28 October 2013

Why gold's contango suggests central bank interference

In Faux Gold Arbitrage I mentioned that Tom makes the case that if anything, backwardation should be the normal state for gold. His paper arguing that case is in the clear on his site here and was also noted by GATA here.

Tom's argument is that backwardation, and not contango, should be the natural state for gold and thus the fact that gold has been in contango for "essentially all of the last 25 years strongly suggests central bank interference with the gold market." It is a counterfactual, trying to guess at how gold would behave relative to fiat if there was no manipulation.

It contrasts with those who focus on the short history of gold in the post gold standard world and observe that gold backwardation is rare, like James Turk in this piece for GoldMoney where he notes that "Gold backwardation is an abnormal condition" and "has only happened two times since this bull market in gold began back in 1999, and each prior occurrence lasted only a few days." Tom's article basically says that just because it is rare, doesn't mean it is abnormal.

James' view is based on the assumption that "interest rates are a reflection of risk" and that a currency "has a higher interest rate because it is more likely to be debased by government and central bank policy (i.e., lose purchasing power)". I think this is only looking at the supply side of the equation, and ignores demand for borrowing money. So for an economy with poor prospects there may be little demand to borrow and interest rates can fall even though no fiat is being printed.

James then says that "interest rates today result from heavy-handed central bank manipulations, thwarting real and accurate price discovery by the market" and that "market forces overpowering central bank manipulation can explain what is now happening in gold". But Toms says if contango has existed while markets have been manipulated and backwardation occurs when market forces overpower, then logically isn't backwardation the natural state for gold?

Tom makes a number of other points (including the point that money is often in backwardation, see my post on that here) and I recommend reading his paper as it will get you to think more deeply about gold, its monetary nature, and what backwardation really means.


  1. Tom's article presupposes the quantity theory of money. To wit, "gold only inflates by its annual mining supply." No it doesn't.

    "I have to conclude that the scarcity of gold". No, it's not scarce at all.

    And last but by no means least, since this is the argument Fekete uses, "Gold is different, as it has
    an enormous stock-to-production ratio". Maybe true but irrelevant. Sand also has an 'enormous stock-to-production ratio', do you covet sand? Does it have a rate of interest? How do you quantify this ratio to determine value anyhow?

    The quantity of something has no bearing on its value. Quality, and only quality, determines value.

    That said, Gold may, or may not contango, personally I think that its importance has been overplayed. The dollar has long since descended into junk, it's a Ponzi scheme pure & simple. That gold hasn't gone into hiding, suggests to me that the basis is not an objective measure.

  2. And on the subject of the scarcity of gold, hasn't Tom heard that it grows on trees?