The GLD Standard
January 3, 2010
Managing currencies is simple. People today don’t know how to do it, so it seems hard. But, actually, it is simple.
You can set up all sorts of currency systems. Hong Kong has a dollar peg. Singapore has a peg to a currency basket. The U.S. and Europe have a cabal of bureaucrats who make shit up as they go along. However, the best system is to have a currency pegged to gold. Gold is the most stable thing out there, in terms of monetary value, so if you peg to gold you’ll have the most stable currency possible. Not only is gold more stable than any alternative, but it is so stable that you can treat it as being completely stable, in an absolute sense.
Many, many governments have tried to peg their currencies to one thing or another — usually a major international currency — and most of the time, it has blown up in their face. This makes them rather hesitant to do so again. But, their failure is really a failure of technique. They didn’t know what they were doing. So, of course it blew up. What did you expect?
Unfortunately, most gold standard advocates today also don’t know how to peg a currency properly. They talk a lot about gold “backing,” which is totally meaningless. You can tell they don’t know what they are talking about, because if they knew what they were talking about, they wouldn’t be talking about gold “backing.” If these people wanted to set up a gold standard system — with the best of intentions — it would eventually blow up in their face. Probably pretty quickly.
I’ve said many times that the secret is supply and demand. Or, really it is just supply, because you can’t control demand. You manage the supply to maintain the peg at your specified level. “Supply” is known as “base money.” It is not MZM, M1, M2, M3 or any of these other measures which are measures of credit, not money.
Sometimes people halfway understand what I am talking about here, but they basically don’t think it would work. The history of failed “pegs” weighs heavily in their mind. I mention in my book that the exchange rate between dollar bills and ten-dollar bills — namely, 10:1 — is maintained exactly by this method, and it always works. How is it that one worthless piece of paper — a “$1 bill” — is always worth 1/10th that of another worthless piece of paper, known as a “$10 bill”? It’s not due to government coercion. There’s no black market in $1 bills and $10 bills. Nobody goes to jail for exchanging seven $1 bills for a $10 bill. The Fed doesn’t intervene in the domestic exchange market. The 10:1 ratio is not just a government edict, it is these paper chits’ real market value. However, sometimes people need a little more help than that.
What is a currency? It is a worthless piece of paper. Why does it have value at all? It is a combination of two things. First, there is at least some demand. People want to use it as a facilitator of transactions. Probably the government demands that taxes be paid in that currency, and probably bans the use of other currencies domestically. What if I decided today to make my own currency, and printed up $200 worth? The supply is very small. Only $200. And limited, since I control it. However, nobody would take my funny paper in trade for goods and services. In other words, it would have no value, because there is no demand.
Second, supply is limited. For example, what if everyone was allowed to print $20 bills on their color laser printer, and this was totally legal? But, at the same time, the government would not take the homemade $20 bills in trade for anything. Of course the value of $20 bills would collapse to their production cost.
Oddly enough, the value of $1 bills and $10 bills may not collapse, if their supply was controlled. The exchange rate between $20 bills and $10 bills would float. For example, my 90% silver dimes from the 1950s are worth more than a $1 bill today. This is because their supply is limited by the fact that they are made of silver. However, it is not necessarily the fact that they are made from silver that makes them valuable, but rather the limited supply. My MS65 $20 Saint Gaudens are worth about three times the value of their contained gold bullion. In this case, the supply is limited by the fact that they are not being produced anymore, and are in good condition.
Probably anyone would agree with this in principle. But, observe what we didn’t say: we didn’t say that a currency’s value results from an interest rate policy, or because some government buffoon talks about a “strong dollar policy” in public. We also didn’t say that there needed to be a vault full of gold, or foreign currency “reserves” or “backing” or whatever. These things are secondary, and ultimately unnecessary. The important thing is supply and demand.
So, as an example, let’s take the GLD gold ETF. What is it?
The ETF is a “piece of paper.” Actually, it is not even a piece of paper, but electronic ephemera. Literally, it is a liability on the part of your stock brokerage, set against an asset (presumably a “deposit”) at the Depository Trust and Clearing Corporation. The DTCC doesn’t own the ETF either, but rather has an asset with Cede & Co., which owns (supposedly) most of the equity in the United States. I don’t think you could get an actual piece of paper — a real stock certificate, which is a legal document indicating direct ownership — even if you asked nicely. You might be able to get direct registration, so you would directly own the ETF rather than going through a chain of counterparties, but you would have to make a special request.
So, you own a commitment based on a committment, based on a committment, based on ownership of the ETF. What is this ETF? It is a legal contract, signifying — well, what exactly? I suppose it’s in the prospectus. Presumably, it indicates a fractional ownership of the assets of the trust. However, the GLD prospectus is very, very complicated. There is all sorts of language indicating that, if push came to shove, nobody is obligated to do anything for anyone ever. A paper currency signifies nothing whatsoever. It is not a legal contract for anything. GLD is more-or-less the same thing, which is to say nothing at all, though this is clouded in billows of legalese.
We do know one thing: the ETF is “pegged to gold.” Its market value is linked to gold bullion, in an apparently reliable fashion. How does the ETF accomplish this? Via the adjustment of supply.
Sometimes there are lots of buyers of the ETF. The market value of the ETF may threaten to rise above the market value of gold bullion. In this case, the manager of the ETF sells additional shares of GLD, on a real-time basis to meet the increased demand, and maintain the value of the GLD in parity with gold. The total number of GLD shares in existence increases. In central bank terminology, this is an unsterilized intervention. This is how the vast majority of GLD shares have come into existence.
Does the trust then buy gold bullion with the money from these new shares? Maybe. Maybe not. Who knows. The point is, GLD remains pegged to gold whether or not there is actually any gold (or tungsten!) in some vaults somewhere.
Note something else here: the shares outstanding of GLD has increased by a huge amount. However, the value of GLD is unchanged. It is pegged to gold. (Since we assume that gold is stable in value, that means that GLD is stable in value too.) There are all sorts of people who say that “printing money” — in any quantity at any time — is “inflationary.” However, we see that the enormous increase in the GLD shares outstanding over the past three years or so was not accompanied by a decline in the value of GLD. This is because the increase in GLD was in response to rising demand. If the trust didn’t sell freshly-printed shares of GLD in the open market, the market value of GLD would have risen! So, it is perfectly possible to have increasing “base money” without a decline in currency value, if that increase in supply matches an increase in demand.
Sometimes there are lots of sellers of the ETF. The market value of the ETF may threaten to fall below the market value of gold bullion. In this case, the manager of the ETF buys shares of GLD, to support the market value of the ETF. The total number of GLD shares in existence decreases. This is also an unsterilized intervention, in central banker-speak.
Let’s say that, for whatever reason, nobody wanted to own GLD anymore. Why? I don’t know. It doesn’t matter why. Maybe they all wanted to switch to PHY, Sprott’s new gold ETF which promises (unlike GLD) to hold gold bullion in physical storage on a 1:1 basis with shares outstanding. Heck, I would.
GLD now has a market cap of $43 billion. Let’s say that, within a month, 90% of the holders want to sell, and there are no new buyers.
Assuming that GLD maintains its link with gold bullion, then the GLD managers would have to buy 90% of the shares outstanding of the ETF. These shares would disappear from circulation. At the end of the month, the number of GLD shares outstanding would have fallen by 90%. However, the value of GLD would remain the same — pegged to gold.
Think about that. We have a 90% reduction in “demand” in the very short time period of a month. But, the “currency” — GLD — remains pegged to gold. Unless you were paying close attention to the shares outstanding, you might not even notice that anything happened at all.
Some other important points here. The shares outstanding of GLD fell by 90%. That is a big reduction. However, the value of GLD did not rise. Thus, a decline in “base money” by itself does not create monetary deflation. It was in response to a change in demand. In fact, if the shares outstanding was not reduced by 90%, the value of GLD would have fallen below its gold parity.
Now let’s take a different example. Let’s say that 90% of GLD holders want to sell, but the GLD manager does not buy shares on the open market. Supply does not decrease. The number of shares outstanding (“base money”) remains unchanged.
Obviously, with demand down, and supply unchanged, the value of GLD would fall. It would fall below its parity with gold bullion.
The second thing that would happen is that GLD holders would observe that the value of GLD is falling below its gold parity, and that the GLD managers are not doing what they said they would do. As a result, there would be even more selling, and even less buying, as it has become apparent that the GLD managers are either incompetents or criminals. The demand for GLD would absolutely plummet. In other words, GLD would have a “currency crisis.”
This is how most currency crises come about. For whatever reason — any reason will do — there is a decline in demand for a currency. The currency managers fail to address this decline in demand by reducing supply (base money) appropriately. The result is that the currency does something unpleasant, which leads to an even larger decline in demand, which is normally followed by a similarly incompetent response. Kaboom!
Observe that there is no “interest rate policy” for GLD. Nor is there a “strong GLD policy.” Nor is there a “forex intervention” of the manipulative, invasive, coercive sort. Nobody cares about MZM, M1, M2, M3 yadda yadda for GLD. GLD has no government deficit, unemployment rate, stock market, or associated economy. The GLD manager does not have to make public pronouncements with carefully worded language. The IMF doesn’t have to make promises, carefully balanced with demands. None of this is necessary. The only thing that is necessary is that supply is adjusted to meet demand, in accordance with the GLD:gold bullion parity.
“Aha!” the gold-“backing” people say here. “But GLD has 100% gold bullion reserve coverage of its outstanding shares!”
Oh really? Maybe it does. Maybe it doesn’t. It doesn’t matter.
After all, the reason that Sprott is introducing PHY — a real, 100% physical gold-storage fund — is that GLD is nothing of the sort, even if they like to make vague inferences that they are.
Now, here’s the catch: it doesn’t matter in principle.
Let’s take our example above. The “demand” for GLD falls by 90% in the space of a month. There is huge selling of GLD (not gold bullion). The shares outstanding of GLD have to be contracted by 90%. In other words, the trust needs to buy 90% of the shares outstanding of GLD on the open market to maintain GLD’s peg with gold.
Obviously, to do this they need money. Not gold — money.
If the market cap of GLD is $43 billion, then the trust needs $43B * 90% or $38.7 billion of cash to buy up GLD in the open market. Theoretically, the fund gets this cash from selling gold bullion on the physical metal market, and then taking the cash and buying GLD in the stock market. I say “theoretically.” Because, actually it doesn’t matter where the cash comes from. It could be diverted out of the budget of the Defense Department, for example. The Fed could print it out of thin air.
Now, let’s say that the GLD trust didn’t actually go and buy any gold. The trust doesn’t actually have any assets at all — no futures, derivatives, forwards, no nothing. Rather, the managers of the trust took the money they got by selling shares of GLD and parked in a personal Cayman Islands bank account. In other words, GLD is a Ponzi scheme.
The problem, of course, is that there is now no money to buy GLD in the open market. Like a Ponzi scheme, it works as long as the shares outstanding is growing. When the shares outstanding is shrinking, there are no assets to trade for GLD in the open stock market. This is why people want 100% backing of their “currencies.” So it doesn’t become a Ponzi scheme.
GLD also supposedly offers direct exchange of shares for bullion, for large accounts. I would be surprised if anyone was actually capable of doing this. It’s probably one of those promises which is broken as soon as someone asks for someone to perform on that promise. Today, even the Comex futures market is not delivering in bullion, but rather in shares of GLD! Do you really think you’re going to get gold bullion out of GLD? Not in any meaningful size, I’d guess.
The point, however, is that as long as the trust is able to buy GLD in the stock market — in other words, as long as the manager of the currency is able to adjust the supply — then GLD will remain pegged to gold.
For a real currency, the process is a little different. Instead of trading GLD for cash in the stock market, the central bank trades cash (base money) for government bonds. This reduces the supply of currency (base money). As long as the central bank has something to trade for base money, and that base money disappears (unsterilized), the value of the currency will be supported. The central bank doesn’t have to sell bonds. It could sell stocks, or real estate. The government could even take tax revenues, and simply make them disappear, thus reducing base money. The point is, the supply is reduced.
Once you understand this process, then the fear factor is greatly reduced. People have confidence that, when they establish a gold standard system, it won’t blow up in their face. Also, we can see that it is not necessary to have lots of gold in a vault somewhere. It’s all about managing the value of a paper chit via supply adjustment. Gold in a vault does not manage the supply of paper chits. Gold doesn’t have a brain. It cannot act. Gold, by itself, does not increase or decrease the supply of base money. Hoping that “100% backing” — a big pile of gold in a vault — will somehow manage the supply of paper chits for you is extremely irrational.