Gold Loans and Reversing a Model’s Line of Causation

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The 1970s was a crucial turning point in the history of 20th century gold markets. The costs of the Vietnam War and increased domestic spending had the effect of accelerating inflation. Meanwhile, US gold stock declined to $10 billion versus outstanding foreign dollar holdings estimated at about $80 billion.[1] Prior to that, the London Gold Pool made up of seven European central banks and the US Federal Reserve, a group which cooperated in maintaining the Bretton Woods System, found itself increasingly unable to balance the outflow of gold reserves and defend the fixed gold price of US$35.[2]

On August 15, 1971, President Nixon, a self-proclaimed Republican “conservative,”[3] imposed a 90-day wage and price control program and other various expansionary fiscal policies in what became known as the “Nixon Shock”[4]. Most importantly, Nixon closed the gold window to prevent foreign governments that had been holding dollar-denominated financial assets from demanding gold in exchange for their dollars. By March 1973, all of the major world currencies were floating and in November 1975, the G-7 (i.e, Group of Seven) formed to hammer out the final details on a framework for a new monetary system. That agreement, which was finalized in January 1976, called for an end to the role of gold, the establishment of SDRs as the principal reserve asset, and legitimized the de facto system of fiat currencies and floating exchange rates.

The reason for retelling this story is because these events, along with a collapse in gold prices after peaking on January 21, 1980 at the high price of $850, led directly to formation of the gold leasing market during the mid-1980s. Gold loans evolved as a means for central banks to earn a return on their bullion inventories to cover the cost of warehousing bullion[5][6] by leasing gold in exchange for a lease rate. This rate is derived from the difference between the LIBOR and Gold Forward Offered (GOFO) rate.[7] Alternatively, a central bank could swap gold in exchange for currency such as US dollars.

A leasing transaction involves a central bank transferring ownership to a leasing institution (i.e., borrower), who could then sell the gold on the spot market and invest the proceeds. At a later date, the borrower would buy back the gold and return it to the central bank while paying the lease rate. Because gold could be leased at a relatively low rate from the central bank and then sold quickly on the spot market, participants in this market included gold producers who thereby gained cash to finance gold production at a comparatively low rate of interest, while simultaneously hedging against falling gold prices.[8]

The market for gold loans developed quickly after the October 1987 stock market crash left many mining companies with reduced access to capital. Prior to 1990, GOFO rates for gold normally were below 2 percent on an annualized basis and never exceeded 3 percent, providing an inexpensive source of finance for mining companies.[9] The Financial Times reported that some 30 central banks were estimated to have engaged in gold loans around this time.[10] Then in 1990 Drexel Burnham Lambert collapsed with large outstanding gold liabilities to many central banks, resulting in increased wariness and reduced supply of gold loans from central banks.[11] As a result, lease rates rose reflecting an increased tightness in the market after the loss of central bank suppliers, as well as a substantial risk premium over the implicit cost of providing such loans.

Nevertheless, the market for gold loans grew throughout the 1990s, and an informal global interbank system developed permitting dealers to borrow gold on a short-term basis in order to fulfill delivery requirements. When bullion subsequently dropped below $300 an ounce in late 1997, and drifted in that range through 2002 in what is now referred to as the “Brown Bottom,”[12] the gold carry trade came to dominate the derivatives markets. Gold’s steady appreciation since 2002, however, has rendered this trade obsolete. As a result, there has been a wholesale transformation in the gold market since the millennium began.

In a research paper published by the Swiss Finance Institute (SFI) titled, On the Lease Rate the Convenience Yield and Speculative Effects in the Gold Futures Market, the authors examine this aspect of the gold market in detail. They note that, “…since late 2001, the profitability of the carry trade has diminished. Rising gold prices have increased risk and diminished the trade’s profitability as a result of increasing repayment costs. Consequently, the prevalence of the gold carry trade is predicated on two factors: the rate at which the central bank is willing to swap or lease gold, and whether or not the gold price is increasing.” Further, the authors Barone-Adesi, Geman and Theal (2009) observe that the COMEX “is witnessing historically low derived lease rates, decreasing hedging activity and steadily rising non-commercial open interest.”

The reason why is because the gold carry trade is risky on two dimensions. First, if the borrower invests in long-term bonds, rising interest rates could cause downward pressure on bond prices exposing the leasing institution to principal risk. Second, since the borrower is effectively short gold, if the loan is called by the central bank and gold has risen in value, they may have to purchase gold at a higher price in the spot market. Hence, there always exists the potential of driving up gold prices even higher due to short covering. This unwinding of the carry trade, as with other similar trades (e.g., yen carry trade), can result in volatile markets.

The question then is to what extent is speculation having a “tangible effect” on gold valuations, and “if so, by what mechanism does speculation influence prices?” The SFI paper points out other academics, such as Kocagil (1997), who defined “speculative intensity” as the “spread between the futures and expected spot price,” and concluded that “speculation increases spot price volatility and thus has a destabilizing effect on price.” Another researcher, Abken (1980), based his analysis on the intuition that the only return that gold yields is based on the anticipated appreciation of gold above “any marginal costs associated with the storage of gold.” Abken argues that, “during times of uncertainty, excess demand for gold as a store of value [drives] up the spot price causing stored gold to be brought to market.”

The authors of the SFI paper, on the other hand, base part of their methodology on the work of Houthakker (1957), one of the first researchers to use trader commitment data to study speculation. To understand how speculative agents can affect the gold futures market, Barone-Adesi et al. (2009) examine the open interest data from the CFTC Commitment of Traders (CoT) report, thereby identifying commercial open interest with hedging activity, and conversely, non-commercial positions with speculative activity. The authors also study the relationship between gold leasing and the level of COMEX discretionary inventory.

Not surprisingly, Barone-Adesi et al. (2009) arrive at some obvious conclusions: First, they note an ever-increasing percentage of non-commercial open interest reflects increased speculation in the gold market. Second, “the lease rate and the speculative pressure appear to work in opposition to one another; the former acts to decrease short-term bullion inventories via lease repayments, while the latter result suggests speculators dominate leasing activity in the long term… Finally, the presence of speculation in gold futures contracts can be associated with increased futures contract returns and that this effect increases with increased futures contract maturity.” What these observations suggest in their entirety is that “speculation plays a significant role in the COMEX gold futures market” as opposed to hedging activities.

Uh, okay… but isn’t this a foregone conclusion? Albeit, On the Lease Rate the Convenience Yield and Speculative Effects in the Gold Futures Market derives its determinations from some interesting theoretical ideas between the relationship of gold loans, bullion inventories, convenience yield and speculation; but in the final analysis this paper raises the specter of Muth’s (1961) Rational Expectations and the Theory of Price Movements: “In order to explain fairly simply how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant economic theory.”

In other words, models unfortunately have the bad habit of assuming a predetermined conclusion around which expectations are formed, which in effect reverse the model’s line of causation. Our conclusion: research bias, the process where the scientists performing the research influence the results in order to portray a certain outcome, seems to be at work here—even though we happen to agree with Barone-Adesi, Geman and Theal's conclusions.

On the Lease Rate and Convenience Yield of Gold Futures

Footnotes:
[1] Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed. (originally published 1977). Boston, MA: Wadsworth Cengage Learning.

[2] Bordo, Michael D., and Barry J. Eichengreen (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. University of Chicago Press. pp. 461–494 “Chapter 9, Collapse of the Bretton Woods Fixed Rate Exchange System” by Peter M. Garber.

[3] Nixon tape conversation No. 607-11.

[4] “The Economy: Changing the World's Money” Time Magazine, Oct. 4, 1971 [First reference by Time of “Nixon Shock”]; http://www.time.com/time/magazine/article/0,9171,905418,00.html

[5] “Bullish on Bullion” by Peter Madigan, Risk Magazine, Feb. 1, 2008, Incisive Media Ltd.

[6] According to O’Callaghan, Gary (1991), two key disadvantages in holding gold as opposed to a financial instrument are storage costs and the fact that holding gold does not bear interest.

[7] Barone-Adesi, Giovanni, Geman, Hélyette and Theal, John (2009). “On the Lease Rate, the Convenience Yield and Speculative Effects in the Gold Futures Market” (March 12, 2009). Swiss Finance Institute Research Paper No. 09-07.

[8] O’Callaghan, Gary (1991). "The Structure and Operation of the World Gold Market" International Monetary Fund, IMF Working Paper WP/91/120, Master Files Room C-525, p 33.

[9] Ibid. pp 33-34.

[10] Gooding, Kenneth, “Gold Lending Rate at Record Level,” Financial Times (London), Dec. 4, 1990, p 34.

[11] “Fool’s Gold,” The Economist, Mar. 17, 1990, p 79.

[12] Term used to describe the period between 1999 and 2002, named from the decision of Gordon Brown, then the UK's Chancellor of the Exchequer to sell half of the UK's gold reserves in a series of auctions.

References:
Barone-Adesi, Giovanni, Geman, Hélyette and Theal, John (2009). “On the Lease Rate, the Convenience Yield and Speculative Effects in the Gold Futures Market” (March 12, 2009). Swiss Finance Institute Research Paper No. 09-07.

Bordo, Michael D., and Barry J. Eichengreen (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. University of Chicago Press. pp. 461–494 “Chapter 9, Collapse of the Bretton Woods Fixed Rate Exchange System” by Peter M. Garber.

O’Callaghan, Gary (1991). “The Structure and Operation of the World Gold Market” International Monetary Fund, IMF Working Paper WP/91/120, Master Files Room C-525

Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed. (originally published 1977). Boston, MA: Wadsworth Cengage Learning.

Prisoners Dilemma on the Paradox of Solution

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Of all the inhabitants of the inferno, none but Lucifer knows that hell is hell, and the secret function of purgatory is to make of heaven an effective reality. ~Arnold Bennett, English novelist (1867 – 1931)

Martin A. Armstrong is a man who is spending time in purgatory—both literally and figuratively. For those not aware, Armstrong is the former chairman of Princeton Economics International Ltd. indicted in 1999 on charges of bilking Japanese investors. He languished seven years in jail for contempt of court, supposedly the longest someone has ever been held without trial in United States history. All the while, Armstrong claimed that he was innocent of the fraud itself before finally pleading guilty in 2007. He is now serving a five-year sentence for conspiracy to commit fraud.[1][2]

Said to be “bizarrre (sic) and eccentric,” this “notorious… self-professed expert in the history of money and things gold”[3] is also a prolific writer whose narrative is the kind of grist for the mill influencing Matt Taibbi’s “investigative journalism”.[4] It is therefore not surprising, given Armstrong’s incarceration and his self-claimed title as “America’s #1 Political Prisoner,” to discover that his writings are tinged with conspiracy theories. On the other hand, as Kissinger once noted, “Even a paranoid can have enemies.”[5] Regardless you are probably asking, why devote time discussing The Paradox of Solution if Armstrong’s credibility is questionable? [Article continues below embedded paper.]

The Paradox of Solution 4-18-10


To begin with, notwithstanding the background context it’s a short and interesting read, and for someone who you would expect to “rail against the machine” it comes as a surprise to learn that Armstrong defends the establishment. Well, at least in regards to the “original intent” of the Federal Reserve and his implied support for the Volker rule. On this and the U.S. Government’s evolving policy response to the financial crisis, Armstrong reveals himself to be a man seemingly caught between faith and skepticism. His voice predictably adds to the chorus of doomsayers, but then he lends ineffectual advice as to how we can avoid our fate.

Second, while some may argue that Armstrong suffers from the Dunning–Kruger effect, the literary tradition of the wise fool who “speakest but sad truths”[6] provides reason enough to read The Paradox of Solution. As William S. Burroughs’ once said, “Sometimes paranoia’s just having all the facts.” And where Armstrong’s essay becomes truly fascinating is in our humble opinion the last third of the article where he begins to discuss that “meaningless and intangible social construct,”[7] money.

When money was tangible, debasement was the game. Hence, I’m sorry, but a GOLD & SILVER STANDARD will not eliminate inflation! Those who argue for “sound money” just do not understand that what is money, is far less important than WHO controls money. Politicians from ancient times have always sought to make just a little bit more to cover their spending that has never been responsible. Some have needed money desperately to defend the nation as was the case in Athens. Others just wanted to spend more to have nice things like Nero. Regardless of the reason, it is WHO controls the quantity and quality of money that truly matters—NOT what is actually money!

There is a video on the Intertubes[8] featuring a “steel cage death match” on the subject of “inflation versus deflation” between James Grant, founder of the venerable Grant's Interest Rate Observer, and the well-respected David Rosenberg, chief economist with Canada’s Gluskin Sheff & Associates [see: http://tinyurl.com/2dbgcvb]. Say what you will about Armstrong, but in both this debate and a March 31, 2010 Bloomberg interview with Keith McCullough, James Grant had the nerve to ask a most important matter of faith, ‘what is the US dollar?’

But maybe that’s the trouble with Treasuries. The fundamental trouble is that they are IOUs denominated in a currency that nobody knows what it is. What’s a dollar? What’s a dollar? David can’t tell me. Nobody can tell me. If Alexander Hamilton were here, and unbriefed (sic) on the events of the past two hundred years, he could tell me. And what he would say is that the dollar is defined as 371 and ¼ grains of pure silver, or 24 and ¾ grains of pure gold. And it was too under the 1792 Coinage Act which Hamilton himself wrote. And those were the definitions, and incidentally, Section 19 of that landmark monetary legislation ends in these telling words, quote “shall suffer death” closed quote. Now, can you tell me what kind of felony was punishable by death under an Act to regulate the mint? The act of debasing the currency was—that was a capital offense. So watch your back Ben Bernanke [audience laughter], cycles turn. [Time: 8’50”]

Nevertheless, “cash is king,” especially in a liquidity crisis; however, for cash to function as a means to discharge debt, then the largely unasked question is: what defines cash as cash?[9] Such philosophical musings may seem from the realm of madmen or fools, but when the highly respected James Grant half-jokingly references the following satirical article by The Onion, U.S. Economy Grinds to Halt As Nation Realizes Money Just A Symbolic, Mutually Shared Illusion,[10] you know that something is amiss. But what exactly?

Armstrong, alluding to a collective fear of what the future holds for “Western dominance,” strikes at the very heart of the matter. In hunter-gather societies, “there is no TRADE because there is no concept of the future as we understand it… In order for society to have created a concept of money, there had to have been the realization that there is a tomorrow. Something of VALUE is now to be stored and retained… Once this concept of future was born yielding the idea of VALUE, everything from banking to derivatives began to emerge even in ancient times… The concept of barter thus emerged with the concept of future. Then, money emerged as a universal language of barter… The wealth of a nation emerged from the productive forces of its people.”

According to Ludwig von Mises, “The concept of money as a creature of law and the state is clearly untenable. It is not justified by a single phenomenon of the market. To ascribe to the state the power of dictating the laws of exchange, is to ignore the fundamental principles of money-using society.”[11] Armstrong echoes this sentiment, “It is nice to create a unrealistic view of a world where all we have to do is restore a gold standard and all will be well.” But then he turns around and disagrees with Mises, “It is not what is money, but who controls it that has always counted.”

Armstrong seems to view the world as a top-down establishmentarian exercise by a political class, which in turn he rails against. But with respect to the “control” of money, it has not always been true that this was the function of government. Alessandri and Haldane (2009), who reference Reinhart and Rogoff (2009) in their paper Banking on the State, clarify monetary history for us: “From the earliest times, the relationship between banks and the state was often rocky. Sovereign default on loans was an everyday hazard for the banks, especially among states vanquished in war. Indeed, through the ages sovereign default has been the single biggest cause of banking collapse.”

John Locke once wrote, “Credit is nothing but the expectation of money, within some limited time.”[12] As Grant (1994) noted, “To credit is to believe and to lend money it is necessary to trust someone.” Yet, financial history is rife with periods when “prolonged prosperity wore down the skepticism of creditors” only to result in eras of economic hardships.[13] It seems that we have entered into such a period with Chinese officials and some leading economists wanting a greater role for Special Drawing Rights (SDRs) in foreign exchange reserves. Yet, as Aiyar (2009) noted in his paper, An International Monetary Fund Currency to Rival the Dollar? “…the SDR is not a currency in its own right. Rather, it is a derivative of four national currencies. A derivative is not a currency.”

Armstrong, to be fair, taps into the current zeitgeist of confusion regarding the Frankenstein nature of our financial system. As Selgin (2010), senior fellow at the Cato Institute, affirmed: “the Jekyll and Hyde nature of contemporary central banks… has made apparent our utter dependence on such banks as instruments for assuring the continuous flow of credit in the aftermath of a financial bust and the same institutions’ capacity to fuel the financial booms that make severe busts possible in the first place.” In that one line Selgin actually does a better job in describing Armstrong’s so-called “paradox of solution”.

In the final analysis, however, Armstrong’s ramblings are indeed perplexing. He is anti-Washington, anti-SEC, and anti-CFTC, but at the same time he wants to “regulate the REPO market to eliminate posting collateral that explodes in the middle of the night.” Is this to be done by a neutered Federal Reserve? According to Armstrong who positions himself as a Fed apologist, “The Fed is incapable to [interest rate] management and should just raise or lower the reserve ratio banks must put up at the Fed.” As the saying goes, with friends like these who needs enemies.

Maybe Armstrong is just economic literature’s “wise fool” reincarnate into real life. Albeit, the world is now a place in which Joseph Stiglitz, the Nobel Prize-winning economist and Columbia University professor, speaks against the orthodoxy of “rational expectations” asserting that economists are among those at fault for the financial crisis, which exposed “major flaws” in prevailing ideas.[14] Wise fool or not, Armstrong comes across as a man who seeks redemption by trying to save us from ourselves. Then again, the same could be said about Fed Chairman, Ben Bernanke. Perhaps Sir Walter Scott put it best in his novel, Ivanhoe: “Our heads are in the lion's mouth,” said Wamba, in a whisper to Gurth, “get them out how we can.”[15]

Footnotes:
[1] Martin A. Armstrong. (2010, April 9). In Wikipedia, Free Encyclopedia. Retrieved: May 1, 2010, from http://tinyurl.com/2847kvo.

[2] “Japanese Regulators Get a 2d 'Scalp' Under Their Belts.” Stephanie Strom, New York Times, September 17, 1999. http://tinyurl.com/2edlqwk

[3] “The Enigma of Martin Armstrong.” January 04, 2009. http://tinyurl.com/2595sb4

[4] “What Is Ture/Slant?” Matt Taibbi, Taibblog http://trueslant.com/matttaibbi/

[5] Source: “His Legacy: Realism and Allure.” Time.com, Jan. 24, 1977. http://tinyurl.com/2d8smj4.

[6] Scott, W., Sir, 1771-1832. Ivanhoe, by Sir Walter Scott. 39015036703273. Edinburgh, A. & C. Black.

[7] “U.S. Economy Grinds to Halt As Nation Realizes Money Just a Symbolic, Mutually Shared Illusion.” The Onion, Inc., Issue 46-07, February 16, 2010. http://tinyurl.com/ycy9bct

[8] Etymology: chiefly Internet slang, humorous, from the “Series of tubes” analogy used on June 28, 2006 by then United States Senator Ted Stevens to describe the Internet.

[9] Frankfurter, Michael “Mack” (2010). “The Mysterious Case of Hamilton’s Monetary Enterprise, the Financial Instability Hypothesis, and Exter’s Inverted Pyramid.” Draft Article, February 15, 2010. http://docstoc.com/docs/25405145

[10] “U.S. Economy Grinds to Halt As Nation Realizes Money Just a Symbolic, Mutually Shared Illusion.” The Onion, Inc., Issue 46-07, February 16, 2010.

[11] Von Mises, Ludwig and Greaves, Percy L. (1978). “On the Manipulation of Money and Credit.” Dobbs Ferry, N.Y.: Free Market Books, p. 69.

[12] Source: “Pleas for peace and union against political intolerance and sectional animosity: Speeches of Thomas F. Bayard, R. E. Withers, S. B. Maxey in the Senate of the United States, March 30, 1876, with the speech of George S. Boutwell.” Harvard University, 1876. Digital Copy, p. 74. “Speech of Hon. Thomas Francis Bayard, of Delaware, in the United States Senate, May 27, 1878.”

[13] Grant, James (1994). “Money of the mind: Borrowing and lending in America from the Civil War to Michael Milken.” New York: Noonday Press, pp. 5 & 8.

[14] “Stiglitz Says Crisis Exposed ‘Major Flaws’ in Economic Ideas.” Scott Lanman, BusinessWeek, January 2, 2010.

[15] Scott, W., Sir, 1771-1832. Ivanhoe, by Sir Walter Scott. 39015036703273. Edinburgh, A. & C. Black.

References:
Aiyar, Swaminathan S. (2009). “An International Monetary Fund Currency to Rival the Dollar?” The Cato Institute, Center for Global Liberty & Prosperity, Development Policy Analysis, No. 10, July 7, 2009.

Frankfurter, Michael “Mack” (2010). “The Mysterious Case of Hamilton’s Monetary Enterprise, the Financial Instability Hypothesis, and Exter’s Inverted Pyramid.” Docstoc, Draft Article, February 15, 2010. http://docstoc.com/docs/25405145

Grant, James (1994). “Money of the mind: Borrowing and lending in America from the Civil War to Michael Milken.” New York: Noonday Press.

Von Mises, Ludwig and Greaves, Percy L. (1978). “On the Manipulation of Money and Credit.” Dobbs Ferry, N.Y.: Free Market Books.

Haldane, Andrew G. and Alessandri, Piergiorgio (2009). “Banking on the State.” Bank of England. Based on a presentation delivered at the Federal Reserve Bank of Chicago twelfth annual International Banking Conference on “The International Financial Crisis: Have the Rules of Finance Changed?” 25 September 2009.

Reinhart, C. M and Rogoff, K (2009). “This Time is Different: Eight Centuries of
Financial Folly.” Princeton University Press.

Selgin, George (2010). “Central Banks as Sources of Financial Instability.” The Cato Institute, The Independent Review, V. 14, N. 4, Spring 2010, pp. 485-496.