Think about the similarities between the following three statements:
- “My paper gold future contract will be honored by delivery of gold.”
- “If I trade my gold for paper now, I will be able to get gold back in the future.”
- “I will be able to exchange paper money for gold in the future.”
The reason why there was a significant backwardation (smaller backwardations have occurred intermittently since then) is that people did not believe the first statement. They did not trust that the gold future would be honored in gold.
And if they don’t believe that paper futures will be honored in gold, then they have no reason to believe that they can get gold in the future at all.
If some gold owners still trust the system at that point, then they can sell their gold (at much higher prices, probably). But sooner or later, there will not be any sellers of gold in the physical market.
Higher Prices Can’t Cure Permanent Gold Backwardation
With an ordinary commodity, there is a limit to what buyers are willing to pay based on the need satisfied by that commodity, the availability of substitutes and the buyers’ other needs that also must be satisfied within the same budget. The higher the price, the more holders and producers are motivated to sell, and the less consumers are motivated (or able) to buy. The cure for high prices is high prices.
But gold is different. Unlike wheat, gold is not bought for consumption. While some people hold it to speculate on increases in its paper price, these speculators will be replaced by others who hold it because it is money.
Once the gold owners have lost confidence, no amount of price change will bring back trust in paper currencies. Gold will not have a “high enough” price that will discourage buying or encourage selling. Thus gold backwardation will not only recur, but at some point, it will stay in its backwardated state.
In looking at the bid and ask, one other observation is germane to this discussion. In times of crisis, it is always the bid that is withdrawn – there is never a lack of asks. Permanent gold backwardation can be seen as the withdrawal of bids denominated in gold for irredeemable government debt paper (e.g., dollar bills).
Backwardation should not be able to happen at all as gold is so abundant. However, the fact that it has happened and keeps happening means that it is inevitable and that, at some point, backwardation will become permanent. The erosion of faith in paper money is a one-way process (with some zigs and zags). But eventually, backwardation will become deeper and deeper (while the dollar price of gold is rising, probably exponentially).
The final step is when gold completely withdraws its bid on paper. At that point, paper’s bid on gold will be unlimited, and this is why paper will inevitably collapse without gold.
Permanent gold backwardation leading to the withdrawal of the gold bid on the dollar is the inevitable result of the debt collapse. Governments and other borrowers have long since passed the point where they can amortize their debts. Now they merely “roll” the debt and the interest as they come due. This leaves them vulnerable to the market demand for their bonds. When they have an auction that fails to attract bids, the game will be over. Whether they formally default or whether they just print the currency to pay, it won’t matter.
Gold owners, like everyone else, will watch this happen. If government bond holders sell their securities in response to this crisis, they will only receive paper backed by that same government and its bonds. But the gold owner has the power to withdraw his bid on paper altogether. When that happens, there will be an irreconcilable schism between gold and paper, with real goods and services taking the side of gold. And in a process that should play out within a few months once it gets started, paper money will no longer have any value.
Gold is not officially recognized as the foundation of the financial system. Yet it is still a necessary component. When it is withdrawn, the worldwide regime of irredeemable paper money will collapse.
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