities shows a clear annual cyclical pattern that closely follows the crop year. It starts with contango just after harvest, and ends with backwardation when supplies are drawn down just before the new crop is brought in.

The behavior of the gold basis lacks this cyclical pattern characteristic of the markets for agricultural goods. Contango obviously follows the fluctuations of the interest rate up or down, the adjustment being practically instantaneous. But, in addition, there is a rather curious phenomenon that can be described as the secular vanishing of the gold basis. This means that, as a percentage of the carrying charge (interest) the gold basis has been steadily eroding and by now has all but reached zero. Reversals in the trend, if any, are minor and temporary. It is difficult to imagine any combination of circumstances in which there could be a major reversal in the trend of the gold basis, unless there was an explosion of interest rates.

It is incumbent upon economic theorists to explain the peculiarity of the secular vanishing of the gold basis, which is not observed in the case of the basis of other non-agricultural commodities such as the base metals, for example.

The overwhelming fundamental fact about gold during the past half a century is the steady and relentless absorption of new supplies from the mines through individual hoarding demand. Half a century of gold production at peak rates of output has disappeared without a trace and is by and large unaccounted for. This is more gold than had ever been produced previously. At the same time also absorbed was whatever monetary gold governments and central banks have in their wisdom dishoarded.

It can hardly be doubted that if further supplies of monetary gold were dishoarded, it would be easily absorbed as well, and any setback in the price of gold on that account would be temporary. One should also remember that net dishoarding of gold by governments and central banks is a thing of the past. Countries such as China, Russia, Brazil, to mention but a few, are on record as wanting to buy all the gold they can without unduly disturbing the price. This means that the combined net private and official demand for gold will be insatiable for the foreseeable future. This is in full agreement with the secular vanishing of the gold basis.

The burning question is what happens when gold markets go to permanent backwardation, as is likely if present trends continue. Clearly, the gold futures markets will be no longer viable as they are presently constituted. The main source of gold for investment purposes will be permanently shut, as a negative gold basis means that all offers to sell cash gold have been withdrawn. To see this we have only to remember that paper gold promising future delivery can no longer be trusted under the regime of a negative basis, as explained above. The huge volume of trade in paper gold would disappear with the advent of permanent backwardation.


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