Is a deflationary gold standard bad?

I've never really got why a gradual deflationary bias was a problem. Consumers know, for example, that just about any electronic good (computers, plasma screens etc) will get cheaper in the future, yet this does not seem to stop them from being made and bought. The fact that only those people who really really want the good will buy it and those are no so enthused will wait until it gets cheaper does not seem to stop business from making money.

If it was conspicuous consumption fueled by debt (and an inflationary bias) that got us into this mess, then would not a system with a deflationary bias be the solution? It has a built in frugality: your money will have more purchasing power in the future, so only buy today what you actually need. People would also only want to take on debt if they were actually going to be productive/efficient rather than just trying to bubble up asset prices. Now maybe if we can convince Greenies that a Gold Standard would work against consumerism and thus be good for the planet, we've got a chance.

The above thoughts were prompted by these comments left at this article Gold Standard ... Debunked or Another Bubble?:

Dirk, on November 24, 2008 at 12:58 pm, said:

I’m happy someone gets it- that constraining global economic activity based on a single metal that doesn’t really correlate to economic activity makes no sense.

Clearly, the gold standard is deflationary in absence of either major gold finds, or major negative economic shocks. More goods and services chasing a fixed money pool will create massive downward pressure on prices. And downward pressure on prices and assets equals lower incentives for investment, more difficulty paying off debt, and a negative wealth effect that creates real economic stagnation.

Inflation, on the other hand, creates pressure to invest money- not hoard it. As long as a currency promises a future redemptive power, it will keep its value. Perhaps fixing currency values to a “total energy” metric- the sum of all oil, coal, gas, solar, nuclear, etc. reserves- would allow for both economic growth and a guarantee of some future redemptive power for something really useful.

16 Stanley Pinchak, on November 25, 2008 at 2:03 pm, said:

Wow so much muddled thinking in one place. It is amazing that my browser didn’t pop up a warning.

1) Any stock of money sufficient to be accepted by the public as a money and selected as the medium of exchange is capable of serving as money. There is no need to grow the stock of money. Despite this false criticism, the gold stock does grow at a predictable (by mining engineers) and low rate between 1% and 3% per year.

2) The purchasing power of a money is related to the stock of money and the demand for money. Its purchasing power is also related to the supply and demand for all other goods in society for which it is exchanged. Thus as productivity increases, the purchasing power of a stable or slowly increasing money will increase. This has the effect of making daily expenses of those with debts easier to bear.

The only time a debt would become harder to pay off would be if the debtor was in a field of employment where his pay decreased in line with the increase in purchasing power of money. This might be a possibility, but at the same time that human actors today judge their debt burdens based on future expectations of income, those operating under a regime of increasing purchasing power of money would be capable of determining their expected future debt load capabilities. Those who guess wrong in such a situation are no different than those who bite off more debt than they can chew under our inflationary regime.

The biggest improvement that increasing purchasing power has is for savers and those on fixed incomes. Savers would earn interest + the difference in purchasing power between when they started saving and when they start consuming. This is the opposite of today where the difference in purchasing power subtracts from the interest and reduces the incentive to save. This will have the effect of greatly encouraging saving and the stock of loanable funds, driving interest rates to natural and sustainable low levels. This will benefit the saver/consumer in the future as well as the entrepreneur and the durable good consumer in the present.

Inflation on the other hand encourages debt based financing. It favors instant gratification, but since there are fewer savers since debt is the preferred method of financing, the purchases of today are not sustainable. The increase in consumption fueled by new money is not fully offset by the preferences of a ever shrinking class of savers who abstain from present consumption. This results in a business cycle like we see continuously under a system of bank credit expansion (ex nihlo). Inflation encourages capital consumption and not investment as Dirk claims. Empirical evidence of this is present in the dilapidated factories and rotting machinery of the American Rust Belt.

3) All business cycles (as in repeated and not caused by something like war or famine) are the result of fractional reserve banking and its concomitant ex nihlo credit expansion. There can be no stable and sustained economic growth under a fractional reserve banking regime. There will always be over-expansion combined with malinvestment, and and then retrenchment as the bad investments are liquidated. Attempting to tie a money to a commodity standard while maintaining a fractional reserve banking system is unsustainable. There will inevitably be calls for the creation of a central bank and lender of last resort as the bust causes bank runs.

The only viable solution is to realize that fractional reserve banking on demand deposit money is clearly a case of conflicting views of a contract and thus an untenable and invalid contract. How can a depositor demand a physical object which the banker (rightly?) assumes is lent to him for his purposes. A physical object must have a clear owner and can not be subject to control simultaneously by two parties of differing opinion under which direction to place the object. Thus demand deposits must be maintained in a warehouse fashion with 100% reserve maintained at all time. This eliminates the possibility of a bank run (in the historical sense and in the practical sense of potential damage to the depositor). Furthermore by limiting bank loans to funds deposited in time accounts (i.e. true saving) there will cease to be a business cycle.

4) The idea of a world central bank is superfluous with a free monetary system and 100% reserve banking. The main purposes of the central bank are to ease governmental expansion and to act as a lender of last resort. A world central bank will only lead to world bureaucracy. If banking is on a firm economic and legal foundation, there is no need for a lender of last resort. A world central bank is only an excuse for the establishment of world government. It can not prevent world wide business cycles while maintaining a fractional reserve banking system. Furthermore, if it maintained a 100% reserve banking system, it would still be subject to political considerations in open market operation and would still cause misallocations of resources, though not of the intertemporal kind as explained by the business cycle theory. The misallocations would result in privileged borrowers being able to bid resources from those who obtain the increase in the money supply last.

5) The myth that a gold standard would limit growth is preposterous. One of the greatest periods of economic (and population) expansion was obtained under a gold standard and under a period of increasing purchasing power of money (Cf. the 19th century). There is no theoretical nor physical restriction on the growth of economy based on a sound monetary system besides the subjective actions of individuals to save which allows for the implementation of longer and more productive production techniques.

The claim that unemployment is higher under a gold standard is also ridiculous. All non voluntary unemployment is the result of artificial restrictions on the movement of labor or its price. One must be careful not to make the mistake of comparing the unemployment rates of a central bank and fractional reserve banking boom period to an average or bust phase unemployment rate under the fractional reserve banking system which has persisted in the United States prior to its inception. Under a free market, all labor wishing to be employed will be. All state intervention attempting to reduce the ranks of the unemployed can only be obtained by reducing the well being of other actors in the economy. As such interventionist attempts to reduce unemployment, though they may increase productivity (doubtful), will not be optimal as compared ex ante in terms of the satisfaction of wants of all economic actors. On utilitarian and natural rights grounds, state intervention in the labor market is counterproductive, misguided, and should be avoided.

6) The idea that there is not enough gold to back all of the fiat currencies of the world is the most foolish statement of all. Logically one can take the stock of gold available and divide it by the weighted sum (by exchange rate) of the currencies of the world. This could provide backing for every single dollar, ruble, yen, etc. However, this is a bad policy, for the market should be left free to choose its own money, it should not be instituted from on high via state decree or central bank policy.

All that needs to be done is to eliminate legal tender laws and taxes on market selected monies. Since we have several thousand years of history showing that Gold and Silver are typically selected as money, we should start by eliminating taxes on them. If there is a push for a different medium of exchange, it should be treated in the same fashion. At the same time, all fractional reserve demand deposit banking must be subjected to traditional legal principles regarding property rights.

This means a reversion to 100% reserve banking. From these two changes, the market will perform the transition to a sound money with the minimum disruption and transfer cost. A state imposed system can only result in higher costs, as well as a retention of particular privileges for the state, most commonly in the form of a central bank, liable to interfere in the money supply through open market operations and subject to the political whims of demagogues.

Money, an essentially useless substance?

Dmitry Orlov recently posted an article titled Definancialisation, Deglobalisation, Relocalisation.

For those not familiar with Dmitry, he is the author of Reinventing Collapse, which is all about "prepar[ing] for life without much money, where imported goods are scarce, and where people have to provide for their own needs, and those of their immediate neighbours."

In this article, Dmitry has a go at money and suggests barter can do the job but then suggest this is probably a better solution:

One option is to organise as communities to produce certain goods that the entire community wants: food, clothing, shelter, security and entertainment. Everyone makes their contribution, in exchange for the end product, which everyone gets to share. It is also possible to organise to produce goods that can be used in trade with other communities: trade goods. Trade goods are a much better way to store wealth than money, which is, let's face it, an essentially useless substance.

I can't say I share Dmitry's belief in this socialist nirvana. The catch for me is “everyone makes their contribution” bit. Anyway, my main beef is with his belief that trade goods are a better way to store wealth and that money is essentially useless. Now I'm not going to discuss why money is better than barter (either between individuals or “communities” it doesn't matter), as I think most people reading this get it. I'm more interested in why Dmitry would be so negative on money given its obvious efficiency it brings to exchange. The explanation is in this statement later in the article:

When we use money, we cede power to those who create money (by creating debt) and who destroy money (by cancelling debt). We also empower the ranks of people whose area of expertise is in the manipulation of arbitrary rules and arithmetic abstractions rather than in engaging directly with the physical world.

This has to be one of the best examples of the infiltration of the idea of fiat into society. This guy's whole shtick is about radically challenging society yet he can't conceive of money as anything but debt, so much so that he proposes returning to barter rather than retaining the benefits of money, but money which is directly engaged with the physical world – gold.

Another example of this misguided thinking is his statement that a lack of money “makes it more difficult to hoard wealth”. Professor Fekete has often debunked this demonisation of hoarding. Dmitry himself is confused on this matter – he thinks it is OK to hoard wealth in the form of trade goods, but not money.

I considered replying to Dmitry's article on these matters, but thinking about how brainwashed (I can think of no better word) he is on money, I considered it a futile task. I could see a stereotypical negative perception of gold as some goldbug doom and gloom eccentricity. I see a need to condense Professor Fekete's work into an easy (and quick) to understand case for sound money. Another one for the to-do list.

The War on Gold II

Further to my post of 6 May on the book Sutton, A.C., The war on gold, 1977, '76 Press, California, USA, below are some extracts from the book I've made for my personal reference:

Page 59: It is this disciplinary function of gold that is irksome to politicians and managed-economy bureaucrats and academicians. Politicians are always eager to buy votes with promises of perpetual prosperity, and bureaucrats are happy to go along to expand their own empire building.

Page 60: Of course, a market clearing price for gold (assuming a 100 percent cover for all present paper debts), might suggest a price of $800 to $1,000 an ounce. This would be a pleasant windfall for those with the foresight to own gold, but it would mean psychological devastation for those who have built their careers on the philosophy of helping everyone to live at the expense of everyone else. The latter need to conduct and anti-gold crusade for their own self-preservation.

Page 111: Defeat turned to disaster between November 1967 and March 1968, as the U.S. lost a staggering $3.2 billion from its gold stocks. By this time other European central banks followed the French example and told the United States that further defense of the dollar would require U.S. gold; none of theirs would be available. The end came on March 14, 1968, the day the Gold Pool lost 400 tons of gold to private buyers. The loss of 20 percent of the U.S. gold stocks within five months finally galvanized the Treasury into action. At the request of the Federal Reserve Bank and the U.S. Treasury, President Lyndon Johnson asked the Bank of England to close the Gold Pool operation.

Page 122: Certainly, a paper system will not last in open competition with gold and silver coins. It is recognition of Gresham's Law that forces the U.S. Treasury to be vehemently against the issue of any gold coins, even and innocuous gold bicentennial memorial coin. While at the same time the Treasury must keep a damper on the price of gold in the market place.

Page 143: The remaining question is not whether the debt structure will collapse, but when. What do we mean by “collapse”? H.A. Merklein defines collapse as a “combination of unemployment and inflation so rampant that the market ceases to function effectively.” (“Can the U.S. economy collapse?” World Oil, December 1975.) Merklein suggests that, given a 50-percent inflation rate, “public confidence in government issued fiat money tends to break down ... and barter begins to replace the money economy.” According to Merklein's calculations, with a ten-percent unemployment rate, collapse could begin at 30-percent inflation - a figure exceeded by the United Kingdom, Argentina, and Italy in 1975. Even granted the existence of many unknowns, Merklein's evidence does suggest the early 1980s as Doomsday for the United States.

Page 151: It was, in effect, a declaration of bankruptcy. When President Nixon closed the gold window he did not, as he said, demonetize gold. On the contrary, he demonetized the dollar! Regardless of his words, his actions emphasized the premium value of gold over fiat dollars. The propaganda war on gold by the U.S. since 1971 has been designed to prevent this single fact from penetrating the consciousness of the American public. When the real significance of the demonetization of the dollar is fully grasped by Americans, the result will be monetary panic, probably followed by the collapse of the debt pyramid.

Page 153: Then, on December 31, 1974, the United States removed the official ban on gold ownership by U.S. citizens. At the same time it began a massive internal propaganda campaign, with the help of an unquestioning media, against gold holding.

Page 157: The current battle – one the U.S. Treasury must win or go down in disgrace – is to prevent significant numbers of American investors from acting on the paper-gold equation. At all costs the American citizen has to be persuaded that paper dollars are at least equal to, if not better than, gold.

Page 159: The Treasury, the Federal Reserve System, and the Congress are under the illusion that they can decree what is money. They cannot. They can legislate legal tender, but that is not necessarily the same thing. Money is what people and countries will accept in exchange for goods and services. This may, or may not, be paper dollars. Historically, as we have seen, money has been gold, silver, copper, and even iron. These currencies have led to stable monetary systems. Money has also been leather, mulberry leaves, and rice paper; today it is wood pulp and ink and the present debt system. Historically, the latter have been the unstable systems. Why? Because at some point holders of these latter moneys look for something of intrinsic value as a store of wealth, and the find none.

Page 172: In early 1975 only about ten percent of South Africa's gold output was used to mint the Krugerrand, the one-ounce coin that is held mostly by individuals, not central banks, as a hedge against inflation. By the end of 1975, 25 percent of the South African gold production entered the Krugerrand presses. As a result, significantly less gold reached the world bullion market. Test marketing promotion of the Krugerrand in Philadelphia, Houston, and Los Angeles had “staggering” and “incredible” results, according to coin dealers. A major New York advertising agency, Doyle, Dane, and Bernback, was hired by the Krugerrand distributor, Intergold, to promote gold coins directly to the America public, which previously had been exposed soley to the bear-market tactics of the U.S. Government. The response was truly “staggering.” By the end of 1975, Krugerrand sales were running at the rate of 5,000,000 coins annually – an amount equal almost exactly to the total proposed IMG annual sale for 1976.

Page 180: The Treasury plan obviously is to maximize uncertainty in the market to depress price, and it cannot maximize uncertainty by regular sales. It can do so only by random sporadic actions at critical market turns, for example in deflationary periods accompanied by maximum propaganda.

Page 200: The legalization of gold in the United States in 1975 was probably not a withdrawal from coercion but an interim effort to make the propaganda war on gold more credible. History suggests that gold will once again be made illegal in the United States and subject to arbitrary seizure by a police-state apparatus. Looking back over monetary history, we see that gold has always been prominent as a protector of individual sovereignty. Private gold ownership is inconsistent with the aims of dictatorship; a war on gold is a necessary concomitant to centralized political power. Wars and fiat currencies have always gone hand in hand.

Page 203: As we look into the future (in competition with the professional prognosticators), the domestic war on gold looks like this: there will be an increasing realization by the public that the ratio between paper-debt and gold in inexorably shifting in favor of gold. That public confidence is the all-important requirement to keep a paper-debt money system afloat . . . and this confidence is eroding. Surges in confidence-erosion will account for short-run increases in the price of gold, while for intermittent periods the government will regain some public confidence; when this occurs, gold will settle back to its approximate long-run ratio to paper-debt units. At some point, however, there is a distinct probability of panic – if debt holders see the debt pyramid collapsing or even anticipate its collapse. Particularly this will be true if there is general realization that paper assets are actually someone else's debt and are inherently worthless. However, it is important to note a distinction between “realization” and “action.” Investors may “know” the pyramid is illiquid and in danger of collapse; they may not “act” on this knowledge. The herd instinct suggests that only a few will bale out in time; the majority will act in panic, too late.

The death of gold

While I have only been blogging for a short while, I have been following goldbug chatter since 1998 when I took up a position in the Depository division of the Mint. At that time it was all doom and gloom with the price in a downward trend, helped along by Gordon Brown with his auction.

This unheard of method of selling central bank gold (usually it was done on the quiet and announced later) was not endorsed by anyone and really only left two conclusions: either he was stupid or it was a conspiracy. For an example of the latter, see this 25 May 1999 posting by GATA: "A political decision was made by the British to make sure the price of gold did not rise above the key $290 gold carry trade borrowing point of the bullion dealers and to make sure that the price would tank when the first pre-gold sale announcement in more than 20 years was made."

Since that time the the gold price has risen from $250 to $1000, which implies a very unsuccessful manipulation. In some sense this is true. Consider that around 2001/02 the total amount of gold leased out was estimated between 10,000 and 16,000 ounces (see this Golden Sextant commentary) compared to approximately 30,000 oz of central bank holdings. One could conclude the increase in gold from 2002 to 2009 is proof the manipulators ran out of firepower (ie gold to lease to support short selling) over that time.

If indeed central banks have leased all they can, then one would assume that the market is finally poised at the crucial tipping point that the commentators from those early days have been waiting for, where further physical buying that is already in excess of mine and scrap supply will overwhelm supply from short sold leased gold, resulting in a parabolic rise in the gold price as the shorts are broken, scrambling to cover their positions being unable to post sufficient collateral to cover the huge rise in gold.

This is the 1980 spike revisited, but at a much higher inflation adjusted price. How high? There are as many guesses as their are commentators - $2200, $5000 or more? This is the end game that many goldbugs have been waiting for, when they can shout "we won"!

But will they have won? I would argue not. I would argue that such a scenario would actually be the death of gold.

Those who welcome a 1980s spike have lost sight of the real war. There are others who are driven by base greed. They have fallen into the trap of seeing gold as an investment. It is no such thing. It has no power to create wealth - it is an inert thing. It is only the entrepreneur and inventor who create wealth. Hawking gold as an investment is bubble behaviour, no different to the debt fueled bubbles in stocks and real estate. Such people are no friends of gold.

Gold is money. Often stated, but what does it mean? Gold is for storing wealth, not making it. I can only suggest reading Whither Gold? by Antal Fekete if you want to get what I am talking about. Those who understand this understand that the real war is gold as money versus fiat as money. The winner is the one that can demonstrate an ability to store wealth.

One may argue, how can fiat win when it has lost 95% of its value since the Federal Reserve came into power in 1913? This is too broad a sweep of time for the average person. They look only year to year, and single digit inflation looks stable to them. There is some vague understanding that money loses value, but it is not dramatic and anyway, the way to deal with this is to "invest".

To beat gold in this war, all you have to do it make it look unstable. This is why a parabolic rise in the gold price is counterproductive. It makes the average person see gold as a speculative investment, worst still, one that does not pay a dividend. Parallels to 1980 will be drawn, focusing on the bust after that bubble. This does nothing for gold's image as a stable store of wealth.

From this point of view, the theory of suppression of the gold price misses the point. To kill gold you don't manipulate its price, you manipulate its volatility. If gold looks unstable, it is unlikely that a gold standard will ever be accepted.

Therefore, at the one moment in time when people may lose faith in debt based investing as a way to beat inflation and preserve wealth, when they are looking for something else more stable, gold will fail to win them over.

I mentioned earlier about a tipping point. I would like to conclude with one last idea: one other advantage of manipulating volatility rather than price is that your firepower lasts longer. All you need to do is start a trend, or help a trend along. Herd behaviour and chartist momentum will do the rest. Bullish or bearish, it doesn't matter. As long as the price moves wildly, your ends are served. For those that believe in manipulation this thesis means we are not at a tipping point and the manipulation has many more years to run.

Credit Restriction

From Prosperity and Depression: A Theoretical Analysis of Cyclical Movements, G Von Haberler, rev ed., 1939, published by League of Nations:

Prosperity comes to an end when credit expansion is discontinued. Since the process of expansion, after it has been allowed to gain a certain speed, can be stopped only by a jolt, theere is always the danger that expansion will be not merely stopped but reversed, and will be followed by a process of contraction which is itself cumulative.

If the restriction of credit did not occur, the active phase of the trade cycle could be indefinitely prolonged, at the cost, no doubt, of an indefinite rise of prices and an abandonment of the gold standard.

Well, we abandoned the gold standard, had unrestricted credit, so now we wait for an indefinite rise of prices?

Bookkeeping is more or less based on the assumption of a constant value of money. Periods of major inflations have shown that this tradition is very deeply rooted and that long and disagreeable experiences are necessary to change the habit. One of the consequences is that durable means of production - such as machines and factory buildings - figure in cost accounts at the actual cost of acquisition, and are written off on that basis. If prices rise, this procedure is illegitimate. The enhanced replacement cost should be substituted for the original cost of acquisition. This, however, is not done, or is done only to an insufficient extent and only after prices have risen considerably. The consequence is that too little is written off, paper profits appear, and the entrepreneur is temptted to increase his consumption. Capital in such case is treated as income.

The paper profits are also likely to add to the cumulative force of the upswing, because they stimulate borrowers and lenders to borrow and lend more. The foster the optimistic spirit prevailing during the upswing, and so the credit expansion is likely to be accelerated. This phenomenon has its exact counterpart during the downswing of the cycle.

Those interested in the above may also find Professor Fekete's paper Is Our Accounting System Flawed? of interest.

Metal Accounting I

This article discusses the issues associated with keeping track of precious metals. I call it metal accounting because the point is to ensure that ounce debits (ie assets) always equals ounce credits (ie liabilities). This should be of interest to anyone holding unallocated metal because the extent that your "custodian" doesn't have control over their metal activities is the extent that your holding is not backed and thus the custodian is exposed to precious metal prices. If this exposure is excessive, and the price rises, they go bankrupt.

I put custodian in inverted commas because unallocated metal, even if backed 100% by physical, is not the same as a true custodial service, commonly referred to as allocated metal. With allocated, you hold title to the physical metal and the storer is just a safekeeper of your metal. It is off the balance sheet of the storer and control of it is a very simple process: run listing of how many bars your are holding for a client, do a count of the bars in the vault, the two should equal.

Unallocated metal, on the other hand, is on the balance sheet of the storer. This is why it is so important that debits equal credits, from an ounce point of view. At first you may think that the controls around keeping track of allocated should apply to unallocated - if you owe 100oz to clients, then you should have 100oz of physical gold on site. What this article hopefully reveals is that it is not necessarily that simple and an appreciation of the need for stronger controls.

The Golden Table

Let me start with an imperfect analogy for the manufacture of precious metal products: making a wood table. Looking at your plans, you go down to the hardware store and buy some wood and nails, say it costs $100 all up. It is not likely that you will get the exact lengths you need, so some sawing is involved. Whack a few nails in and you have your table.

If I asked you what the table cost, you look at me strangely and say $100 and wonder why I was so stupid. Your answer, however, has made one assumption: that your "by-products" of the table making process are worthless. What are these by-products? They are the wood offcuts and sawdust and your assumption is most likely correct.

Now consider that you are making the same table out of gold. Lets assume the same $100 purchasing cost for the raw gold (it would have to be a really small table) and same process - you have to cut up the gold planks. When I asked what the cost was, would you still say $100? Of course not, you aren't going to sweep up the golddust and throw it and the gold offcuts in the bin like you would with the wood. You would melt them down and sell them to a refinery and the money you would get back would reduce the initial cost of $100. It is like the hardware store giving you a refund for the wood offcuts and sawdust.

This is what makes precious metal manufacture different from normal manufacture and is a function of the high value of precious metals and the fact that you can melt the by-products and reuse them without any or much loss of "utility". My first exposure to this was when I looked at a stocktake count summary and saw a line called "sweeps". It was literally the amount of gold after refining from the sweepings from the factory floor. That plus the fact that the counts were done down to 1/1000th of an ounce that was my first indication that this minting business was just a little bit different.

The existence of by-products introduces our first complication in precious metal control - estimations. To help illustrate the issue, let us first complicate our gold table process. As your local hardware store doesn't sell gold planks, you have to buy standard size gold bars from your local refinery. You therefore have to melt them and pour them into a mould for the legs of your table.

To melt and pour gold, you have to heat it to above its melting point. The reason for this is that gold cools very quickly and if it is just at its melting point it will go solid before you can finishing pouring it. However, this creates a problem because when something is above its melting point (but not yet at its boiling point), some of the liquid is evaporating. Now you might think how much gold would really evaporate and I don't know the technical answer to that. But what I do know is that it must be enough because above any gold furnace I've seen there is a hood that sucks in the fumes, taking it to a "scrubber" that collects the gold particles. However much gold is evaporated, it must be worth enough to go to all that trouble. Consider also that the crucibles in which the gold bars are melted also, over time, absorb amounts of gold.

Estimations

So how do you do a precious metals stocktake? First step is working out your "theoretical" or book inventory. Say you received 100oz of raw gold and recorded shipments of 90oz of coins. 100 minus 90 equals 10oz. Second step seems simple enough, go around and count all the physical gold and it should add up to 10oz. Easy.

OK, lets say there are 5 x 1oz finished coins on the shelves and 3 ounces of "offcuts". But what about the gold in the sweeps, embedded in the crucibles, in the scrubbers? This is where one has to estimate the gold that is onsite, but not measurable - for example you don't want to crush up and refine your perfectly good crucibles just because it happens to be a stocktake date. Introducing estimations, however, introduces room for human error. This is minimised by keeping historical records of the usual gold recovery from spent crucibles, scrubbers etc, so that there is a reasonable basis or justification for the estimated "onsite but not measurable" gold. Lets say this is worked out to be 1 ounce.

We are still missing 1 ounce. At this point consider that not all "recovery" controls are 100% effective. Scrubbers still let some gold evaporated gold out, for example. I've only described a few of the many recovery type controls in a precious metal factory, there are many more and over high volumes of manufacture bits of gold can be lost. The use of the word "loss" is often interpreted as "theft" but it is more accurately described as a "production" loss. It is a sort of known unknown. But this is not really fair, because production managers, again from historical stocktakes, know that there is a certain ratio of production losses to volume manufactured, which enables them to calculate and expected production loss.

Lets say in our example that the production loss ratio is 1% (our production manager would get fired if that was an actual loss). The estimate loss is therefore 0.950oz (1% of 95 coins made). This leaves us with a stocktake result of 5+3+1+0.95 = 9.950oz against theoretical or book inventory of 10oz. What happened to the 0.050oz? In a precious metals stocktake this is the key question.

First thing that is looked at is the accuracy of the count of measurable/countable physical gold. Second the production manager reviews the by-product estimations. If these two look OK, then third is to consider the effectiveness of the recovery controls. For example, maybe there was a hole in the ducting to the scrubbers and thus more gold was lost to evaporation. If controls are OK then it only leaves two possibilities:

1. Your production loss ratio is not correct. Maybe for every 95 coins made you lose 1oz?
2. Maybe your production loss ratio is correct. Therefore, someone in the factory has managed to secrete 0.001oz out every week over the past year.

The problem is that it is not easy to answer the question, because the stocktake result relies on estimations. This is why mints have one other "recovery" control - physical metal detection of staff as they leave the factory!

The above discussion is simplified, of course. There are many more processes involved in a refinery or mint and many more opportunities for production losses, necessitating many more controls. This is where accurate historical records and experienced staff come in to keep account of precious metal.

There is one thing we have missed. In our example, we only have 9oz in physical metal. Whether the 1oz is 0.95oz of production losses and 0.05oz of theft, or 1oz of production loss, doesn't change the fact that we have lost 1oz. If the 10oz book inventory was funded/acquired from clients holding unallocated with us, then we only have 9oz of physical against 10oz of liabilities.

This is why this article was titled Metal Accounting I. In Metal Accounting II, we will discuss how the 1oz loss is dealt with and introduce yet more opportunities for gold to get lost.

Silver Smoking Guns

This recent post (well delayed for those not subscribing to Tom Szabo's Metal Augmentor) is the sort of quality analysis that I wish many of the so-called silver experts would do. Worth reading.

For those pressed for time, some excerpts:

What if, instead, we studied the Bank Participation Report under the assumption that it is NOT a smoking gun? Can we then find some use in it? I humbly offer one hypothesis.

Let’s go out on a limb and suppose that the increase in the COMEX silver short futures positions by the U.S. banks did not directly cause the price of silver to fall. This is actually pretty easy to do since the short futures positions were put on before the price of silver actually fell.

If the short futures position of the U.S. banks didn’t cause the price of silver to fall, which is obviously true, perhaps the same market conditions that did cause the price of silver to fall also resulted in the banks establishing the large short futures position. How would that work?

To answer the question, we obviously need to look at the market conditions that prevailed during the relevant time frame. And because we have hypothetically eliminated the “smoking gun thesis”, we must now substitute bona fide market forces for the price manipulation that is alleged to have caused the price of silver to decline precipitously.

... if the banks are still holding their COMEX short positions as hedges against loan collateral in the form of physical silver and gold, that could represent a dangerous overhang to the market. It is especially troubling that the loans have not been paid back in almost a year. Another squeeze in liquidity could cause more defaults that would force the banks to sell the silver and gold collateral. One possible early manifestation of this would be a sudden jump in the contango especially as measured by the LBMA silver forward rates.

... I’ll just note that while we’ve had quite a climb in the silver forward rates since the mild backwardation in the shorter maturities earlier this year, we haven’t reached the critical point. In my estimation, the critical point would be reached if the normalized forward rate (after removing the effect of interest) climbs above the historical average. This is something to watch closely while the bank participation in COMEX silver futures remains so large and so short, and I intend to do just that.

Australian yield curve and mortgage rates

Below is a short commentary on mortgage rates I received from Jackarine Ludwig of Aggregated Awareness:

The Mystery Behind the Parabolic Yield Curve is a nice report by Gary Dorsch, an American chartist I follow. Rarely does Australia get a mention in his reports. It is good that he's done so now. His charts a good, because they tie in with political & economic events.

Although I don't see the rise in the Australian yield curve as a mystery. And whether Wayne Swan wishes to call it the fault of the 'bond vigilantes' in the US Debt markets or not is irrevelent. Fact is, China is the biggest foreign holder of bonds, both from the US and elsewhere, including Australia. It is obvious that they are the 'bond vigilantes' which Swan refers to.

Regardless, it makes perfect sense from a fundamental supply/demand equation, that more supply would reduce prices, so I don't know what Swan is complaining about? Under his, Ken Henry's & Kevin Rudd's command, the Treasury is going into record setting hock mode for the foreseeable future. By 2012, this government has projected a total deficit of A$300 billion. You read that right, that's billion with a B. What did he reckon was going to happen? Bond Prices to rise & yields fall when he was getting involved in issuing more bonds? HaHaHaHa...What a fool. It is obvious to anyone with a brain, that more Australian bond supply would reduce bond prices & subsequently increase yields. Nothing conspiratorial there Mr. Swan.

If you wish to follow the short & long end bond yields of Australia, US & UK, may I suggest this site. It is updated daily.

Now if you didn't think bond yields are important, then you have obviously never borrowed any money or paid any taxes. If you have borrowed money or paid taxes, then I can say that the yields on 3 year Aussie Treasury bonds, sets the mortgage rate for 3 year adjustable rate mortgages, and the 10 year Aussie Treasury bond sets the rate for longer term mortgages, the 7 year, 10 year or 15 year fixed rate mortgages. And these yields are the interest paid by your tax dollars toward those creditors who have purchased these bonds, both domestic & foreign.

For mortgages, the normal rule of thumb is that banks add 2.5% to the price of these bonds to come up with the mortgage rates. Although lately, because of the rising bond yield, and the fact that it's politically unpalatable to raise home loan rates at the moment, the banks have been copping the bond rate increases and not passing it onto retail borrowers. Therefore, in the past month, banks have not been adding 2.5% to bond yields to calculate their mortgages, but more like 1.7% for the 15 & 10 year fixed mortgages. But I read a story yesterday that said that CBA were looking at raising rates again, but having just gone to their site we can see that they haven't raise them yet.

I received this commentary on Friday and now a number of Aussie banks have moved their rates up in between RBA moves, which is unusual. Maybe the first indication to the average Joe that the Government is not some all powerful economic lever puller who can make it all OK?

AUD Gold Scatter Graph

Just one of the many fun charts you can produce from the Perth Mint's historical data.

Canadian Mint - $20m loss?

Extracts from the Ottawa Citizen 9 June:

On government orders, the Royal Canadian Mint has called for a criminal probe into as much as $20 million in unaccounted-for gold and precious metals at its Sussex Drive headquarters.

The looming police investigation comes eight months after the Crown corporation first learned it had lost track of the riches last October. It didn’t inform the government until the Citizen revealed the mystery last week.

An internal “precious metals reconciliation” project was initiated by the Mint last fall. In March, with that reckoning apparently no nearer to finding answers, an external audit was commissioned. Its findings are expected next week.

From the Ottawa Citizen 6 June:

NDP MP Pat Martin, representing Winnipeg Centre and vice-chair of the Commons' government operations committee, believes four months should have been ample time for the external audit to find an auditing or accounting problem.

Still, Martin thinks theft is the least likely explanation for the unaccounted gold.

"Given the sheer volume of activity lately, there could be some slippage and line loss in the processes. There could be some maladministration with the accounting systems and, in the worst-case scenario, somebody's figured out a way to slip some precious metals out of there, but that's the least likely of the three," he said.

Knowing the issues involved in precious metals reconciliations, I am doubtful that the police are going to be able to do any better unless the Mint has specific evidence/reasons of theft. I'll discuss why in my next blog.