The withdrawal of the gold bid on the dollar will bring about the collapse of the dollar
By Keith Weiner
In Part I, we looked at the concepts of
nonlinearity, dynamics, multivariate, state, and contiguity. We showed that
whatever the relationship may be between prices and the money supply in
irredeemable paper currency, it is not a simple matter of rising money supply à
rising prices.
Here is a fitting
footnote for Part I. I just bought a pair of Levis jeans at Macy’s for $45. I
remember buying a pair of Levis Jeans in Macy’s in 1983 for $50. In 30 years,
the price of Levis Jeans has fallen by 10%. By any conventional theory based on
the money supply, the price should have risen by several hundreds of dollars.
In this part, we
look at some mechanics, the understanding of which is a prerequisite to the
theory of interest and prices. To truly understand anything, you have to know
what happens in reality step by step. This is even more important in an
abstract field like monetary science. We discuss stocks vs. flows, how prices
are formed in a market, a broad concept of arbitrage, spreads, and how money
comes into and goes out of existence.
Let’s drill down
into a point I made in passing in Part I.
It is worth noting
that money does not go out of existence when one person pays another. The
recipient of money in one trade could use it to pay someone else in
another. Proponents of the linear QTM[1] would have to explain why
prices would rise only if the money supply increases. This is not a
trivial question. Prices rise whenever a buyer takes the offer, so no
particular quantity of money is necessary for a given price (or all prices) to
rise to any particular level.
It is seductive to
respond by way of the common analogy of “too much money, chasing too few
goods”. But, is that an accurate picture of how markets work?
Money supply is a
quantity of stocks. One could theoretically add
up all of the gold in human inventories, or all of the dollars in the financial
system, and come up with a scalar number of ounces or dollars.
How about goods
supply? This is a different meaning of the word supply.
Unlike in money, the supply of goods means the flows of
goods. To discuss copper or wheat, one must measure how much is mined or grown
every year. This would be pounds or bushels per year.
Flows of goods cannot be compared in any meaningful way to the stocks of money; pounds per year cannot be
compared to ounces. Just like in physics, length cannot be compared to
velocity; one cannot compare meters to meters per second. That is not a proper
approach to science—physical or monetary.
This brings us to an
important fact. The stock of money is not consumed after a transaction.
However, in the normal case, goods are. Other than the monetary commodities of
gold and silver, only small inventories are normally kept as a buffer in all
other goods. To state this in everyday terms, if Joe buys a loaf of bread from
Sally for $1, he will eat the bread (or it will go bad) but Sally has the money
until she spends it. If Acme Pipe buys 1000 pounds of copper, it will
manufacture it into plumbing and sell the plumbing.
Now let’s move on to
the mechanism of price discovery. In Part I, I stated:
In any market,
buyers and sellers meet, and the end result is the formation of the bid price
and ask price.
There is not just
one monolithic price, but two prices: the bid, and the ask (also called the
“offer”). If you come to market and you must buy, then you have to pay the
offer. For example, you own an apartment building and your lease obligates you
to provide heat for your tenants. So you go to the heating oil market. If
heating oil is bid $99 and offered $101, you must pay $101. Note what happens
next. The seller of that oil – assuming you just bought all of his oil –
leaves. He has exchanged his oil for your dollars and he goes home. The next
seller may ask $102. Now the market is bid $99 and offered $102.
Next, a heating oil
distributor comes to market with the day’s production. He must sell, because
tomorrow he will produce more. What price does he get? Did your purchase push
up the price? You did not push up the bid price, and so the new heating oil
vendor must take the bid of $99. Now this consumer is sated, he has the oil he
wants. The next best bid could be $97.
There is a
counterintuitive process here. The bid is formed
by the competition of producerswho keep
selling until the marginal seller does not accept the bid. The ask is formed by the competition of consumers who keep buying until the marginal buyer
does not accept the ask. This is a critical idea in Austrian School analysis,
so I encourage readers to stop and think this through.
Buyers keep coming
to market and taking the offer (thus lifting it) until a point is reached where
the next would-be buyer balks. This buyer, the marginal buyer,
may make his own bid, above the best bid but below the best offer. At the same
time, sellers keep coming to market and taking the bid, until the marginal
seller balks. This seller may set his own offer, below the best offer but above
the best bid.
There is one other
actor, the market maker. The market maker will act to keep a consistent bid-ask
spread. If the ask is pushed up, then the market maker will raise his bid. If
the bid is pressed down, then he will lower his ask. The market maker is the
only one who can buy at the bid and sell at the offer. His profits come from
the bid-ask spread, the wider the spread the more his profits. Of course, the
next market maker will enter and force the spread to narrow, and so on until
the margin al market maker balks and the spread does not narrow any further.
From the mechanics
described here, we begin to build a picture of how prices are set where the
“rubber meets the road” in the market. If there are more market participants
who buy at the offer then the end result is that prices move upwards. If there
are more who sell at the bid, then prices move downwards.
This may seem
tautological. It is prerequisite material.
We return to my
rhetorical question. Why would prices not keep rising in the case of a fixed
quantity of money? After all, when Joe buys the loaf of bread from Sally for $1
there is no reason why Sue could not buy it from him for $2 and John couldn’t
buy it from Sue for $3 and so on.
The observant reader
may object on grounds that prices can only go up until people cannot afford the
good. Bread cannot be $300 per loaf if no one has $300. This is comparing
stocks to flows once again. What matters is not whether the consumer has $300
in stocks, but whether the consumer has $300 in flows. If the velocity of money
(flows) rises, then the consumer could have $300 of daily income with which to
pay the price of his daily bread.
As we see from the
above discussion of price formation, neither the buyer nor the seller has an
intrinsic advantage. Both come to market and must accept the market price (ask
or bid, respectively). Size does not add any power to the seller. If anything,
the seller has a disadvantage in trying to get a price he prefers, compared to
the buyer. He has capital tied up in his productive enterprise, and certain
fixed costs like payroll that must go on whether he sells or does not sell.
Holding inventory does not normally do him any good. With the exceptions of
food and energy, buyers can afford to be pickier. They do not face the same
problem as sellers; if they go home at the end of the day with money as opposed
to goods, this is not always a problem.
Without delving too
deeply into this topic, I want to paint with a broad brush stroke. There is no
force that guarantees a constant price even if the money supply is fixed. There
are many reasons why buyers could lift the offer or sellers could press down
the bid. Not only can prices rise with the same stocks of money, but they could
also rise with the same flows of goods.
Next, let’s
introduce the concept of arbitrage. People often use this term in a very narrow
sense, to mean buying and selling the same good in different markets to shave
off a small spread. For example, IBM stock is offered at $99.99 in London and
bid at $100.00 in New York, so the arbitrager could simultaneously buy and sell
to pocket a penny. Or, in the gold market, which I write about frequently, one
could buy spot gold and sell December gold for a 0.3% annualized spread.
In this paper, I use
the word arbitrage to refer to a much broader concept. I won’t fully explore it
herein, but we need to discuss one relevant aspect.[2] Let’s go back to
our example of the landlord. What is he doing? He is seeking to make a profit
by renting out apartments to tenants. The rent is his gross revenue. How is the
rent set? If he needs to rent a unit, he must take the bid.
What are his costs?
Broadly, he must buy land, construction materials, construction labor,
maintenance labor, heating oil, etc. We will address later that he must pay the
rate of interest on the capital.
The landlord must
buy these things at the offer. We can look at him as doing an arbitrage between
his inputs—bought at the offer—and his output product—sold on the bid. The
landlord’s spread is Rent(bid) – Inputs(ask).
In this light, what
should he be the limit of what he is willing to pay for his inputs? A bit less
than the rent he receives, at most.
I give this example
to make it clear why we should not think the primary driver of markets is the
consumer with a bank account balance as his budget. One might think of a
consumer who has a total of $10. Let’s suppose he would want to pay $0.01 for a
loaf of bread. But if he had $100 total, he would pay $0.10, and so on. This is
the siren song of QTM luring one to think that increased stocks of money must
lead to higher prices. It is often stated, “if everyone’s bank account grew by
10X, then prices will be 10X higher.”
Will a middle class
consumer buy more food if he has more money?
At any rate, instead
of the consumer, we should think of the entrepreneur. He is an arbitrager who
will not normally buy inputs unless the bid on his output affords him an
acceptable margin above the offer on his inputs. What will cause consumers to
raise their bid on his outputs? This is a non-trivial question that will be
addressed in a later part of this paper.
Up until now, we
have been using the term “money” without regard to the distinction between gold
and promises to pay, i.e. between money and credit. It is now necessary to make
this distinction to continue the discussion. In the current monetary regime,
money (gold) has no official role to play at all, though it assuredly plays a
role. My permanent gold backwardation thesis[3] can be summarized as follows:
the withdrawal of the gold bid on the dollar will bring about the collapse of
the dollar because dollar holders will drive prices up exponentially by using
commodities to get gold.
Money (gold), of
course, can only come into existence via a slow and inelastic process of mining.
Money does not go out of existence (though gold coins can be melted down to
produce non-monetary objects). Both of these processes are themselves driven by
arbitrage. When the inputs required to mine one ounce of gold cost less than
one ounce, the gold miners spring into operation. When the inputs rise above
one ounce, they shut down. When jewelry sells for more than the cost of its
inputs (principally gold, labor, and perhaps gem stones) then jewelers spring
into action. When monetary gold is worth more than jewelry, then it is melted
down and returned to monetary form by arbitragers known as “Cash For Gold”.
Credit is an
entirely different animal.
[1] Quantity Theory of Money
[2] Those interested can read more about arbitrage in Disequilibrium Analysis of Price Formation by Antal Fekete, January 1, 1999
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