17 December 2011

My thoughts on Freegold

A reader, LS, asked for my thoughts on the following topics:

1) freegold
2) the gold for oil trade
3) the current price is not a real physical price of gold because of happenings in COMEX/LBMA
4) do you believe the current world affairs will resolve itself towards freegold or something similar?

Firstly, I haven't had the time to read FOFOA in depth given the amount of material and thus give it justice. My comments here are therefore tentative thoughts.

Freegold is very interesting and I can see the logic of the idea of leaving fiat to perform the medium of exchange role and gold the wealth store role. I have a feeling free banking (see also) and a restriction on maturity transformation would need to be involved for it to work. There is a hell of a lot of discussion condensed in that sentence, more than I have time for at the moment.

I would also argue that Freegold needs to allow gold leasing but not gold lending. By "leasing" I mean as in leasing a car, ie physical asset rented (not borrowed and sold). Manufacturers of gold products like the Perth Mint could not operate without leasing because with Freegold's ban on lending of gold and other financialisations it would be difficult (impossible?) to hedge against gold price movements.

This leads to my next point, which is that the gold price under Freegold would not be stable and still exhibit some volatility. This is because under Freegold people can save excess wealth either in gold or by investing in productive enterprises (ie true investment). Human nature being what it is we will still have overestimation of the success of productive enterprises, thus failures, thus business cycles, ths varying preferences to store wealth in gold versus investments.

On the Oil/Gold idea, I don't have an option as this is not an area of FOFOA I've looked at much.

The current price is a real physical price as physical buyers and sellers of size (giants) are willing to exchange at that price. When aversion to counterparty risk really hits market players (MF Global you'd think should have been enough), then we will see a divergence between paper and physical.

As to the fourth question, well this is bound to my answer in the paragraph above, which is a necessary condition, but not sufficient, for Freegold to emerge. You would also need consensus that a gold standard is not the answer, and there are strong forces working towards that end. Possibly the biggest problem is getting people to understand the reason why financialisation of gold needs to be banned. How it will end is impossible to predict.

Either way it is going to be exciting to see how it plays out.

26 comments:

Warren James said...

Good thoughts Bron. You'll get plenty of discussion on this one.

The reminder about the mint operations is an interesting one, since it would be almost impossible to function without 'liabilities denominated in gold'. And once that door is open, where does it stop?

(That leasing part is directly related to the mint selling the minted product first then buying the gold for it, right?)

p.s if Freegold does unfold rapidly, better plan for some good security on that one tonne gold coin!

Bron said...

Yes, the Perth Mint business model is lease gold, make product, sell it, immediately buy replacement gold, repeat step 2-4.

I think the door can be kept closed by a restriction that the metal leased can't be sold short - one can only just use the physical asset.

Justin said...

I'm confused here Bron, in your article you state;

"By "leasing" I mean as in leasing a car, ie physical asset rented (not borrowed and sold)."

But in your reply to Warren you state;

"the Perth Mint business model is lease gold, make product, sell it, immediately buy replacement gold"

How is that any different from borrowing gold & selling it?

Bron said...

Justin,

You are correct, manufacturers of gold products cannot strictly operate a "lease" as they transform the gold into another form for sale.

Under FOFOA's strict Freegold rules what I describe would not be allowed but I would ask for some dispensation along the lines that the covering purchase must be done immediately or at maximum by the end of the day.

Yes a sale occurs, but as long as the purchase happens as soon as possible, there is no short position being held.

I cannot see any other way for manufacturers to protect themselves from price fluctuations under Freegold where loaning of gold is not allowed.

Justin said...

Ahh.. I see.

To be honest Bron, I don't think you'll have to worry.

LS said...

Thanks Bron so much for your comments.

What you said have confirmed what I have long suspect, that all these so called paper-physical decoupling is really just wishful thinkings by many gold bugs, even including the all mighty FOFOA, who have no real understanding of how the industry actually works.

Then a follow-up question would be, do you think gold is fairly priced now? why? and if not, what would be your value of gold or method in valuing it?

LS

Anonymous said...

Hi Bron,

Freegold doesn't prevent anyone from leasing gold. Lending gold just isn't enforceable in court as legal tender contract. Gold wouldn't be legal tender so it wouldn't be valid for payment of debts. I believe this was discussed in a FOFOA post called Reply to Bron. :)

FOFOA said...

Hello Bron,

On gold leasing:

I don't know where you got the idea that I have strict Freegold rules. I think you are putting more emphasis on this leasing thing than necessary. I guess it's understandable since your business involves borrowing gold. But as I have said, it is not a prerequisite of Freegold, but more like a natural consequence. The only prerequisite to Freegold is the collapse of confidence in paper gold. The leasing idea is about making a natural concept as clear as possible to the banks that might not get it. Keeping gold out of the business of credit money. Eliminating the lending of gold (or credits denominated in gold ounces) for monetary purposes in which fiat loans will do just fine.

FOA: "Keeping gold out of the fiat arena would be more simple than many hard school advocates envision. The key to that is found in the implementation of international law. The leading economic countries (EuroZone in the future) would have but to establish a protocol that forbid the enforcement of collateral attachment anytime physical gold is traded, lent or involved in a trade. In this context, no banker would lend you gold to buy a house if, in a default, he could not claim your house in a court of law. Even private parties would never lend gold if the asset behind the loan could not be claimed for nonpayment. It's that simple. With a stroke of written law, the trading of gold as wealth would become a final payment with no possible credit implications. Our official fiats and wealth without a country would never again function as one."

Note that the first time this was discussed was in 2001, 3 1/2 years into the Freegold discussion on USAGold. That's because it is not a primary concern and not a big deal. This discussion came about from one of the commenters pushing FOA on the legal issues that might be faced by a currency zone (Eurozone) that wanted to support a sustainable future after the collapse of the old system. Here's the sentence immediately preceding the above paragraph:

"In my discussion with Econoclast, I took his legal meanings and applied them to this "wealth without a country" position…"

Bron, I believe you said your business borrows without having to post collateral because of the WA Government's AAA rating, right? Also, you are not borrowing gold for a purpose that would be equally well served with a fiat loan. So I don't see how your business even applies to what FOA wrote above.

So why do we not want banks lending gold the same way they lend fiat? And why did FOA even have this discussion? Here's a little more. First, Econoclast writing to FOA:

Econoclast: "Any system that could possibly be thought of or proposed must include the use of law. Part of the answer (transparency) includes a complete treatise of the "new" laws written in simple, direct English (8th grade level-2 pages instead of 2000). The laws would be directed towards controlling the bankers, not the people for a change. The laws would be written with input from bankers, but not by bankers. Penalties for financial fraud/counterfeiting/etc. would be severe.

This new gold dollar system would function alongside the current FED system. Any large debts (mortgages, business debt, most importantly, govt debt) would be denominated in fiat dollars. That way govt could continue to operate (maybe, ha ha) and the banksters could still have their play money to manipulate and try to capitalize on. A free market would exist to redeem back and forth as necessary. This free market would show the relative worth between the two currencies."


Cont…

FOFOA said...

2/2

FOA's reply: "Excellent thought sir. Econoclast, using your thrust as my platform:

One of the major problems faced by past hard money planners was that any time real wealth, gold, is denominated as credit money, it always placed the relationship between the rule of law and the rule of gold at odds. If our laws defined gold as official money, and lent it, then by association the law had to define a portion of gold that did not exist in circulation. That portion was the contract asset held as bank savings. Yet, a person's claims against it identified said gold as real. This was and is an inherent contradiction because no law can define the value of real wealth held in contract.

This particular fiat form of hard money owed its existence upon a continuous function of the economy. What the above means is that you cannot take something real and lend it over and over, as banks do when lending fiat, and still demand that the law recognize said contract moneys as hard legal tender.

I would state that no form of lent gold be recognizable or enforceable in the court of law as a legal tender contract. One may borrow gold, relend it, or even borrow against it, but that gold would not be valid in the payment of all debts both public or private. It could not, by law be legal tender. This is not to say the trading of gold would not somewhat supplant currency in function. It could and most likely would to a degree, but it would no longer carry a credit quality that fiat would in the form of a time function. Indeed, in our modern economic structure, a credit time function is very valuable and gives digital contract currencies their demand.

To deal in the future,,,,, to borrow,,,,, to capitalize would require the use of a fiat function. Gold could / would be a final trade; I'll give you ten cars (or gold) for your house,,, deal done. If I want more time to pay, I and we must engage a fiat loan."


Sincerely,
FOFOA

FOFOA said...

Hello again Bron,

On the oil trade:

I won't go into great detail here, but I want to give you a teaser that I hope will show you that ANOTHER knew what he was talking about. Hopefully this tease will blow your mind a little, as it did mine, and give you reason to dig deeper. At the bottom I'll give you the links to two posts that cover the oil story.

Let's start with this mystery (in bold below). ANOTHER wrote the following in April of 1998:

ANOTHER: "I ask you, why did the world go off the gold standard in the early 70s? You have an answer, yes? For all the problems this created, could the countries not just revalue gold upward, to say $300 ( back then ) ? What was the real reason the world entered a period of "freely traded" "managed gold"? "

This question has more impact on the gold market of today than it did then! In days past, it was held as good knowledge that the US stopped gold backing to protect the dollar and keep gold from leaving to other shores.

But, in the same time frame, all central banks did sell gold to all persons, even the US. All treasuries held gold and dollars as reserves. To what end did the world financial system gain with the dollar off gold backing, and then allowed to "dirty float" against all currencies? Would the world not have been better off to find gold revalued to, say $300 and then begin a "dirty float"? Noone would have lost, and the inflation would have, at best, not have been worse!

Truly, I tell the reason for this action. The US oil companies knew that the cheap reserves were found. The governments knew this also. The only low cost oil reserves in the world at this time were in the Middle East, and their cost to find and produce was very low. It was known, that, in time, ALL oil would come from this land. As much higher US dollar prices were needed to allow exploration and production of other reserves, worldwide. But, how to get crude prices, up, when the Gulf States were OK to pump and produce in exchange for "gold backed dollars"? I will not name the gentlemen that brought this thinking to the surface in that era, but it was discussed. It was known that oil liked gold. It was known that "local oil" would be used up without higher prices. What if, the US dollar was taken off the gold standard, and gold was managed "upward" to say, $208 per ounce? The dynamics of the market would force oil to rise and allow for much needed capital to search for the higher priced oil that was known to exist! The producers would find shelter in gold even as the price of oil was increased in terms of a now "non gold dollar"! Price inflation would rise, but gold and oil would also increase. The dollar would continue to be used as the only payment for oil, and in doing so replace gold as the backing for this "reserve currency". All would be fair.

The war in 1973 and the Iran problem did make markets "overshoot", but all did work to the correct end. The result was "a needed higher price for a commodity that was, as reserves, in much over supply by the wrong countries"! It was known that the public would never have accepted this "proposition" as fair. To this end, we have come.

And it is from this end, that the gold markets are managed for today!"


Cont…

FOFOA said...

2/2

Like I said, I'm not going to go into detail, just give you a tease. But you've got to admit that what ANOTHER wrote above is pretty different than everything else we know about the end of the gold standard. He's saying that Nixon had the choice of either revaluing the US gold to continue backing the dollar with higher priced gold, or else removing the backing altogether and managing the price rise as the market took it higher. And it was decided that, because oil liked gold, the latter option would effectively raise the price of oil which they wanted so that more non-ME oil would become economically viable.

So who was this gentleman (or gentlemen) that ANOTHER would not name who "brought this thinking to the surface in that era"? You'd think that after 40 years there would be at least some corroborating evidence, wouldn't you? Well, as a matter of fact there is. And it first surfaced just last year!

We now know that the mystery gentleman was none other than Nixon's National Security Advisor, Heinz Alfred "Henry" Kissinger! And we now have independent and corroborating evidence that Nixon and Kissinger pulled the plug on the Bretton Woods gold standard for the specific purpose of raising the price of oil! We know this now because the Saudi Oil Minister from 1971 gave an interview to CNN just last year!

Sheikh Ahmed Zaki Yamani was the Saudi Oil Minister from 1962 to 1986. Here's what he told CNN in that interview:

Sheikh Yamani: "They decided to raise the price of oil 400%. They needed to help the oil companies to invest outside OPEC. In Mexico, in North Sea and so on. And this will not happen without a high price of oil…"

Sheikh Yamani: "Yes and there was an agreement between the Shah of Iran and between Dr. Henry Kissinger to raise the price of oil… I really highly respect Henry Kissinger. He is really a planner and strategically he is a man to be respected."

Here are the actual average oil prices per barrel for those years:

1971 $3.60
1972 $3.60
1973 $4.75
1974 $9.35
1975 $7.67
1976 $13.10
1977 $14.40

I note that $14.40 is exactly 400% of $3.60. And here's ANOTHER's "overshoot"…

1978 $14.95
1979 $25.10
1980 $37.42
1981 $35.75

The point here is that ANOTHER's tales are not the speculations of your typical market analyst. They are the kind of inside information that never made it into the history books and still resides at the level of former Oil Ministers and National Security Advisors.

You'll find a video of the Sheikh Yamani interview in my post It's the Flow, Stupid. And between that post and the following one, Flow Addendum, you'll get a pretty good idea of how the gold for oil deal worked.

Sincerely,
FOFOA

JR said...

Err Bron... I just had a look at a link you've provided on your google+
posts page - http://www.perthmintbullion.com/Blog/Blog/11-12-19/The_Science_Of_Gold.aspx

Is the Perth Mint claiming that gold is money due to its unaltering quality!? If I'm not mistaken the GSI journal recently had an article describing such.

Very... very interesting, yes indeed.

squirrel said...

Is this argument the goldbug slanging match predicted in The coming goldbug civil war and your PM exit strategy ?

I hope not because Bron and FOFOA are my favourite Bloggers.

squirrel said...

@JR. Gold's chemical stability giving it an advantage as money is not as unlikely as it seems.

Firstly, elements are awesome as a measurement tool over compounds or sub-elemental particles (sorry, but I'm just too lazy to explain why).

Choosing gold is more to do with a coincidence of mineralogy, there are very few minerals which exist as chemically stable elements. Even less of those minerals have a low melting point, malleability, and general niceness, as mentioned in the Perth mint video.

The elemental minerals are: native gold (melting point MP 1300ish C), native copper and native silver, which oxidise on the surface anyway, and have 3 times the MP of gold - so they're out.

Then from Wikipedia: " semi-metals and non-metals (antimony, bismuth, sulfur, graphite)", which suck for too many reasons to mention. I'd add diamonds too, but they suck even more (sorry, but I'm just too lazy to explain why).

Then there is the density argument which really makes gold the only choice for storing wealth in a small space.

Platinum group metals have low density, that's the only argument against them in a purely scientific sense.

But gold is historically money, held in huge stockpiles by central banks ect. ect. you guys know the story far better than I ( but please stop arguing).

squirrel said...

Oh yeah I forgot Mercury which is like a toxic liquid at room temperature, lets have fun with that (still a mineral technically).

Anonymous said...

Bron and FOFOA are also my two favorite PM bloggers. Because of this, I really do *not* want to see them stop "arguing," because I find polite discussions between knowledgable people extremely enlightening. Far better that they "argue" with each other than with the trolls.

JR said...

It's OK Mr Squirrel, I was being facetious.

If you go here and then here to read the series on 'Infinite Money' you will understand.

It was an instructive video by the way, I agree 99% except for the silver is too abundant bit. Quantity is irrelevent.

Bron said...

FOFOA,

Yes, we do not have to post collateral, but we are unique. I am also thinking of all the other businesses involved in the gold value chain (eg miners, jewellery manufacturers, bullion dealers) that also need to hedge themselves against changes in the price of Freegold.

If “no form of lent gold be recognizable or enforceable in the court of law as a legal tender contract” or “the enforcement of collateral attachment anytime physical gold is traded, lent or involved in a trade” is forbidden, then I am concerned that no one would be able to forward sell or forward buy gold or operate a futures market. Those quotes are vague and don’t give me clear indication of what sort of gold transactions can be undertaken and enforced – “involved in a trade” is particularly wide.

FOA may have thought “it is not a primary concern and not a big deal” but I think in attempting to keep “gold out of the fiat arena ... with no possible credit implications” he has not realised that there is a baby (physical industry’s need to hedge) in the bathwater (gold as money) he has thrown out.

I suspect FOA suggested the non-enforcement solution because it was simple and avoided the difficultly of drafting a whole lot of rules to deal with the detailed practicalities.

I don’t think it is enough to say that the “only prerequisite to Freegold is the collapse of confidence in paper gold.” The requirements of the industry to hedge will, in absence of any rules, result in a futures and forwards market continuing or new ones forming, which imply lending of gold and also allow for synthetic lending to occur.

These market players will deal in “paper gold” because if they don’t, they will be out of business. It will probably be done under some very tight contractual terms involving collaterised/security. The problem is that this is the seed from which bullion banking grows.

However if you simplistically ban gold lending and similar transactions to stop this, it is likely to shut out smaller industry players from hedging themselves. This will either lead to people leaving the industry and/or higher costs as they seek to charge to their customers for volatility in the gold price.

When you consider that these industry business are bullion manufacturers and dealers, then this means under Freegold you will have a much reduced liquidity and higher premium costs for investors looking to store their wealth in bars and coins. This works against the role of gold as wealth store.

ANOTHER's tales may not be “the speculations of your typical market analyst” and “at the level of former Oil Ministers and National Security Advisors” but that may be the problem. Were he and FOA too high level and unaware of the practical implications for the physical industry?

My feeling is this part of Freegold as described by ANOTHER and FOA is lacking and needs to be expanded upon.

Motley Fool said...

Bron

The gold hedging you are talking about is against price volatility, yes? Presumably on fairly short time scales, though varying by industry, and continually renewed?

What if... under FreeGold there is very little (almost no) fluctuation of the gold (as priced in currency) on short term scales? In this scenario, how relevant does hedging remain?

Before 1971 there was little exchange rate fluctuations worldwide. Hedging for currency risk only became neccesary after Nixon removed the link.

TF

Bron said...

For most manufacturers we are talking a few months between receipt of raw metal and sale of finished product. Jewellery can have much longer timeframes due to lower stock turnover.

It is possible that gold's volatility under Freegold would be less in the short term, but not enough I think to eliminate the need for some way to hedge against price changes.

In the end we may end up with "true" futures markets where only end producers and end consumers trade and little speculation.

Because one will be able to borrow money, buy gold, store and sell a futures contract, but not be able to do the reverse (borrow gold, sell and buy futures), I'm afraid the resulting futures market will be lopsided from an arbitrage point of view. This is my concern.

Freegold "theory" needs to deal with these practicalities somehow.

Motley Fool said...

Hmm.

Well, for one thing, you are aware that gold would no longer be used for jewellery under Freegold, by virtue of being too expensive, yes? At present jewellers are already switching to other metals with gold's current 'high price'.

Furthermore, hedging is useful to protect against loss due to a decline of the gold price. Under Freegold it is doubtful that governments would allow gold to depreciate, as that would imply a deflationary policy.

I understand your concern about a unbalanced market, but I really do wonder about the relevance in that paradigm.

TF

DP said...

In the end we may end up with "true" futures markets where only end producers and end consumers trade and little speculation.

Which would be a disaster? I recall over some time seeing disparaging comments made by certain European politicians, regarding speculation (sorry, I don't recall any specific instances at the moment, and like Mr Squirrel I am too lazy to go and find any right now... but if I was searching I would probably start off by including the keywords "Sarkozy" and "speculation" I guess...). Usually the comments are specifically regarding ag's, but I suspect really the demon is all financial speculation.

Anonymous said...

try search terms 'vince cable' 'casino capitalism'

Mr Squirrel said...

If anyone is interested, I'm happy to expand on the points I was too lazy to previously.

But it seems like the science of gold is far less exciting than the events unfolding at the moment. Gold Chat is an island of sanity in this crazy world.

Michael H said...

Hi Bron,

One other aspect of freegold that FO/FOA have mentioned is that mine production would be 'controlled' by the government; i.e. the government would buy new-mined gold for its commodity price (plus profit) and sell it for its monetary price.

Could the refiners and others in the gold business fall under this umbrella? I.e. lease the gold from the government.

Bron said...

DP, removing excessive speculation is a good thing, but you do need some speculators or arbitraguers to ensure the futures price retains some reasonable relationship back to the spot physical market.

Michael H, interesting point and possible, although as a libertarian it is not a path I'd prefer.