by
Michael S. Rozeff
A truly major change in the global monetary system is beginning to materialize. The dollar is starting to be dethroned. Foreign governments and central banks are going to do the dethroning. I have no prediction as to how slowly or quickly this process will take. The major dethroners, the Chinese, are on record as favoring a slow process. The transition is already occurring, however. Now that attitudes have shifted among the dethroners, they are likely to keep at it. The transition will be away from the dollar’s use in international exchange and toward the use of stronger and/or more stable currencies. International deals are being made already in non-dollar currencies or through barter. The catalyst for reducing the dollar’s role is the insolvent U.S. banking system combined with the massive government and FED efforts to reflate the system. The weakness of the emperor has been fully revealed. Foreign players are going to press their advantages. The U.S. monetary system has failed. This is not just another stumble. The world is not going to be led forward by a country with problems as large as have surfaced in America. There may not be any viable heir to the throne, and the present king may remain seated for quite some time. There will be many intervening ups and downs of currencies and gold. But the nobles and court are going to be busy forming new coalitions and jockeying for becoming #1. This movement is going to be BIG. Entire economies are going to restructure. But my focus here is on one part of the financial side of things, namely, central banking and gold. Many foreign central banks have supplied credit to the U.S. government. As they move away from that policy, U.S. interest rates will rise and the dollar decline. The dollar price of gold depends on two factors: the dollar exchange rate against other currencies and the world price of gold in those currencies. A dollar decline raises the price of gold in dollar terms. An increase in the world price of gold, other things equal, increases the dollar price of gold. The world price of gold rises or falls with the extent of inflation of all the world’s currencies. The world price of gold has risen in the last few years, but gold investors should realize that it is not a one-way street. If the most important dethroning central banks add gold to their reserves while stemming their production of their own currencies, the world price of gold will stabilize and fall. The dollar price of gold reflects both exchange rates and the world gold price. I believe and argue below that the foreign governments and central banks have intentionally pursued dollar policies for decades that were exactly the opposite of what you or I as rational profit-maximizers lacking in political power would have done. WHY? Apparently they were rational from the point of view of those who did possess political power and certain of their supporters that included exporters. It is highly pertinent to the price of gold to understand what has been going on and how it now appears to be changing. Why it’s changing now is, in my opinion, partly a matter of political competition. That’s a polite way of saying that other states may be starting to see their way clear to shaking off U.S. superpower dominance. They may be starting to feel their oats. They may feel that power lies in combining against the U.S. in certain ways while cooperating in others. Secretly, they may have tasted blood and be licking their chops. They may be gloating at the American difficulties. I don’t think that "statesmen" are nice guys. They don’t build up massive armies and navies with nuclear weapons because they are nice guys. It is also partly a matter of economic necessity. Manipulations of economies have resulted in serious economic dislocations and inefficiencies. How did foreign central banks do the opposite of what you and I, who lack power, would have done? We will need to understand inflation to grasp that. In popular articles these days, there is massive confusion over inflation (and deflation). I will aim for utter clarity on this matter. The Federal Reserve Bank in America has to turn its earnings on its U.S. securities back to the U.S. Treasury (in excess of its costs of running the bank.) This means that the government bonds carried as assets have no value to the FED. The present value of an asset with zero cash flows is ZERO. These bonds do NOT back the currency that the FED issues. (Foreign central banks that carry U.S. bonds as assets may be in a different situation, depending on their laws.) Federal Reserve notes are backed, for all practical purposes, only by the GOLD that the FED carries, which is 261.5 million oz. The following discussion is aimed at understanding the price of gold in a currency issued by a central bank. This will then illuminate the mystery of what central banks have done over the past 40 years to place the dollar on a throne and in what ways they behaved opposite to what a profit-maximizer would have done. Suppose that we have a central bank that has a single asset: 250 oz. of gold. It has a single liability. It has issued 750 notes per oz. Each note is dubbed a "dollar." In this scenario, the dollar is defined as the piece of paper, the note, and not as a weight in gold. The total number of notes issued is 187,500 = 750 x 250. Suppose, further, that the bank stands ready to convert any note into gold if a note holder wishes to redeem it. 1,000 notes bring 1.3333 oz. if this is done. The price of gold in this situation, expressed in dollars, is and has to be $750 per oz. Actually, the situation is really the reverse. The value of $750 is 1 oz. , since it is the oz. of gold that gives value to the notes issued against it. I define a new concept called the Zero Discount Value (ZDV) of gold. The ZDV of gold in a specific currency is the total number of currency notes issued divided by the total number of oz. of gold held as an asset against that note issue. Bank reserves that are fully convertible into currency notes also enter the total of bank notes. This definition will help us to define inflation with precision and it will help us to understand the pricing of gold. It will also lead to an understanding of the dollar policies of foreign central banks. Our hypothetical central bank has187,500 notes (dollars) and 250 oz. , so that the ZDV is $750 per oz. The ZDV of gold is the value of gold expressed in bank notes under the assumption that all outstanding notes are converted into the bank’s holdings of gold. Even if there is no convertibility, the ZDV is still the same number. It is the value of gold under the assumption that all the notes are exactly 100 percent backed by gold. The ZDV for a bank changes through time. Why? Because the bank’s holdings of gold and its issue of notes change through time. I define inflation as an issue of central bank money (notes and reserves) not secured by additional assets of equivalent worth. Inflation is a note issue that is made without additional asset backing, in this case, gold. Inflation is an increase in bank notes issued relative to the gold held as backing. Let the bank issue another 12,500 notes with no change in gold holdings and no other asset entering the bank’s possession. This issue is inflation. The ZDV is now $200,000/250 oz. = $800/oz. The zero discount value of gold rises to $800 because of the inflation. Inflation of notes, which is the inflation defined here, has many effects not discussed here such as inflation of various kinds of prices. The single effect being emphasized is that the ZDV of gold, by definition, has to go up when the bank inflates the number of notes that it issues. By the same token, deflation is a reduction in bank notes relative to gold held as backing. In this case, the ZDV declines. There is no economics or finance in this calculation. It is all definition, but it is clear definition. The economic reasoning comes in when we try to understand how the ZDV of gold and its market price are related.
Suppose we are back to the situation where the bank has 187,500 notes outstanding and holds 250 oz. of gold. The ZDV is $750/oz. Now let us change the scenario. Let us say that the bank no longer allows note holders to convert the notes at the bank and get gold in return from the bank’s tellers. The bank is still in operation. It does not close its doors and repudiate its notes. It suspends convertibility for an indefinite period of time. Let us suppose that private people can trade notes outside the bank, and that a market springs up on the curb outside, or that down the street is a tavern exchange. The question is this: What is the price of bank notes? Or the same question put in another way: What is the price of gold expressed in these notes? If people think that the bank has stopped conversion because it intends to issue more notes or even repudiate the notes altogether, then people will try to rid themselves of these notes. In other words, if they expect inflation of the notes and a rising ZDV, they may bid the price of gold up above the ZDV, which is the same as bidding down the note value by selling notes. This produces a premium for gold. Any premium that may arise will depend in a complex way on expectations and on other factors such as interest rates and other prices. I discuss this case no further. Let us address the question of the price at which gold will sell when there is no conversion and without this inflation effect which we know raises the ZDV. In other words, let us analyze one thing at a time. Leaving inflation aside, several factors at a given moment in time restrain the price rise of gold from rising above its ZDV. If the notes are forced to be legal tender by government law, then such a law will tend to sustain their value even if there is no conversion. The notes will be useful to pay taxes and debts. This factor has an important implication. If the legal tender law is rescinded when a bank is not allowing conversion, the notes are likely to lose value and gold go higher. The bank might resume convertibility, in which case all those who bought gold at greater than $750 would lose. Central banks do resume convertibility, although it can take a good many years. Buying gold at prices above ZDV near the time when the suspension ends is a losing proposition. Let gold's price be $1,000, which is above its ZDV of $750. The bank itself has the incentive to sell out enough of its gold at a rate of 1,000 notes per oz. to absorb all the notes outstanding. Since 187,500/1,000 = 187.5, that will take 187.5 oz. The bank can then own the remaining 62.5 oz. free and clear with no liabilities against them. The bank can put a lid on the price of gold by selling gold, and that will be profitable for the bank but only when gold’s price exceeds the ZDV. In reality, ZDV serves as an effective moving ceiling on the price of gold. It certainly rises with inflation, but market prices rarely get above the ceiling at any given time. Going above the ZDV is not impossible. Gold did just that in 1980 for a brief time. It appears that when this happened, there was an incentive for arbitrageurs to borrow and sell gold (or simply to sell gold they owned) to receive more dollars than the hypothetical conversion price (the ZDV) warranted. How does this work? Suppose gold has a price of $1,000/oz. when the ZDV is $750 and the bank owns 250 oz. of gold as backing. By selling 1 oz. at $1,000, the speculator receives notes that are more than worth their weight in gold (if there were convertibility). He receives the equivalent of 1.33 oz. of gold for a sale of 1 oz. of gold. The speculator has a strong incentive to sell gold when its market price exceeds its ZDV. This completes the discussion of gold selling at above the ZDV. We saw that inflation causes the ZDV to rise over time. We saw that at a given instant in time, the ZDV at that moment acts as a ceiling to the market price of gold. Will the ZDV also act as a floor? Let’s now consider the possibility of gold selling below its ZDV. In fact, this is what has happened to gold priced in dollars for MANY years since 1980 when gold entered its long bear market and this situation STILL prevails today even after 8 years of price increases. In U.S. dollars, gold’s ZDV today is over $7,000 an oz. and rising. The ZDV has not provided a floor to the market price of gold, and yet there are arbitrage forces that are at work to drive market price up to the ZDV. Suppose gold is $250 an oz. in the market but the ZDV is $750. Let us attempt an arbitrage. We borrow $250 (or use our own capital) and buy an oz. of gold. We take the gold to the bank and try to redeem it for $750. If we could do that, we could then repay the loan and keep a profit of near $500. This shows that there should be some economic incentive that prevents the gold price from falling too far below its ZDV. Is there? If so, why hasn’t it operated? There are years when gold has been 85 percent below its ZDV! What’s the impediment? The central bank itself could borrow $250, buy an oz. of gold, and then issue 750 notes without raising the ZDV. It could then repay the loan (I neglect interest.) Its balance sheet would then have 251 oz. gold plus 500 notes as assets and 188,250 notes outstanding. Netting out the notes, it has 251 oz. gold and 187,750 notes. The ZDV falls to $748.008. Deflation occurs. The bank has a profit by this arbitrage. If it offers to redeem at $750/oz., that will use up 250.33 oz. of gold. Its profit is the other 0.67 oz. worth $500. The FED did not do this arbitrage, despite the fact that gold was very much below its ZDV, or conversely, that dollar notes were much above their fully convertible price in gold. There was and is a strong profit incentive to deflate that the FED spurned. The FED wanted gold dethroned and the dollar placed on the throne. Profits from the source I have outlined were not an incentive for it. It did not want deflation. It wanted inflation. No speculator could get $750 for an oz. either, because the FED refused to redeem. That is part and parcel of an intentional policy of inflation. It is an essential part of such a policy. Otherwise, private parties will turn in the notes and seek a different money. So that avenue for profit also was blocked. The private entrepreneur has another option. Use gold to start a competing bank. Issue a competing currency. For $750 in central bank notes, the new banker buys 3 oz. of gold in the market. He keeps 2 oz. as profit. He then issues 750 notes of his own, called the DOLAR, convertible into gold at 750 per oz. As he buys up the gold and sells the central bank notes, he drives the gold price in dollars up. He keeps doing this until the ZDV is reached. Hence, here is another economic force that operates to make gold’s price converge to the ZDV. Obviously, this avenue has been largely but not entirely blocked. There are barriers to entry that are significant in the form of getting an entire system that uses dollars to use DOLARS. Nevertheless, people like James Turk and his GoldMoney venture are pursuing this option. Another way is for ordinary people to buy gold and sell the dollar. To spend $250 to buy an oz. of gold when one knows that the ZDV of a note is $750 is to get something worth three times more than the weight in gold of what one has given up. Still, this is not a riskless arbitrage. It relies on the prospect that others will eventually exploit the profit potential that exists when gold is well below its ZDV. There is another way to arbitrage the difference between the market price of gold and its ZDV when the market price is less than the ZDV. Other central banks can borrow dollars, buy gold, and then issue currencies against it. With these currencies, backed by gold, they can repay the dollar borrowings and still have a profit. They can gain the arbitrage profits in precisely the same way that the FED might have or that private entrepreneurs might have. MANY foreign central banks have done the opposite. They sometimes have sold gold. They have usually accumulated dollars in substantial amounts in the form of dollar loans. They have not only not competed with the FED and taken advantage of this arbitrage opportunity, they have gone the other way and supported the FED and the U.S. government by their loans. This was one part of the financial side of government-run economic policies. So when we run through the arbitrage possibilities, we find that most of them have been blocked or spurned. Central bankers dethroned gold, never fully, by not taking advantage of the profitable opportunity to issue solid currencies that compete with the dollar by buying gold and selling the dollar when gold’s price is far below its ZDV. Instead they chose to act as satellites of the U.S. The central bankers cooperated with governments that geared a major part of their economy’s production for the American market and took dollars in exchange. They lent to the American consumer to finance his consumption of their goods. They weakened and inflated their own currencies intentionally. This is the situation that appears to be changing. It started changing at least six years ago in Asia, for China has been accumulating gold secretly for at least six years. China recently began a campaign encouraging its citizens to hold wealth in gold and silver. But the situation began changing as early as 1979 with the European Exchange rate mechanism. The euro came into being between 1992 and 2002, and that competes with the dollar.
America is down. Is she out? America is capable of putting her house in order. She has great strengths lodged in her people. It is not too late to resuscitate the American economy and revive its vitality. Will the proper policies and radical system changes be instituted to accomplish that challenge? Unfortunately, there are no current signals to that effect being given off by America’s ruling elite. We are seeing the very opposite. Foreign leaders can read these negative signals as well as we can. They are acting accordingly. They are starting to dethrone the dollar.
October 20, 2009 Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire. Copyright © 2009 by LewRockwell.com. Permission to reprint in whole or in part is gladly granted, provided full credit is given.
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The
arbitrage opportunity pointed out above is a manifestation of an
overvalued dollar compared to gold and a world economy with serious
distortions in product, labor, and capital markets. They are two
sides of the same coin: the financial side and the real economy
side. These distortions have built up over decades as many countries
manipulated their economies while their central bankers aided and
abetted the dollar. A great deal of restructuring lies ahead.