Mining Web''s Tim Wood joins Tocqueville''s Hathaway on manipulation of gold


By Vincent Cook

Reg Howe is to be highly commended for
calling our attention to an academic paper
co-authored by former Treasury Secretary
Lawrence Summers concerning a positive
correlation between wholesale price levels
and interest rates that existed under the
classical gold standard (also known as
"Gibson's paradox").

It should be noted that the paradox depends
on a couple of crucial assumptions about the
classical gold standard, namely that 1)
interest rates on secure financial
instruments such as British consols are a
good proxy for risk-free real interest rates,
and 2) the money stock is relatively fixed so
that general price levels move inversely to
the demand to hold money.

In fact, the crucial piece of the puzzle
missing in the Summers-Barsky explanation of
the phenomenon is that the total money stock
also included "paper gold" produced by the
financial system.Specifically, fractional
reserve banks issued bank notes and accounts
that were backed by less than 100 percent
physical reserves but were nevertheless
treated as the equivalent of monetary gold by
the market due to their redeemability at par
on demand in gold coin. Many governments
also issued notes and token coins whose value
was maintained by fractional gold reserves.

In a gold-standard country, investors in
long-term fixed instruments like bonds,
consols, debentures, etc., had to pay
attention to the risk of the national unit
being devalued in terms of its gold content
or the redemption of banknotes, demand
accounts, etc., being suspended. Unlike
modern government bonds, British consols and
other government instruments under the gold
standard were not typically viewed as being
risk-free. Governments simply could not
manufacture gold coins on a whim in the same
way that they manufacture fiat paper pounds,
dollars, euros, etc., nowadays.

If a consol holder feared getting paid in
devalued pounds or irredeemable pound notes,
he would require a higher interest rate as
compensation. This was true even in the
absence of inflationary expectations with
respect to consumer prices. The first
assumption is false, particularly under
conditions where the reserves for "paper
gold" are considered inadequate and the
government is regarded as being likely to
resort to extreme monetary measures to bail
out its banks. Given that the British
government had in fact temporarily suspended
the redeemability of pound notes on a number
of occasions, the existence of risk premiums
for consols was entirely reasonable.

All other things being equal, more "paper
gold" means more money chasing after the same
stock of goods. Given the effect of "paper
gold" on the money stock, the second
assumption is false too. Price changes need
not be inversely correlated to changes in the
demand to hold money.

Indeed, these assumptions are both falsified
under the same conditions.

After all, excessive quantities of "paper
gold" would naturally tend to bid up prices
as well as call into question the ability of
investors to receive the full quantity of
gold owed them over the long haul. This is
true even if the short-term prospects for the
redeemability of "paper gold" appear to be
relatively good and consumer prices are
stable. The resolution to Gibson's paradox is
that sufficiently large quantities of "paper
gold" both depreciate the gold currency and
create fears of a possibly less-than-full
redemption of long-term promises to pay gold.

So what does all this mean for GATA's
accusations against today's financial

The mindset of the Summers-Barsky paper seems
to be one of ignoring the inflationary
potential of "paper gold" and the unique
kinds of redemption risks that such an
inflation poses.

It is difficult to say what the motive of
Summers was in writing this paper, but one
thing is clear: Lease rates on gold are way
too low. Gold creditors (presumably central
banks, for the most part) are being taken to
the cleaners, and certain gold debtors are
getting a free ride with absurdly cheap gold

* * *

Vincent Cook is a senior technical writer at
the University of California's Office of
Technology Transfer and has been a GATA
supporter since the organization's founding.


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