Thursday, July 12, 2012

Fallacies – 1. Paper Gold is just like Paper Anything


This is the first in a new series I'll be returning to occasionally. I have recently come across a number of fallacies relating to the subject matter of this blog and my plan is to compile them and then correct them one at a time.

1. Paper Gold is just like Paper Anything

This first fallacy aims to undermine a good deal of what Another and FOA wrote about by claiming that the paper gold market has the same effect on gold as any paper market has on its underlying commodity. This fallacy claims that the same arguments made for an explosive revaluation of physical gold could be made for anything else, therefore they must be wrong.

Commenter "ForLiberty" put it this way:

"This whole 'paper gold is holding the price down' argument makes zero sense to me. It is just a logical nonsense. All paper trades have two parties - bidup and biddown. A paper gold trade could have never taken place if nobody wanted to short it. This is how all markets work. There are paper tomatoes sold too. Is there a conspiracy there too?"

ForLiberty was apparently paraphrasing Martin Armstrong who wrote something remarkably similar:

"They argue that today gold is really paper gold, and the market have multiplied that many times. They argue that the real gold is only about 5 billion ounces. They then argue that the paper gold depresses the price of gold and this is why it is not where it should be right now. All this sound nice, however, you can make the same argument about anything traded today from wheat to stocks and bonds given the derivative markets. Some see conspiracy behind everything."


Is he correct? No he's not. Can we really make the same argument for anything else? No we can't. The paper market for commodities is just as likely to have a levitating effect as a suppressing one because it allows for financial participation by those who have no need or ability to hold the actual commodity. Gold is the only one that is unequivocally suppressed by the existence of a paper market.

No conspiracy. The mere existence of a commodity-like paper market for gold suppresses the price naturally, systemically. Long term systemic suppression of gold is something totally separate and different from short term price manipulation or distortion which can occur in any commodity or paper market.

Here's ANOTHER explaining that the BIS (primarily European central banks at the time) not only anticipated that a paper gold market would lower the price of gold, but that in the 1980s they supported the creation and expansion of this market for that very purpose:

Date: Mon Feb 16 1998 14:40
ANOTHER (THOUGHTS!) ID#60253:

"The BIS leads the creation of a paper gold market that will lower the world price of gold to the extent that it remains above "production costs".

Guess what, it worked! Contrary to all expectations of oil shortages, inflation, debt collapse and what have you, It Worked! But, there is one small problem?

The BIS and other various governments that developed this trade (notice I didn't use conspiracy as it was good business, as the world gained a lot), thought that the paper gold forward market would have allowed the gold industry to expand production some five times over! Don't ask where they got this, as they are the same people that bring us government finance and such."


In other places ANOTHER explains that we should not be upset with the CBs because they were just buying us time. And later he explains what they were buying time for—to make it to the launch of the euro. He also muses about the fact that it's the Westerners playing in this new paper gold market who are most upset about the low price. The physical buyers in the East see it as a gift. But I digress.

Nobody is claiming there are more than 5 billion ounces of paper gold. In fact, there is probably far more physical in the world than paper gold. Enough physical gold to cover all of the paper a few times over perhaps. But that doesn't matter, it is only the flow that matters. It's the same with commodities that get produced and then consumed. It's the flow between production and consumption where the price is discovered in the paper markets. But gold doesn't get consumed at a rate anywhere close to its next closest competitor. It just accumulates.

In commodities the paper market regulates the flow between the producers and consumers, acting as a kind of a shock absorber against unexpected supply and demand shocks. But gold is different because it just accumulates. There are two main differences between gold and everything else. The first is that gold just accumulates rather than getting consumed, so there is no reason for there to ever be a supply side shock, even if all the mines suddenly stopped producing. In fact, today we have a 60 year "supply overhang" in gold. Nothing else comes close.


The second difference is that the vast majority of demand for gold is in currency terms, not weight terms. This is not true for commodities. If you need a ton of copper for a construction site, you need a ton of copper. That's weight-denominated demand. But gold demand is overwhelmingly in currency terms. If you need a tonne of gold, what you really need is $50,000,000 worth of gold. It doesn't matter how much it weighs because you're just going to stick it in a vault.

Having a paper market as a shock absorber for the gold market only has the effect of keeping the price too low. My explanation for the LBMA survey discrepancy is a perfect example.

Since gold is not consumed by consumers or industry the way corn, oil, copper and grains are, and because it simply accumulates, supply shocks are not economically critical. On the demand side, gold is apparently used as a "safe haven currency". And we apparently had a demand shock of around 7,575 tonnes in Q1 2011. The normal supply for that period would have been around 700-1000 tonnes, so the paper gold market acted as a shock absorber and absorbed that demand shock by expanding. That way the price of gold only rose $30 in a quarter with a demand shock of 10 times the normal physical supply flow.

But that wasn't really demand for 7,575 tonnes of gold. It was demand for $337B worth of gold. Hypothetically, if the price of gold had been $55,000/oz. in Q1 2011, that demand would still have been for $337B worth of gold, the only difference being that the $337B demand could have been supplied by only 190 tonnes (a mild 20% increase in flow rather than an extreme 1,000% increase) and the price of gold would therefore have barely felt a bump in the road, even without a paper market shock absorber.

Therefore, having an elastic paper market shock absorber for gold is only necessary if the price is too low, because there will always be plenty of supply if the price is high enough (60 year supply overhang, remember?). At today's price, having a paper market shock absorber is apparently necessary to keep the gold market from blowing up.

It logically follows that it is the very existence of the paper gold market which is keeping the price too low, because if you took it away, price alone would have to regulate the flow. Take the paper market away from other commodities and you simply remove the investor/speculator money in the middle thereby exposing producers (and consumers) to unpleasant shocks.

We have no idea what the "stock" of paper gold is. The LBMA survey only gave us a glimpse of the flow (paper gold turnover) over a given time period (Q1 2011) and in a given market (loco London spot, forwards, options and swaps, with spot transactions being 90% of the reported trades). That turnover was 2,700 "tonnes" of paper gold per day with 64% of the LBMA members reporting. We only got a lucky glimpse because the largest banks in the world (bullion banks like JP Morgan Chase, Goldman Sachs, HSBC, Barclays, Deutsche Bank, Credit Suisse and UBS) are lobbying for a technical rule change that will make their overall Basel III compliance easier.

Sincerely,
FOFOA

616 comments:

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Nickelsaver said...

Must be tiring to setup and knock down the same strawman over and over and over.

db said...

Is it just me reading too much FOFOA, or this article in ZH is kind of challenging FG?

http://www.zerohedge.com/news/guest-post-why-us-dollar-not-going-zero-anytime-soon

Anonymous said...

db,

I'm not really sure if it challenges FG. CHS makes a bullish case for the US dollar, but as the dollar index spikes up: what is it that the world is fearing? running out of dollars? or dollars becoming worthless?

Another key point, he says:

(There is another fundamental reason why the U.S. became a net importer not just of oil but of finished goods and raw materials, and we'll look at that later.)

Yeah, that fundamental reason is intricately connected to why the USD is seriously threatened.

It is very well explained in Moneyness.

May be CHS should elaborate on how we can perpetually keep increasing our trade deficit and everything will continue to be peachy.

Nick said...

db,

"This process of extravagant creation of paper money is also called hyper-inflation."

Anyone who reads their FOFOA knows this extravagant creation of paper comes after the onset of hyperinflation.

I stopped reading the article after that sentence ;)

Jeff said...

Only an idiot would lump GATA and the hard money crowd with FOFOA. But we know that already, no?

FOFOA: One of the biggest struggles I observe in newish visitors to my blog is that they instinctively try to reconcile everything they learned from the hard money camp—ZH and GATA being two bright stars there—with what they read here. Their effort inevitably leads to contradictions that cannot be resolved. And because ZH, GATA and the rest of the hard money camp is so much more ubiquitous than my little blog, they win by default in minds that are unable to think for themselves.

Here are a couple of the irreconcilable concepts found on this blog that noobs must either reject or ignore in order to hang on to their ZH/GATA CB thesis.

1. Remember when Aristotle wrote this? "In working on this project, I was personally shocked when I discovered that we absolutely NEEDED paper currency in order to set Gold free. In the perfect world you lapse into in your comments, everything you say is well and good. We don't live in that world, however. My biggest challenge in piecing together my proffered solution was to accept what this real world had to offer and avoid foisting my own preferences onto the world like a square peg in a round hole."

Have you ever seen anyone in the hard money camp write anything like this? Or can you imagine them ever doing so? Yet this is one of the core fundamentals necessary to understanding Freegold.

2. And FOA wrote this: "Several years ago, many gold bugs and gold advocates missed the path as the trail turned." "Yes, the war now is between the Euro and the dollar! The Washington Agreement [a Central Bank agreement] placed gold 'on the road to high prices'." "The war between gold and the dollar has been over for a while now… Leaving gold bugs with a lot of questions that ask why this: both systems will strive for a higher currency price for gold; one doing it because they have to; the other doing it because they want to! The casualty on this battlefield will be the world gold market as we know it. A market caught between how Western perception thinks gold's price should be "discovered" and at what price level trading in physical gold craters the entire paper structure… This paper gold market will be cashed out at prices far below real bullion trading so as to inflate further the books of the Bullion Banks,,,,,, not destroy them. At least this is how the US side will proceed."

Again, have you ever seen anyone at GATA or ZH write anything like this? Or can you imagine them ever doing so?

First let me state that Zero Hedge and GATA both provide a great service and they both do fantastic work, ZH comments section notwithstanding. It is their underlying thesis about fiat currencies and central banks in general that I have a problem with. And this is not a problem with only ZH and GATA, it is a problem with the entire hard money camp.

Their foundational thesis is that fiat currencies and the CBs that manage them are the most fundamental flaw in today's system from which all other problems flow. This directly conflicts with my thesis that using the same medium in both the primary and secondary monetary roles is the fundamental flaw from which all other problems flow. My thesis applies to both hard and easy money systems. Their thesis points to the CBs as the bad guys. My thesis holds up a mirror and says, "We have met the enemy, and it is us."

Piripi said...

Good one Jeff,

That FOFOA quote should be a stand-alone post on this blog, just so it can be linked to regularly. The difference in thesis really is as simple as that comment states: all our monetary problems (and the problems that those problems then cause) all stem from the single act of using the medium of exchange as a store of value. Period.

p.s. would you mind using bold or italics or at least quote marks around quoted material... I'm finding it difficult to differentiate between authors in some of your recent comments.

Texan said...

Option 3. Contracts settled in cash. And hopefully the more discreet "storage" companies such as the one you referenced won't be "gated".

And yes, paper gold owners will be none too happy. But paper gold contracts being torn up is the norm, not the exception. USG 1971, for example. Didn't seem to stop demand for gold then, did it? 20x in 10 years.

AD, selling paper gold is probably the oldest monetary scam there is. The whole concept of "fiat" is "paper gold" with no "legally enforceable" delivery obligation of gold itself, ie seigniorage. That is the only difference with futures - deliverability. Turn off deliverability requirement and a gold futures contract is worthless, there would be no futures market for gold.

And it's pretty clear that if governments can't be trusted to deliver gold, any entity less than a government sure as hell isn't going to be deliver either, in a pinch. So just what exactly is the point of gold futures? Simple - it is "gold backed currency" (without really being backed). Ie a total scam. And it is absorbing billions of dollars of real physical demand that doesn't want to be "inconvenienced" as you put it with owning the real stuff.

enough said...

Hi AD and TEX

Quoting TEX but I guess attributed to AD (dont read his posts)

"doesn't want to be "inconvenienced" as you put it with owning the real stuff."

One can own stunning gold proof and "satin" finish bullion coins for less than 3% over spot.

I own the full series of Australia Perth Mint Roo's/Nuggets (1986-2012), Isle of Man Cats (1988-present), Gibraltar Dogs (1992-1998), Bermuda Triangles (1996-2007), many Panda's and quite a variety of other "world modern" coins.

These are things of beauty and craftsmanship, procured at marginal premiums which happen to be made of the store of wealth par excellence.

IMHO a much better way to enjoy one's life savings than a printed monthly statement pulled from digits floating around in cyberspace .

I personally dont care if I could have gotten fractionally more weight at most 1% less over spot for generic rectangles.

IMHO, owning physical with detailed unique images associated with each year is far removed from being "inconvenient". It is a complete joy !!!

AdvocatusDiaboli said...

Texan & enough,
I agree, okay so (hopefully) peaceful option 3: The paper holders (those private savers) receive a nice letter, stating "you are cashed out at current price, money is being wired to your bank account". Let me conclude on that assumption:

Now what? Do you believe that somebody that just received this money let's say $100K, will rush into the next coinshop and will spend that exact same amount on physical regardless of price? Up to what price?

1.) I think people want paper, because they dont want to be bothered with responsibility and are scared by consequences. At least in western europe I see that behaviour. And even by myself, when I first walked across the street with a couple of kilos it felt strange. If I remember well, it took my wife six month to get along with dealing having that around the estate. I think this is wide spread in todays society and probably gets worse (in other social areas you see that by the crazy demand for social welfare).

2.) I see no real valid argument for the conclusion that suddenly those earlier paper holders will spend 100K on just 2ounces for exclusively longterm savings (not talking mania bubble of speculation). That is just not human behaviour. I know FOFOAs argument about that: "Its about the money in gold...". But that's just not like humans work. Plenty of people consider already today gold too expensive, although probably most of us goldbugs consider it cheap or at fair price. That's why I have been buying, but although I love those useless yellow stones in my hand, I would never ever spend those moon prices, when even hobby 49ers dig it out at these todays prices. This strange assumption "giants sucking at any price", sorry, but that's what I really consider conspiratist retarded.
Greets, AD

DP said...

although I love those useless yellow stones in my hand, I would never ever spend those moon prices, when even hobby 49ers dig it out at these todays prices. This strange assumption "giants sucking at any price", sorry, but that's what I really consider conspiratist retarded.

That's because it would appear you can't conceive of the value assigned to today's euro melting away during what would otherwise have been the mother of all deflationary depressions. You don't understand the ECB's single mandate. Without establishing this basic principle, it's impossible to fully appreciate the Freegold concept.

Indenture said...

"I see no real valid argument for the conclusion that suddenly those earlier paper holders will spend 100K on just 2ounces for exclusively longterm savings"

The word just is also where you miss. It appears you believe the number of ounces is important instead of the storage price per ounce.

AdvocatusDiaboli said...

I.
I explicitely pointed that out, that it does not work that way!
Do you personally would buy something for 100K from me, whereas somebody pulls it out of the ground somewhere for maybe 3K and is forced to sell it for a living, in competition with other mud diggers?
Answer that question before any further argument.

Indenture said...

wow. that is some strange chip on your shoulder.

Tommy2Tone said...

yea, that's called a buffalo chip.

Metalike said...

Fofoa,

If gold is a store if value, as it obviously is, why do you get in so much trouble explaining why it shouldn't compete with the dollar (a currency?
Shouldn't we focus on how it should or shouldn't compete with government bonds? And if so, explain why should government be so concerned if savers shuned goverment bonds in favour of gold.

jjokoloco said...

FOFOA

If physical gold is a store of value, as it is, why do we keep comparing it with dollar notes (which are only currency)?

As I understand, dollar notes are currency; paper gold, US Bonds & Treasuries are promises; and physical gold is the ultimate store of value.

Paper Gold is a promise to deliver physical gold.
US Bonds & Treasuries are promises to deliver dollar notes.

How wise would it be to rely on promises if you want to store value?

You either store value or you store promises!!

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