In the past when I made claims that the dollar is doomed and other fiat currencies along with it are doomed, I never could make a compelling argument as to why I believed that was true. Not incorrectly, I said the fiat monetary system is flawed. I have observed and talked in this letter about the fact that since Nixon took us off the gold standard in 1971 and made the U.S. the world’s reserve currency, debt from which fiat money is manufactured has grown exponentially while income (GDP) has grown at best in a slow linear manner. I noted quite rightly that by creating money out of thin air, the Fed and other central banks deny price recognition for capital, which leads to mal investment and is one reason that debt continues to grow much more rapidly than income. Ultimately the chronic
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In the past when I made claims that the dollar is doomed and other fiat currencies along with it are doomed, I never could make a compelling argument as to why I believed that was true. Not incorrectly, I said the fiat monetary system is flawed. I have observed and talked in this letter about the fact that since Nixon took us off the gold standard in 1971 and made the U.S. the world’s reserve currency, debt from which fiat money is manufactured has grown exponentially while income (GDP) has grown at best in a slow linear manner. I noted quite rightly that by creating money out of thin air, the Fed and other central banks deny price recognition for capital, which leads to mal investment and is one reason that debt continues to grow much more rapidly than income. Ultimately the chronic budget deficits and rising debt levels of the private sectors as well as chronic trade deficits would collapse the system. With the loss of confidence that followed, there would be no choice but to go back to a non-political monetary system that permitted free market economics in order to avoid chronic market imbalances. Those arguments were unconvincing to all of my friends who live outside of the gold bug culture.
Enter Alasdair Macleod and the Concept of Time Preference
While as a sympathizer of Austrian economics, I had been aware of the concept of “time preference” but I had not made the connection between the relationship of that economic concept and the manipulation of interest rates by central banks. Suddenly the reason for the inevitability of the demise of the dollar and its replacement by gold became crystal clear to me. I want to share that with you now and also to pass along the link to my discussion with Alasdair, because I think he explains it so well: https://jaytaylormedia.com/media/taylor20190827-3.mp3.
Here are the basic ideas that Alasdair passed along on my show.
- Time Preference simply means that a dollar owned and held in possession today is worth more to its owners than the possession of that same dollar at some date in the future. There may be a few exceptions to that rule, such as a student foregoing income and cash presently to earn a degree if it is perceived that the receipt of that degree will boost earnings sufficiently higher in the future to justify foregoing income in the present time.
- Interest rates when determined by free markets as opposed to rates manipulated by central banks foundationally based on the concept of Time Preference. I’m willing to lend you money but only if you are willing to pay me what I require to let go of my dollars today. To a lesser or greater degree other factors such as risk of having that money returned to me at a prescribed time or some extremely compelling need to use those dollars for consumption now might require a much, much higher interest rate for me to lend my dollars now.
- Quoted interest rates to the extent they are free market are based on the collective will of each market participating acting individually.
- An Implied Time Preference annual rate for gold vs. the dollar. Gold’s current one-year time preference (interest rate) is between ~1.5% and ~2.0%, which is basically the same as one year U.S. dollar interest rates now. When the dollar time preference (interest rate) is higher than the time preference for gold, there is no reason for investors to load up on gold. For example, during the 1980s, six-month U.S. T-Bills paid ~6%. With gold’s forward rate of 1.5% to 2.0% at that time, gold bullion banks made a fortune by taking borrowing gold, selling it and using the proceeds to buy U.S. Treasuries. Whether he realized it or not, Paul Volcker used time preference to killed gold and restore capitalism to the S. by slamming on the brakes of monetary expansion in 1980. That caused interest rates to rise upward to 18% in some instances. The rate paid on dollar Treasuries were so far above the market’s time preference for the dollar that investors dumped gold causing it to crash from its 1980 high of $850 into the low $200s. During this timeframe, renowned brilliant gold analyst Frank Veneroso calculated that 10,000 to 15,000 tonnes of gold had been lent out or swapped by central banks during those years into the market driving the price of gold downward. Massive profits were made by shorting gold and using the proceeds for various arbitrage opportunities, the safest being U.S. Treasuries with great spreads.
- Bullion Banks have continued to short gold but now that seems to be changing. Why so? The answer comes back to the concept of “time preference.” Above I noted that while gold bullion banks could borrow gold at 2%, sell it for dollars and use the dollars to buy U.S. Treasuries at 6%, they made huge amounts of money. And as long as gold’s time preference (interest rate) didn’t rise above the rate they received on Treasuries they could make money with the gold carry trade. But now things have changed. Dollar interest rates are now more or less equal to gold’s interest rate. So, not only are profit opportunities gone, but with the world entering a recession and rates heading still lower, the gold carry trade is not only unprofitable but can lead to huge losses especially against leveraged transactions. Alasdair is convinced this is the dynamic that has driven the price of gold so dramatically higher in the last couple of months. No wonder Bill Dudley, former president of the N.Y. Fed, last week implored Chairman Powell to ensure President Trump is not reelected. Trump’s hard stance against China is pushing the Fed toward additional monetary ease and lower dollar interest rates, meaning that the elite bullion banks are getting squeezed in their huge gold short positions. Rather than receiving hundreds of billions in gifted profits from Federal Reserve manipulation, thee huge banks are losing big on these transactions.
- Fact: Not only the dollars and gold have time preference rates, but all commodities do as well. While dollars, gold, and silver serve as mediums of exchange and as such are the first commodities to gain from declining dollar interest rates, oil, base metals, and even real estate have time preference value as well which brings me to the next point.
- When S. rates go negative, commodities will go ballistic! Alasdair pointed out that while the euro and the yen and other European currencies can go negative and that will not be good for their economies, the repercussions of negative U.S. rates is likely to blow up the existing dollar-centric global currency system! Why? Because all commodities around the globe are priced in dollars. And when the dollar has negative rates, time preference will dictate to the world to get rid of dollars and buy commodities. Alasdair argues quite logically that all commodities will go into backwardation with negative dollar rates, meaning that the demand to presently own/hold commodities will keep the short-term futures prices higher than long term commodity contracts.
- What’s the likelihood that the U.S. rates go negative and what happens if they don’t? The chart above on your left displays the countries with negative interest rates and those that still have not entered that mysterious world in part or in whole. Negative rates, meaning the absence of time preference, opportunity is growing around the world and that is driving money into the S. where rates are still slightly positive. This also has the impact of causing the dollar to be overvalued by some 15% or so, which hurts the U.S., which is leading President Trump to push Chairman Powell very hard to also print money in what is becoming a 1930s style beggar-thy-neighbor trade warfare. If the Fed holds firm in refusing to lower rates, it is likely to lead to a market crisis sooner rather than later. On the other hand, as noted above, if the world’s currency enters negative territory, it will lead to backwardation across all commodity sectors and the end of the dollar-based global financial system. While I take seriously the desire of the elite to see Trump defeated and to even be willing to trigger a depression to make that happen, I think the jury is out on which way that will go. Trump is hated by virtually all the elites who are pushing for a one-world government with themselves of course in charge. No borders. No restriction on technological gifts to China. No strong dollar but rather a one-world currency is what they want. So, there is a very strong undercurrent from the elites to see the stock market and the U.S. tank. After all, the elites feel secure in their castles with their own armed guards protecting them.
- It may be beyond the elites’ control. Even if the elites get their way by refusing to issue money to accommodate the liquidity needs to keep stocks ever rising and the U.S. economy from recession, the global economy is in a downward spiral that appars to be out of control. The chart above right displays the pathology of Keynesian economics. With each credit cycle, debt becomes so great that the manipulation of interest rates has to continually decline with each cycle because the point at which rising rates lead to a recession/depression is constantly falling. In the S. it usually has taken an interest rate of about 5% to lead the economy back to a growth path. Now with rates only 2½% in the U.S., it seems that there simply isn’t enough fire power to turn things around in the next downturn. Moreover, Alasdair makes the point that the only time we have seen both the top of a credit cycle and trade wars was 1929. The chances of any kind of mild recession this time, especially with central banks everywhere out of amnuniton, appear to be in the range of zero to none.
Here is how Alasdair finished off his latest report titled “Negative Interest Rates and Gold.”
As well as being modified by its specific supply and demand conditions, Gold’s time preference is essentially for its moneyness, represented by its use as a medium of exchange and store of value. The moneyness aspect links it to its exchange value for all commodities, and it is this aspect of gold’s qualities that should warn us that a backwardation in gold, emanating from negative dollar interest rates, will herald a general backwardation in commodities as well.
We must not forget that markets anticipate events where they can, so with a recession threatening to turn into a slump and with a looming credit crisis in the wings the prospect of negative rates will be increasingly priced into the relationship between commodities and fiat dollars. Assuming economic prospects darken because of the coincidence of American tariffs and the emerging crisis stage of the credit cycle, it will be check-mate for central banks. They were never appointed nor are they technically equipped to save the currency at the expense of widespread bankruptcies, not just in the private sector, but of their governments as well. And that is what markets will be faced with.
The current situation has striking similarities with the 1930s, and the prospects for the global economy are driven by the same broad factors. With the gold standard then and not now the price effects are already showing differences. Nor was there a bubble of hundreds of trillions of outstanding derivatives then as there are today. This time, the monetary sins since the ending of the Bretton Woods agreement seem set to come home to roost all of a sudden, even if dollar rates are lowered towards zero and only stay there. But if they go negative and the more below zero that they go, the greater the backwardation on the whole commodity complex. The more rapidly commodities will be bought so the dollar, taxed with negative rates can be sold, and the quicker market actors will devalue the currency.
With all other fiat currencies referenced to the dollar, it will mark the start of a process that is likely to collapse the entire fiat currency system. Bullion banks which are too slow to recognize the change and have not shut down their gold obligations will be forced to steal their customers allocated gold, or go to the wall, adding to the disruption. All commodity derivatives will face a period of rapid contraction of open interest, in lockstep or one pace behind those of gold.
Instead of central banks stabilizing the system by monetary easing, the easing itself will guarantee the crisis. The development of a problem in gold markets, driving the gold price rapidly higher while some banks are caught napping, is likely to anticipate a wider financial and systemic crisis. Therefore, with gold’s sudden move higher coupled with its persistent strength we can reasonably certain that we are seeing the start of the dismantling of the dollar-based monetary system, and that gold has much further to go.