Professor Fekete's Calls for the Return of Sound Money.

PREMATURE OBITUARIES

Antal E. Fekete

It is open season for wild monetary prognostications. More premature obituaries on
the dollar have been posted on the Internet. For example, see Jim Willie’s The US
Dollar Paper Tiger (Gold-Eagle, January 11) with epitaphs like “the U.S. dollar
rising to the cemetery”, or “dollar death dance”. Or see another article, Jeff
Nielsen’s entitled Maximum Fraud in U.S. Treasurys (Gold-Eagle, January 3). It
betrays maximum misunderstanding about keeping the dollar on a life-support
system. It assumes that the Fed and the U.S. Treasury are fighting tooth and nail to
keep the value of government debt high lest it collapse in want of support from
Japan, China, and other countries.

 These views hang the picture upside down. In actual fact, the Fed and the
U.S. Treasury desperately want to beat down the value of the dollar. The greatest
obstacle frustrating their effort is the stubbornly high and still increasing value of
U.S. Treasurys. Captains of the world’s monetary system are yanking levers and
twisting throttles which are no longer connected to anything. The captains are no
longer in control. Yet they continue to wave their batons feverishly and pretend
that the orchestra is paying attention. They want Jim Willie, Jeff Nielsen and
everyone else to believe that the falling interest-rate structure is the outcome of
their deliberate monetary policy. In fact, the Fed and the U.S. Treasury are trying
to stop the rate of interest from falling further. They instinctively realize the threat
of falling interest rates brings deflation and depression in its train. The dollar is
much too strong, contrary to the wishes of policy-makers. It is not so easy to beat
down the value of the dollar as suggested by Keynesian textbooks, even if you
have the key to print shop where the presses are running. The dollar’s strength
prevails in spite of the withdrawal of Chinese and Japanese support of the U.S.
bond market, and in spite of the destructive monetary policies of the American
guardians of the dollar.

This observation reveals the prevailing profound misunderstanding about the
nature of this financial crisis. To set the matter right, in this article I shall
recapitulate the argument that I have been presenting on the Internet for the past
ten years.

Where Keynes went wrong

At the heart of my theory is speculation, the main driving force of the huge
oscillating money flows between the commodity market and the bond market. It
can, and often does, overrule official monetary policy.

 It is well-known that Keynes had a poor understanding of speculation. His
occasional excursions to the pits resulted in significant financial losses for him. No
more successful was he as a theorist. For example, he introduced the concept of
normal backwardation as the main underlying feature of the futures market. He
insisted that in buying futures contracts speculators demand - and receive -
compensation for their services as ‘insurers’ in return for carrying the price risk
that owners of physical commodities and first order financial assets are unable or
unwilling to carry. First order financial assets such as stocks, bonds, foreign
exchange, mortgages must be carefully distinguished from higher-order financial
assets such as futures and options on first order financial assets, options on futures,
options on options on futures, and so on and so forth ad libitum. Keynes did not
live to see the rise of higher order financial assets. He called the insurance
premium speculators pocket when their contracts mature ‘normal backwardation’.

 Backwardation is the name for the market condition under which futures are
offered at a discount relative to physicals. Keynes is putting things upside down.
The futures market, far from being an insurance-operation, is in fact a market for
warehousing services. The warehouseman buys the physicals and sells the futures
as a matter of arbitrage. But he can do that only if the future price is at a premium
over the cash price. This condition is known as contango, which is the exact
opposite of backwardation. For example, at harvest time cash wheat is plentiful
and contango is robust. The elevator operator, our warehouseman, is buying cash
wheat against selling wheat futures. In doing so he performs a useful service to
society: that of warehousing and rationing the wheat supply until the next crop
comes around a year later. The premium, the difference between the futures price

and the cash price is his fee for the service. To create this arbitrage opportunity
was the main justification for starting futures trading in wheat and in other
agricultural commodities in the 19th century, when the monetary unit was a positive
rather than a negative value. Notice that nature is responsible for the fluctuation in
the price of agricultural commodities: weather, unforeseen natural disasters, climes
and other things over which man has no control.

All this has changed when, at the behest of Keynes, governments exiled gold
from the monetary system and embraced a negative value, debt, as the monetary
unit. As an immediate consequence a lot of new futures markets sprang up, chief
among them the futures market for foreign exchange and the bond market. In these
the cause of fluctuation was no longer nature. Instead of nature-created risks, here
futures trading addressed artificial risks created by man. Keynes blithely assumed
that futures trading would have the same stabilizing effect on the price of these
financial assets as it did in on the price of agricultural commodities. This was his
worst blunder. When man or a committee of men rather than nature calls the shots,
speculation becomes destabilizing. The nature of speculation has changed beyond
recognition. In the first scenario when nature alone calls the odds all speculators
start with equal chances. No combination of bets is capable of changing the odds.
This is no longer the case when risks are man-made. In this case speculation
assumes the character of gambling. Here speculators (gamblers) are matching their
wits against that of the house. Here, given a bottomless purse, a combination of
bets can indeed change the odds. The gamblers can even beat the house. We have
seen it happen time and again: speculators in foreign exchange or bonds won and
the government or the banks had to take huge losses.

It would be more reasonable to talk about normal contango than about
normal backwardation, the obsession of Keynes. Backwardation in many ways is
an anomaly. If and when it occurs, it indicates scarcity. In case of scarcity there is
no need for warehousing. Keynes got it all wrong.

The problem of warehousing applies to gold par excellence, which owes its
status as the monetary commodity (independently of the wishes of governments
and banks) to the size of stocks which are large relative to flows which are meager.
The stocks-to-flows ratio of gold is a high multiple, in contrast with that of copper,

for example, which is a small fraction for reasons of its fast declining marginal
utility.

If gold is forcibly divorced from money by order of the government, or to
say it differently, if a negative value such as debt is foisted upon society as the new
monetary unit, then the price of gold will fluctuate inviting speculation and gold
futures trading. The gold futures market, if it is to function at all, must be a
contango market. Otherwise it would give an opportunity to speculators to make
risk free profits (they would buy cash gold at a discount and sell futures at a profit).
That would immediately eliminate the discount on gold futures (making a mockery
of Keynes’ normal backwardation.) However, in the case when gold is scarce as a
result of flight from paper currencies, permanent backwardation of gold puts in an
appearance. This sounds the death knell of the regime of irredeemable currencies.

Not only did Keynes misunderstand speculation, but he also completely
misconstrued the God-ordained role of gold in society. He did not see that variable
foreign exchange rates would ultimately undermine paper currencies and bond
values due to gold hoarding. Moreover, vanishing confidence in foreign exchange
rates and bond values could be directly measured in terms of vanishing contango.
Ultimately, all monetary gold would be driven into hiding. The biblical writing on
the wall “Mene tekel upharsin” (you have been put on the scale and found
wanting) would become reality in a literal sense.

Ever since gold futures markets started trading in the early 1970’s, they were
subject to the Law of Vanishing Contango. It was never properly understood by the
so-called experts or by anyone else. While nobody could predict when contango
would go into permanent backwardation, it is certain that when this ominous event
happens, the music stops and the game of musical chairs is up. Mainstream
economists ignore the problem of permanent backwardation in gold. They do it at
their own peril.Keynesian/Friedmanite economics is going to be shipwrecked on
the reef of permanent backwardation. Irredeemable paper currencies which they
have spawned will be ignominiously wiped off the face of the earth.

Economic resonance

When at the behest of Keynes foreign exchange rates were deliberately
destabilized, a couple of other ominous things happened. Most importantly, interest

rates were also destabilized that made an old phenomenon, the Kondratiev long-
wave cycle self-boosting, leading to runaway-vibration. As may be recalled, this
rather rare physical phenomenon caused the Tacoma suspension bridge in
Washington state plunge into the river in 1940. Parcels of energy bombarding the
bridge in gusting winds resonated with one of the characteristic harmonic
frequencies of the bridge. As a result total energy, rather than dissipating
harmlessly, kept piling up. It ultimately overwhelmed the statics of the bridge.
Engineers have forgotten to take runaway resonance into account when the bridge
still existed only as a blueprint. Likewise, designers of the regime of irredeemable
currency have failed to consider economic resonance. Runaway vibration exists in
economics whether recognized or not. It can destroy currency and bond values just
as it can destroy bridges.

 I describe the present economic crisis in terms of economic resonance. The
economy experiences oscillating money-flows between the commodity market and
the bond market. When money flows from the bond market to the commodity
market, we witness the inflationary phase of the cycle. Inevitably, rising interest
rates accompany this phase. At the top of the cycle the money-flow will reverse
itself and will go from the commodity market to the bond market. This is the
deflationary phase of the long-wave cycle that, no less inevitably, is accompanied
by falling interest rates. These huge money-flows are driven by speculation. There
is a linkage between the price level and that of interest rates compelling them to
move in the same direction (always subject to leads and lags). Furthermore, the
two resonate. It is altogether too naïve to suggest that the government is equipped
to control the phenomenon of economic resonance. As the story of King Canute
shows, tides of the sea cannot be turned back by royal proclamation.

 For centuries the Kondratiev cycle has been kept on a leash. Resonance was
always damped so that vibration could never reach runaway levels. Neither prices
nor interest rates were allowed to grow indefinitely. At one point the policeman
would stop their march and turn them back. The policeman was none other than the
gold standard.

 The regime of irredeemable currency fired the policeman and resonance has
become self-boosting. Runaway vibration is in the making. When the energy level
of the self-boosting system overwhelms centripetal forces, the system snaps like a

broken chain, releasing the surplus energy most destructively. This is the substance
of every crack-up boom. Like Mises, I also object to the use of the word
hyperinflation, albeit for a different reason. It suggests that the phenomenon is
linear and follows the laws of the Quantity Theory of Money. The more money is
printed, the higher do prices go. However, we are here facing highly non-linear
phenomena. Our economy is torn to pieces by runaway vibration. We are
victimized by the self-destruction of the monetary system subjected to oscillating
money-flows boosted by the resonance of fluctuating interest rates resonating with
fluctuating prices.

The vampire of risk free bond speculation

Another ominous thing happened when, at the behest of Keynes, foreign exchange
rates were deliberately destabilized. Monetary policy has become counter-
productive. When the central bank intervenes in the market to control the rise of
interest rates, it inadvertently makes prices fall; and when it intervenes to stop
prices from falling, it inadvertently makes interest rates rise. The upshot is that the
central bank intervention, rather than tempering movements, aggravates them.

 Once more, the source of the trouble is Keynes’ poor understanding of the
dynamics of speculation. Whether combatting inflation or whether combatting
deflation, the central bank has only one policy tool, namely, printing more money.
Keynesian economics pretends that the central bank operates in vacuo. It can
assume away any and all side effects. But there is one side effect it certainly cannot
wish away, and that is bond speculation that follows the central bank like the
shadow follows the thief. The bond market is huge, exceeding the equity market in
size more than ten-fold. Equally huge is its speculative following.

 When the central bank wants to control rising interest rates, then it goes into
the open market to be a net buyer of Treasury bonds. Inevitably, speculators want
to preempt the central bank. They strive to buy the bonds first, dumping them into
the lap of the central bank at a higher price afterwards. Speculators are making risk
free profits. The central bank is helpless. It has to pay the speculators’ price.

 Likewise, when the central bank wants to control falling prices, it goes into
the open market to be a net buyer of Treasury bonds. Speculators will gratefully
take the new money so created. Of course, the central bank wants them to buy

commodities to prevent prices from falling. However, speculators have a better
idea. They go to the bond market where the fun is. Commodities are too risky for
their taste, especially when they can make risk free profits in bonds. The risk free
profits speculators make are made possible by Keynesian monetary policy.

 This is the fundamental flaw of Keynesian economics. At the present
junction the Fed is buying bonds to combat deflation. Bond speculators know this,
will buy the bonds first driving down interest rates in the process. The result is
more deflation, not less. The Keynes-inspired central bank action is counter-
productive. Policy-makers are blind and don’t see this. They stick to their self-
defeating monetary policy. They actually become the quartermaster general of the
depression they are trying to avoid. As if cursed by a particular kind of madness,
policy makers saddle society with the vampire of risk-free speculation. They turn
the constructive energy of stabilizing speculation into a most destructive kind of
energy: destabilizing speculation. The problem cannot be cured because bond
speculation cannot be eliminated. It should be clear that as long as the world does
not succumb to a military conflagration such as a world war destroying supplies of
goods and production facilities, the danger is not inflation as predicted by the
Quantity Theory of Money. The danger is deflation due to risk free-profits with
which Keynesian economics inadvertently tickles speculators.

 It is suggested that the world is facing an imminent inflationary collapse of
the dollar for reasons of over-issue. But what the world is getting is a deflationary
collapse of the economy, as a result of the obtuseness of academic economists and
policy-makers sold on Keynesian economics. They fail to see in the collapse of the
rate of interest the inherent destruction of capital. Businessmen are lethargic. They
know that making new investments while interest rates keep falling is suicidal. No
matter how low interest rates may go, their competitors who invest later will have
the advantage of investing at lower rates still.

Destruction of the wage fund

The German economist Heinrich Rittershausen (1898-1984) predicted the
horrendous unemployment that was to hit the world economy in the 1930’s in
terms of the destruction of the wage fund. He pointed to the failure after World
War I to rehabilitate the real bill market. The victors in their conceitedness ignored

the fact that the wage fund, out of which workers could be paid up to 91 days in
advance of the sale of merchandise they are producing, was part of the volume of
circulating real bills. When the bill market was destroyed in consequence of the
deliberate decision not to allow real bill circulation to return after hostilities ended,
the wage fund was destroyed along with it. There was no one to advance the funds
out of which wages could be paid for labor whose product has not been and may
not be sold for up to 91 days. But workers could not wait 91 days to buy food,
clothes and shelter for themselves and for their offspring. In the absence of a wage
fund employers had no choice but to lay off their employees.

 Rittershausen was ignored by economists in the Anglo-Saxon countries. His
message is still being ignored in the world today. But make no mistake about it,
unless gold bill trading is rehabilitated soon, the world will face a new wave of
unemployment far worse than that of the 1930’s. This also confirms the
deflationary diagnosis for the present crisis.

 The majority of hard-money analysts call for a hyperinflationary collapse of
the dollar. Their analysis is faulty. Like a cornered rat, the dollar is capable of
putting up a vicious fight for survival. In the words of Mark Twain, all the
obituaries on the dollar are premature. The dollar is not a push-over. A yen-yuan
coalition (or any other combination of existing or yet to-be-invented fiat
currencies) cannot send it into oblivion.

To say that the dollar is strong is not the same as saying that is also healthy.
In fact the irredeemable dollar is terminally ill. The reason for this is its departure
from constitutional money. The Constitution mandates a metallic monetary system
for the United States. Nothing shows the bad conscience of our monetary
leadership more clearly than the fact that they could never muster up enough moral
courage to propose a Constitutional amendment giving the federal government the
power to establish a monetary unit based on negative values such as debt.
Cheerleaders for fiat money in academic circles, in the media, and in financial
journalism will not be able to live down the shame that will be their lot when the
world economy collapses. The excruciating economic pain that people will suffer
as a consequence will be their responsibility. The break-down in law and order will
be their fault. As history and logic conclusively prove, fiat money is not a viable monetary system. It is prone to succumb to the sudden death syndrome. Whether
caused by inflation or whether caused by deflation, sudden death is assured.

It should not be beyond the wit of human intelligence to see this coming and
fend off the disaster by making a timely return to sound money, based on a
monetary unit of a positive value as mandated by the American Constitution.

January 13, 2012.

Professor Fekete's Website