I have declined to answer the challenge of an opponent of mine to debate the semantics of the word “arbitrage”. He keeps referring to me by name and to my work through innuendoes. He puts words into my mouth which I have never uttered, and so completely misrepresents my views that I cannot escape the conclusion that he never read or properly digested my theory of permanent gold backwardation.
The threat of permanent gold backwardation is one that, in my view, casts a dark shadow on the future of our civilization much the same way as the disappearance of gold from commerce cast one in 476 A.D., the year when the Western half of the Roman Empire collapsed, world trade succumbed to barter, law and order broke down, and centuries of Dark Age descended upon Western Europe. For this reason the subject should be treated responsibly and with the humility it deserves. This I cannot discover even in traces in the self-indulgent tirades of my opponent. I fail to see how his broadsides could be treated with respect. However, I do see the need for restating my theory clearly for the benefit of those who have an open mind and are desirous of learning.
There are three broad explanations justifying the existence of futures markets:
(1) Insurance offered to producers and consumers to cover the risk of extreme price swings.
(2) Outlet for human gambling instincts whereby gamblers can place their bets on the course of future price movements in the hope of large leveraged gains.
(3) Market for warehousing services.
The first (1) is the pat explanation offered by Keynes and the Keynesians. Keynes himself coined the expression “normal backwardation”, suggesting that the normal condition of the futures markets is backwardation, i.e., when the basis (spread between the price for delivery in the nearby future and the price for delivery on the spot) is negative. Contango, when the basis is positive, is an aberration. Keynes unambiguously stated that the negative basis is the “insurance premium” collected by the insurers for their service from the producers and consumers. They unloaded their price risk to the insurers against the payment of this insurance premium. In more detail, the producer can sell forward if he is concerned that the price will fall; the consumer can buy forward if he is concerned that the price will rise. According to Keynes’ argument it stands to reason that the producer will get paid less for his goods to be delivered in the future, because the insurer has taken his cut in the form of a negative basis. Likewise, according to the rest of his argument, the consumer will have to pay more for delivery on the spot, because the spot price incorporates the insurance premium in the form of a negative basis.
I shall not enter the debate whether or not there is a grain of truth in this explanation. It is clear that Keynes did not understand, nay, he completely misrepresented the essence of speculation in commodity futures trading. He has blithely wiped out the distinction between the action of a gambler shooting helter- skelter from the hip and the business of a professional insurer who scientifically studies his markets, charges a variable insurance premium in a way that diminishes his risks while guarantees reliable profits and the survival of their trade even in the greatest adversity − provided only that the monetary system is sound (which ours is not based, as it is, on irredeemable promises). Thus Keynes’ theory of the futures markets may appear as a joke to practitioners of the trade. This is confirmed by the necessity to change the signature of the basis. If backwardation were really “normal”, it should have a positive basis, rather than a negative one! (Perhaps this bothersome change of signature was the reason why Keynes never mentions the basis in his 1930 work Treatise on Money.)
The second explanation (2) appears a notch more serious. It would be hard to deny the fact that the commodity futures markets, no less than the equity markets attract speculators like a honey-pot attracts the bees.
It may also be that speculation is the necessary catalyst to provide liquidity without which these markets could not function. Having said that, we must admit that there is a clear difference between organized commodity exchanges on the one hand and the casino − or futures markets dealing in financial futures − on the other.
The difference is this: the risks involved in the former are created by nature. By contrast, risks involved in the latter are artificial in that they are created by man, as in the case of the casino that rigs the chances to win at the roulette wheel or at the blackjack table; or by the government that discards the gold anchor in the monetary system and the gold leash in the fiscal system to create artificial risks where none existed before, in the foreign exchange market and the bond market. Risks are rigged in favor of the casino or the government, and to the prejudice of every other participant. Of course the government keeps pretending, mendaciously, that such risks as exist are inherent in the foreign exchange and bond market; they are natural, and bad government cannot be blamed for the economic damage and human suffering they routinely cause. The fact remains, however, that futures markets for foreign exchange or for bonds were conspicuous only by their absence under the gold standard. Not that they were outlawed. You could start one any time of your choice. But variations in foreign exchange rates and in bond prices were so minuscule under the gold standard that speculation simply would not pay.
Of course, mainstream economists fail to make a distinction between risks created by nature and risks created by man. They have a hidden agenda: to exempt the government from responsibility for rising prices, for unstable foreign exchange and interest rates. All untoward economic phenomena must be blamed on Mother Nature even when they are direct consequences of government interference.
The apostle of the false creed that the price of gold has been artificially fixed under the gold standard was Milton Friedman. This Mephistopheles gave the evil advice to the Emperor that issuing irredeemable paper dollars would solve the perennial problem of a bare treasury for once and all. After a hiatus of forty years we can now see the chickens, hatched by Friedman, coming home to roost. Friedman maliciously misrepresented the essence of a gold standard. Far from being a scheme of fixing the value of gold in terms of paper, the gold standard is a scheme of fixing the value of paper in gold. That’s what needs to be fixed, not the other way round! The essence of the gold standard is that it denies the power of regulating the money supply to the government and the banking system. It is motivated by the desire that whenever people think that there are not enough gold coins in circulation, they should be able to do something about it. They will take new gold from the mines, or old gold (jewelry) from the refinery to the Mint and exchange it, ounce for ounce, for spanking new coins of the realm containing exactly the same amount of gold.
The Constitution did not set up a Central Bank for the United States, as Friedman well knew. It established the United States Mint instead. The purpose of the Mint was not the striking of base metal coins, that is, fake money imitating coins earlier struck in silver, to fool the people. The constitutionally mandated Mint was the very means of putting the power to regulate the amount of money in circulation firmly into the hands of the people where it belonged. This power had thus been explicitly denied to the government and to the banks by the Constitution. They could not create money, except on exactly on the same terms as the humblest of subjects could: by taking panned gold to the Mint, or gold that was obtained abroad as payment for exports.
Whether Friedman was too dumb to understand this or he was just a devious intellectual with a hidden agenda to overthrow the Constitution stealthily without even trying to amend it, is a question left to historiography to decide. Had he been an upright man and an honest economist true to his discipline, he would have recommended a Constitutional Amendment to the effect that the irredeemable paper dollar be henceforth recognized as Constitutional money. He would not have stooped to the chicanery of putting through a pocket-amendment in order to fool the public. After all, the Founding Fathers have made provision for amending the Constitution.
Whatever Friedman did, we have to suffer the consequences, which are fearsome.
Thus we are left with explanation (3). Mainstream economics has badly neglected the study of commodity futures markets and can offer no guidance in this regard. The reason for the neglect is abundantly clear. Such a study cannot be based on the assumption that the regime of irredeemable currency is legitimate. In the absence of a gold standard people are forced to hoard commodities for the purpose of saving. Only simpletons would on their own free will choose to save in the form of hoarding irredeemable promises, whether the promise has been issued by a bank or directly by the Treasury. The financial annals fail to mention a single instance of dishonored promises to pay going to a premium. They have always gone to a discount. They are utterly unsuitable for saving because they are destined to lose all their value, down to the last farthing.
In other words, under our present monetary arrangements the commodity market is called upon to satisfy an exogenous demand, namely, demand for commodities needed as a substitute for irredeemable promises pushed down the throat of the saving public. As a consequence, the commodity market cannot help but ultimately turn itself into a gambling casino. Commodity futures trading as it was originally conceived for the purpose of price-discovery and hedging, is badly distorted.
I have taken the task upon myself to find a definitive answer to the question how to explain and justify the existence and legitimacy of futures markets. Here is my answer. Legitimate futures markets include all those trading agricultural commodities where supply is unpredictable for reasons of their dependence upon nature, sometimes giving us bumper crops, at other times crop failures. Futures markets trading non-agricultural commodities are also legitimate.
By contrast, all future markets trading so-called financial futures are illegitimate. The reason is that risks involved in holding financial futures are made artificially by the government and are rigged to the prejudice of the subjects. For example, the foreign exchange market used to be stable and risk-free under the gold standard. Now it belongs to the category of gambling casinos, even if outwardly it resembles commodity exchange markets. The resemblance is a deliberate deception. The government, academia, and the financial press try to lump the foreign exchange markets, bond markets and other derivative markets together with the commodity market to create the impression that the risks they tackle have also been created by nature. This effort is subordinated to the task of perpetuating the regime of irredeemable currency and to prop up the market for government bonds. The latter is in constant danger of collapsing. It has a captive clientele: banks, insurance companies, pension funds, government agencies such as deposit insurance, unemployment insurance, old age security administration funds, and the like. They are under duress to hold government bonds as reserves in their portfolio. In consequence these funds are perfectly useless for the purpose they allegedly serve, namely, to make funds available for payout. In case of real need for selling government bonds, bids are withdrawn and the bonds can only be sold at a deep discount, if at all. The only purpose the government bond market serves is to make the bond appear sound and negotiable, which it is not (save a handful of countries with negligible government debt such as Norway and Singapore, for example).