Development Through Wage-Led Growth
Henry C.K. Liu

Part I: Stagnant Worker Wage Income Leads to Overcapacity 


Part II: Gold Keeps Rising as Other Commodities Fall
This article appeared in AToL on November 24, 2010

As the Federal Reserve engages in serial quantitative easing to release more fiat dollars into the US banking system to enlarge the money supply to try in vain to push on a credit string to revive a gravely impaired economy that is already weighted down with excess debt and misdirected liquidity, with the express purpose of lowering long-term interest rates, gold keeps rising in price as other commodities fall because gold is a monetary metal, not just an industrial commodity. Gold has not increased in value; only the dollar has declined in value as the price of gold rises.
The 28-years-long record high in gold price, at $850 per troy ounce, set at the London p.m. fix on January 21, 1980, had since been broken several times in January and February 2009, hitting a then all-time high of $1,218.25 on December 3, 2009. It was broken again at $1,231.41 on August 19, 2010 and again at $1239.50 on August 25, 2010.  This reflects the sustained decline in the value of the fiat dollar in gold of constant value.
The actual inflation-adjusted record high set in 1980 would be $2,387 in 2010 dollars, or 71% higher than it closed on November 9. Gold is a hedge against a weak dollar, not a hedge against inflation.
Gold futures on the COMEX Division of the New York Mercantile Exchange posted strong gains on Monday, August 16, 2010, as weak economic data from Japan exacerbated investor nervousness about the slow pace of global economic recovery despite central banks, led by the Federal Reserve, having lowered interest rates near zero, desperately resorted to quantitative easing to combat deflation without visible effect. This sparked some safe-haven-driven demand for gold on fears of more central bank quantitative easing. The most active gold future contract for December 2010 delivery rose $9.60, or 0.8%, to finish at $1,226.2 per troy ounce. Gold reached $1,350 per troy ounce on October 5, 2010. December 2010 delivery reached $1500 per troy ounce on the same day.
The smart money, having already been long on gold for decades in the context of fiat money released by panicky central banks, continues to view the price of gold as vulnerable to potential central bank upward market manipulation in the face of general deflation risk in commodity markets in the prolonged financial crisis. Investors are poised to push price of gold towards $1,500 per troy ounce before 2010 ends. 
Gold breached $1,280 per troy ounce for first time in history on Friday, September 17, 2010 and traded at $1350 on October 5, at $1,372 on October 18, 2010, at $1,395.5 on November 5 and topped $1,400 for the first time in history on November 8 amid market uncertainty on the outcome of currency talks in the up-coming G20 summit in Seoul, Korea and renewed concerns over sovereignty debt in the eurozone.
On November 9, gold touched an all time high of $1,424 an ounce as the market reacted to the Fed’s $600 billion QE2 injection into the US banking system and to World Bank President Robert Zoellack’s surprise call for including gold in a new currency based on a basket of dollars, euros, yen and yuan.
Still, that record gold price after adjusting for inflation remained below the peak set in the early 1980s, which meant gold price still has some climbing to do, or the market expects the fiat dollar has more to fall, along with other fiat currencies that derive their exchange value with the dollar’s value in gold.
Goldman Sachs analyst David Greely in mid-October raised his 12-month target for gold to $1,650 an ounce from $1,365, saying that the Fed’s monetary easing policy will keep interest rates low and spur gold purchases.
In the week ending Thursday, October 7, 2010, gold notched what were then new records against the fiat dollar as bullion made a clean sweep of all other currencies. After its gains against the dollar, bullion’s 2.2% advance versus sterling topped the list, followed by a 2.0% gain in yen and a 1.5% appreciation against the Swiss franc. Gold managed to climb 0.8% in euro.
Bullion is the term used to describe precious metals like gold, silver and platinum in a bulk form such as bars (ingots), plates or coins. Bullion is used to store valuable metals in an easily measurable form. The purpose of bullion is to use precious metals as a store of value; bullion is typically stamped with a given weight and refinement (18k gold, 24k gold, etc.) to make it easy to account for.
For the same week, the dollar’s performance was highlighted by the following:
Morning gold fixes in London averaged $1,332, wrapping up the week 3.7% higher at $1,360;
COMEX spot settlements averaged $1,330, but finished only 2.0% higher at $1,334;
Average daily gold futures volume fell 3.9% to 142,055 contracts; open interest rose from 4,753 contracts to 621,941;
COMEX gold warehouse stocks increased by 62,929 ounces (2.0 tonnes) to 10.960 million tonnes; inventories on that day covered only 17.6% of open interest;
One-year gold lease rates slipped to 0.26% or 26 basis points (1 bp = 0.01 percent) while three-month contract rates held steady at 0.3975%;
SPDR Gold Shares Trust (GLD) vault assets fell by 16.2 tonnes (521,935 ounces) to 1,288.5 tonnes.
SPDR funds are shares of a family of exchange-traded funds (ETFs) traded in US and Australian markets and managed by State Street Global Advisors (SSgA). Informally, they are also known as Spyders or Spiders. SPDR is a trademark of Standard and Poor’s Financial Services LLC, a subsidiary of McGraw-Hill Companies, Inc.
The name SPDR is an acronym for the first member of the family, the Standard & Poor’s Depositary Receipts (NYSE: SPY), the biggest ETF in the US, which is designed to track the S&P 500 stock market index.
The risk trade resumed in the week ending October 7, 2010 as investors favored junior gold mining shares over established producers; the Market Vectors Junior Gold Miners ETF (GDXJ) gained 2.8% versus a 1.2% rise in the Market Vectors Gold Miners ETF (GDX); the Gold Miners (GDX/GDXJ) Ratio fell from an average 1.66 the week before to 1.65; the S&P 500 Composite Index’s correlation to gold producers rose 5 points to 14%; the blue-chip benchmark’s correlation to bullion climbed 16 points to -3%.
WTI (West Texas Intermediate) crude oil prices rose 2.1% to close out the same  week at $81.67 per barrel; the gold/oil multiple continued to fall, dropping from 16.8x to 16.2x.
TED is an acronym formed from T-Bill and ED (Eurodollars), the ticker symbol for the Eurodollar futures contract. The TED spread is the difference between the interest rates on London interbank loans and short-term US government debt (T-Bills). Initially, the TED spread was the difference between the interest rates for three-month US Treasuries contracts and the three-month Eurodollars contract as represented by the London Interbank Offered Rate (Libor). However, since the Chicago Mercantile Exchange dropped T-Bill futures after the 1987 crash, the TED spread is now calculated as the difference between the three-month T-Bill interest rate and three-month Libor.
Futures contracts in general and Treasury bill futures in particular, are taxed in the US in a manner that provides individual investors with an opportunity to reduce taxes on gains and to take full tax deduction of losses. The Internal Revenue Service (IRS) considers all futures contracts to be capital assets. Unlike other capital assets, however, the holding period for long-term gain is six months for futures contracts but only long positions qualify. All gains and losses on short positions are short-term regardless of the holding period. This asymmetrical treatment of long and short positions gives individual investors an opportunity to profit at the expense of the government by taking all gains as long-term capital gain at lower tax rates and all losses as short-term with full tax deductions.
One-year TED spreads ending December 31, 2010 (an indicator of banks’ willingness to lend to each other) averaged 53 bps (basis points) - a point higher than the previous week - on lower Treasury yields; three-month spreads also rose a basis point.
Although three-month Treasury Bill rates and three-month Eurodollar deposit rates generally move together - rising in times of monetary tightness and business cycle expansion and declining with monetary ease and cyclical weakness - the co-movement typically is not exactly equal. The TED spread, which reflects the difference between these two interest rates, can offer some attractive trading opportunities to investors/speculators who can correctly anticipate such differential movement between the two rates.
Finance rates embedded in COMEX gold futures traded at a 23 bps discount to one-year Treasuries; the discount started to narrow with the late-week decline in yields; the one-year gold contango averaged $10.70 an ounce, but finished the week at only $9.70.
Contango depicts a pricing situation in which futures prices get progressively higher as maturities get progressively longer, creating negative spreads as contracts go further out in time. The increases reflect carrying costs, including storage, financing and insurance. It is a term used in the futures market to describe an upward sloping forward curve (as in the normal yield curve). Such a forward curve is said to be “in contango” (or sometimes “contangoed”). Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, or a far future delivery price higher than a nearer future delivery. This is a normal situation for equity markets. The opposite market condition to contango is known as backwardation.
A contango is normal for a non-perishable commodity which has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up, insurance cost, less revenue from leasing out the commodity, as in gold.
For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in the case of perishables, since fresh eggs today will not still be fresh in 6 months’ time, 90-day treasury bills will have matured, and so on.
The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a theoretically risk-free profit to bring the price back into line. In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate (the “asset with a known future-price”). Thus, for a simple, non-dividend paying asset, the value of the future/forward, will be found by accumulating the present value at a specific time to maturity by the rate of risk-free return.
Investors need to be aware of return-killing factors through contango. Since contango is a phenomenon when nearby, or front-month, futures contract prices are higher than spot prices, that means when expiring futures positions held by an exchange trade fund (ETF) such as the United State Oil Fund (NYSEArca: USO) are rolled over to the next nearby contract, returns are diminished. That can really add up and cause returns on funds such as USO to vary significantly from spot oil prices.
If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later, and because there are few holders who can make an arbitrage profit by selling the spot and buying back the future. A market that is steeply backwardatedi.e., one where there is a very steep premium for material available for immediate delivery — often indicates a perception of a current shortage in the underlying commodity. Similarly, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.
For example, in 2005 and 2006, a perception of impending supply shortage put the crude oil market into backwardation. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses. It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil because of this backwardation. If such is the case, the premium may have ended when global oil storage capacity became exhausted; the contango would have deepened, as the lack of storage supply to soak up excess oil supply would have put further pressure on prompt prices.
However, as crude and gasoline prices continued to rise between 2007 and 2008 to peak at $139 per barrel, this practice became so contentious that in June 2008, the Commodity Futures Trading Commission (CFTC), the Federal Reserve, and the Securities and Exchange Commission (SEC) decided to create task forces to investigate whether this took place.
A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango. However, by the summer, that price curve had flattened considerably. The contango exhibited in crude oil in 2009 explains the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradable instruments for crude oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase. The United States Oil (USO) ETF also failed to replicate crude oil spot price performance.
BIS Gold Leasing
One reason Bank of International Settlements (BIS) gold-swap activities incite controversy is because, on the face of it, the BIS - being the central bankers’ central bank -  is not supposed to lend directly to commercial banks. However, via its gold-swap the BIS has clearly found a way around this restriction.
BIS Statute Article 21 (a) states:
“The Board shall determine the nature of the operations to be undertaken by the Bank. The Bank may in particular: (a) buy and sell gold coin or bullion for its own account or for the account of central banks.”
So essentially the BIS is free to buy and sell to whomever it wants in connection with its own bullion account: that is to say as part of its own market operations.
Gold Carry-Trade
According to the World Gold Council, bullion banks are investment banks that function as wholesale suppliers dealing in large quantities of gold. All bullion banks are members of the London Bullion Market Association.

Central banks have always leased out their gold to bullion banks to make their assets work for them. This was particularly the case when gold prices were stagnant, with little scope for asset appreciation, thus forcing central banks to seek revenue for the gold it holds.  Central banks would lease their gold to the bullion banks for a price just less than the going interbank market rate — or what they perceived would cover their credit risk by some basis points.
The Bullion banks, to make profit from BIS gold leasing — and to protect against falling gold prices – acting as market makers, would lease the gold forward at a higher price and invest the proceeds at the official market rate, hence capturing the so-called implied lease rate (equal to Libor minus the gold forward rate). These central banks’ own position would then be market neutral to gold price volatility, and they could then profit by a healthy spread.
Gold producers like Ashanti and Barrick were keen to be on the other side of the central bank gold leasing trade to hedge the future sales of their gold production or to help finance increased production. They did this by taking advantage of the gold contango carry trade, much like in the oil market. The cost of financing and sound credit relationships are critical conditions needed to sustain this strategy.
These conditions (low financial cost and solid credit) disappeared with the bankruptcy of Lehman on September 15, 2008. As credit risk rose, the central banks pulled out of the gold leasing market substantially – since there was no incentive for them to lend their gold against rising credit risk. It was also close to impossible to find credit-worthy counterparties.
Central bank withdrawal from the gold leasing market would have put downward pressure on gold forward rates. However, because central bank presence was replaced by bids from the private sector (which had higher finance costs), the effect pushed gold forwards to rise relative to Libor. The central banks stopped leasing gold when lease rates went below 10 basis points needed to cover their credit risk. Meanwhile the reason lease rates went negative was because investors were lending gold against borrowing dollars through their forward purchases on leverage for forward delivery, pushing up gold forwards. As Libor fell, GoFo (gold forwards) fell but not as much as Libor.
With most investors going long on gold against the dollar, with more expensive financing costs than the highly rated bullion banks already long in the market and looking for a return via the contango trade financed with leverage — lease rates ultimately turned negative.
Traditionally, gold interest rates are lower than fiat dollar interest rates because gold is safer. This gives a positive figure for the forward rate, meaning that forward rates are at a premium to spot. This condition is often referred to as contango. On very rare occasions when there is a shortage of metal liquidity for leasing, the cost of borrowing metal may exceed the cost of borrowing dollars. Under such conditions, the forward differential becomes a negative figure, producing a forward price lower than, or at a discount to, the spot price, creating a backwardation.
Market participants borrow money from banks that grant them leverage facilities at a margin. For a hedge fund, that margin can be quite large, up to Libor +200 basis points outright just to leverage a long gold position, which is much higher than for a central bank whose credit in unquestionable. Under such conditions, it makes sense for a central bank to lend dollars and get the gold as the security. Then all participants in the gold market are long and the marginal cost to borrow then is much higher than Libor, which pushes gold forwards up.
Central bank arbitrage has since appeared to have been reversed, largely because the amount of gold that is in the system is more than the market can profitably finance. From the BIS perspective, gold forward rates might have finally become steep enough for it to arbitrage the market. Under such conditions, eurozone institutions became simply intermediaries — matching BIS cash with the gold length that was already in the market which happened to be in need of financing.
A central bank doing a one-year trade on gold would buy gold for payment on October 31, 2010 at $1200 and sell it back for payment on October 31, 2011 at $1208.88. For one year, the central bank can take the gold and put it in its vault and gets a return of $8.88/oz, or 0.74% interest on its dollar investment (8.88/1200 = 0.74% = 1yr GOFO fixing on the LBMA website). This trade is known as cash and carry arbitrage. The central banks, with a massive amount of cash and a gold vault, are in the best position to do cash and carry arbitrage.
For example, the yield on long bond climbed 23 basis points, or 0.23 percentage point, to 3.98%, from 3.75% on October 8, according to BGCantor Market Data. It touched 4.01% on October 20, the most since August 10. The increase was the biggest since a 31-basis point jump for the five days ended Aug. 7, 2009. The 3.875 percent security due end of August 2040 dropped 4 3/32, or $40.94 per $1,000 face amount, to 98 5/32.
The London Bullion Market Association (LBMA) was established in 1987 to represent the interests of the participants in the wholesale bullion market.

The LBMA comprises: 10 market making members who quote prices for buying and selling gold (and silver) throughout each working day from 8.00 am until 5.00 pm (See also: LBMA Market Makers) 44 ordinary members, covering a wide range of banks, trading companies, assayers and refiners, mints and security companies 24 international associates; a category of membership that was introduced during 2000.

The LBMA works with The Financial Services Authority (FSA), which supervises the major market participants, who operate under the London Code of Conduct HM Customs & Excise on tax policy, such as Value Added Tax

The LBMA Maintains the London Good Delivery List for gold and silver through its Physical Committee

The LBMA organizes an annual Precious Metals conference. The inaugural event took place in Dubai in February 2000, a second LBMA conference was held in Istanbul in May 2001, with a third one following in June 2002 in San Francisco. A fourth Precious Metals conference took place in Shanghai in 2003.
The long Treasury bond maintained an average 3.71% yield on October 16. 2010, but weakening rates at the short end steepened the yield curve 2 bps to 0.358%. The euro gained 2.0% vs. the US dollar, finishing the week at $1.3945 after averaging $1.3759.
Daily reads of the one-year monetary inflation rate averaged 0.0% the week of October 15 compared to -0.9% the previous week. At the October 16 rate, the real return on three-month Treasury bills was 6 bps.
Central bank activity to moderate general deflation in commodities is to buy gold (to inject money into the economy) not to sell gold (to withdraw money). Deflationary pressures in commodities will push the central banks to buy gold to help achieve inflation targeting.
Not All Fiat Currencies Are Equal and None is as Good as Gold
There is not much wrong with fiat currencies in the modern monetary world. It is the product of sophisticated civilization and complex financial technology. The problem is the domination by one fiat currency over all others in a world order of sovereign states as the fiat dollar does. Gold as a monetary instrument has the same problem, plus a deflationary bias, since not all nations are blessed with gold mines.
How then do other governments stop the issuer of the dollar from flooding world financial markets with dollars with no quid pro quo from other governments?

That, unfortunately, is very difficult to accomplish. One way is to encourage a multi-currency monetary regime. However, that can end up being a very complex and cumbersome system as the economic fundamentals of the world’s nations are very different.  Besides, the financial elites of the world’s major economies have all been hooked by dollar since the end of WWII. The US economy would have to crash sharply before the dollar will be replaced. Still, there is no alternative currency that can readily replace the dollar.
While the US economy is going through a very tough test since mid 2007, there is no sign to suggest that it would collapse in the near future. Neither do US voters realize that international trade under dollar hegemony is also hurting US workers by exporting their jobs and keeping their wages low. However, workers in the US are still misled by policy makers that the culprit for US unemployment is China, rather than the dysfunction of the neoliberal deregulated trade and finance globalization. The radical left and the radical right in G7 capitalist democracies would have to unite against the neo-liberals who put the world in this economic mess, and fight only after the neo-liberals are defeated and ousted from control of governments.

In a way, by having the bulk of the world’s foreign exchange reserves denominated in dollars, the US is shooting itself also in the foot. As non-dollar currencies appreciate, their central banks suffer a loss in value in their dollar foreign reserves in terms of their own currency. This is one reason why most central banks oppose upward appreciation of their currencies, except perhaps the European Central bank (ECB) which has a strategy focusing on a strong euro to finance euroland development.
Events since the Plaza Accord (pushing down the dollar) in 1985 and Louvre Accord (pushing up the dollar) in 1987, within 2 years, have shown that it would be futile for governments to waste scarce financial resources intervening in foreign exchange markets, as the Bank of England discovered in 1992, but only after making George Soros rich and infamous. The sad record of Japan’s economy in the last two decades has shown that fiscal deficit financing to stimulate the economy can be neutralized by monetary intervention to maintain external trade competitiveness. 
Another reason exchange rate instability may increase in the near term is that the euro-dollar exchange rate will be of less concern to the ECB than it was to its component national central banks because the economy of the eurozone as a whole will be more closed and inward looking than the individual members’ economies. The euro zone’s openness rate (measured by the ratio of trade in goods and services to GDP) is about 14%, compared with 25% for France and Germany individually.

Now if two economies are linked by floating exchange rates, free trade and free cross-border capital flows, the one with a high rate of inflation will see the exchange rate of its currency fall. However, a fall in its currency will increase the cost of its imports thus adding to its inflation rate. In addition, the further rise in inflation rate will push up domestic interest rates further. However, a rise in domestic interest rates will stop or slow the fall of its currency and attract more fund inflows to buy its goods and assets or even “hot money” to try to profit from carry trade. It also increases its export, which reduces the supply of goods and assets in the domestic market, thus pushing up domestic prices, while not pushing down the price of imports as foreign exporter would raise prices to compensate for exchange rate changes. The net inflation/deflation balance will then depend on the trade balance between exports and imports. This had been given by the ECB as the logic of raising euro interest rates to fight inflation in the eurozone.
However, this effect does not work for the US because of dollar hegemony, which enables to the US to run a persistently recurring trade deficit with moderate inflation impacts. That is why the monetary policies and open market measures of the ECB and the Fed are constantly out of sync. US exports tend to have a large component of imported parts, as high as 80% in many sectors, thus clouding the distinction between export and import. The US is now mainly a re-export economy at best, with most of the profit coming from financial advantages derived from dollar hegemony. A similar dilemma exists in US trade with Asia.

The availability of financial derivatives further complicates the picture, because both interest rates and foreign exchange rates can be hedged, obscuring and distorting the fundamental relations between interest rates, exchange rates and inflation. The recurring global financial crises in last decades were manifestations of this distortion.

Market Equilibrium

The theory of market equilibrium asserts that market tends to reach “natural” equilibrium as it approaches efficiency, which is defined as the speed and ease with which equilibrium, is reached.
Yet equilibrium is an abstract concept like infinity, a conceptual end state that has no definitive form or reality. Yet the market is complex because not only the relationship of market elements is poorly defined, or even un-definable, but also the very instruments designed to enhance market efficiency tend to create wide volatility and instability in the market. Thus, a “natural” equilibrium state has a time dimension and can in fact be defined as the actual state of the fluctuating market at any one moment in time. Spot equilibrium then exists in markets only to move to the next equilibrium stage.  
With 24-hour trading, the notion of a milestone moment of equilibrium is problematic. Quarterly settlements also complicate the issue. Further, the very financial instruments created to enhance market efficiency toward its “natural” equilibrium state make the equilibrium elusive. Such instruments are mainly designed to manage risk generated by both broad market movements and momentary disequilibrium. Structured finance mainly involves unbundling financial risks in global markets for buyers who will pay the highest price for specific protection. Because users of these instruments look for special payoffs through unbundling of risk, the systemic cost of managing such risks is maximized. Traders begin to seek market volatility as profit opportunities, thus neutralizing the stabilization effect of hedging. Volatility is in fact derived from synthetic equilibrium.
This dis-aggregation of risk renders the notion of unified market equilibrium an elusive state. The unbundled risks are marketed to those with the biggest appetite for such risks for high compensatory returns. Thus market equilibrium is no longer merely a large pool of turbulent transactions with a unified surface. It is in fact a pool of transactions with many different levels of interconnected undercurrents, each serving highly disaggregated specialty markets.
Equilibrium is this case becomes a highly complex notion, making the prospect of externalities highly uncertain and the impact much more serious. That very uncertainty caused the demised of Long Term Capital Management in 1998 when it lost $4.6 billion on leverage of 250:1 in less than four months following the Russian sovereign bond default.
Interest swaps, for example, are not single-purpose transactions for managing interest rate risks. They can be structured as inflation risk hedges, or foreign exchange risk hedges, or any number of other financial needs or protection. They can even be profit-seeking moves through carry trade. In addition, the impact is not limited to the two contracting parties, since each party usually hedge again with a third counterparty. The spreading of risk results in an under-pricing of unit risk that makes hedging against specific risks a contributing factor in systemic risk. A further irony is that the very objective to insure against volatility risk by covering the market broadly increases systemic risk of illiquidity.

November 22, 2010

Next: Labor Markets de-linked from the Gold Market