Revisiting Zoltan's Gold-mageddon Deconstructed- 2022
How it Could Happen. The mechanism of Gold's Full remonetization
Housekeeping: We have several pieces to put out the next few days and so are posting this whole thing, (intended as a 3 parter) all at once.
Overview
[B]anks have been managing their paper gold books with one assumption, which is that [Nation] states would ensure gold wouldn’t come back as a settlement medium. -Zoltan Pozsar
The above statement is arguably the most important sentence in Zoltan’s recent post entitled: Oil, Gold ,and LCL(SP)R. It is how he closes that note. (Full note at bottom as well)
If you have read his letter (see below) you may prefer quotes pertaining to Gold’s price jump from $1800 to $3600 or Pozsar’s follow up statement to the price of Gold potentially doubling: Crazy? Yes. Improbable? No.
Those statements certainly are nice to read for real-money advocates; especially coming from one of the most respected economists on the street these days.
However, for anyone with precious metals exposure, like a bank or presumably you reading this piece (thank you for that), the quote at top should rule them all.
Here’s why…
Why Banks Short Gold
He gives the reader the rationale by which banks have been profitably shorting Gold since futures were invented. Here is our translation of that same sentence at top.
Translated from the original Zoltanese:
Banks have been using rehypothecation for decades fearlessly with approval of global governments who in turn promised them Gold would never be used as a settlement medium—i.e. have a practical use — again.
Stated as a bank trader once said: Gold? We can short it until the cows come home. Why? Because not only is it unconsumed/indestructible, it isn’t used for anything anymore. Its price is how much more USD money we have to pay you to delay delivery. It’s a collectible, a pet rock, and nothing else. Short it. Government1 can’t let it back in as an MOE. If they did it would destroy them. If we go under, they go under. 2
Zoltan is telling us indirectly what Banks and Nations fear about this Gold-as-settlement-medium concept.
Its return would coincide with the reduction of Bank rehypothecation carry trades as a tell-tale sign Nations need to actually use Gold in deals again.
Ultimately the root of banking's short Gold bias is the fact that noone needs Gold in hand for anything that cannot be delayed3 until later.
This was accomplished by the combination of permitting rehypothecation, changing tax status, and replacing it as the preferred MOE. Once these were done its remaining value as an SOV was an abstraction they could handle. They probably thought: Let it remain an SOV, like art and ceramic figurines. We don’t care. And that is how it has been for decades; until now.
Therefore as Gold owners, traders, and students of economics, we want to know what would entail Gold actually becoming a settlement medium again.
The first question for us in pursuing that goal: What is a settlement medium?
What’s a Settlement Medium?
Here is “settlement medium” in Zoltan’s context again:
[B]anks have been managing their paper gold books with one assumption, which is that [Nation] states would ensure gold wouldn’t come back as a settlement medium. -Zoltan Pozsar
Turns out “settlement medium” is Federal reserve jargon from the UCC: “Medium of settlement is cash or credit to an account in a Federal Reserve bank of or specified by the person to receive settlement.“ -§ 4-213.
In other words, settlement medium is legalese for: Medium of Exchange (MOE).4 Gold is in danger of once again competing with the USD as an MOE. Pet rocks do not have use-cases. But Gold is perfect for this use case.
Gold, Zoltan implies, is reemerging as an MOE competitor to dollars for deals. Why does that matter? Using Gold directly means using less dollars. It’s one thing to use gold5 as a store of value (SOV) as it continues to be held by central banks worldwide for "tradition" sake.
It’s quite another to need it on hand for actual transactions as a settlement medium. Thus, as many of us sense, substituting Gold for dollars as a settlement medium means the price of Gold is way too cheap in dollar terms.6 Gold used as MOE is the nuclear monetary option for nations who feel their currency is unfairly priced against the USD.
Pozsar’s Statement
Before we get to the rest of the sentence, we have to do justice to Pozsar’s Armageddon scenario mentioned prior and what the whole Gold/Fiat world are atwitter over. This is what he said:
War is not about gentlemanly conduct…
The cap of $60 per barrel for Russian oil equals the price of a gram of gold (at current market prices). Let’s imagine this set up as a peg. The G7, led by the U.S., effectively pegs the U.S. dollar to Urals at $60 per barrel. In turn, Russia pegs Urals to gold at the same price (a gram of gold for a barrel of Urals).
The U.S. dollar effectively gets “revalued” versus Russian oil: “a barrel for less”. The Western side is looking for a bargain, effectively forcing a price on the “+” in OPEC+. But if the West is looking for a bargain, Russia can give one the West can’t refuse: “a gram for more”. If Russia countered the price peg of $60 with offering two barrels of oil at the peg for a gram of gold, gold prices double.
Russia won’t produce more oil, but would ensure that there is enough demand that production doesn’t get shut. And it would also ensure that more oil goes to Europe than to the U.S. through India. And most important, gold going from $1,800 to close to $3,600 would increase the value of Russia’s gold reserves and its gold output at home and in a range of countries in Africa. Crazy? Yes. Improbable? No. This was a year of unthinkable macro scenarios and the return of statecraft as the dominant force driving monetary and fiscal decisions.
More at bottom…
Let’s game this Gold-mageddon scenario out briefly and describe what would happen if such an event occurred.
Pozsar’s Gold-mageddon
Here is Pozsar’s hypothetical situation restated. He muses out-loud what would happen if Russia first accepted Oil’s peg at $60. Russia, in his scenario, reciprocates by pegging 1bb oil at 1/2 gram of gold which currently is equivalent to $30. The economics of the Oil/Gold/Dollar triad would look like this (where g=grams; bb=barrels)
IF: 1bb= $60 pegged ( If x=y)
AND: 1bb = 1/2g pegged (And x=z)
WHERE: gold/dollars are not pegged to each other.
THEN: 1/2g = $60 given free exchange-ability. (Then y=z)
Why?
This whole thing starts out as: Nations need energy for economic growth. Oil is, on balance, currently the most desirable energy source globally. These nations seek to use something to buy oil which their counterparty will accept as a Standard of Trade. A Standard of Trade is something universally accepted for transactions with other parties. The acceptor of the “something” must have someone else who will accept it as well
***PIC HERE***
Russia, in Pozsar’s example would be telling the world it will take Gold as payment for Oil, because (and this is key) some other nation will accept that same Gold as payment from Russia to buy stuff too. Gold thus becomes a standardized settlement medium for three economically interdependent nations.
Russia would make the USD and Gold compete as mediums of exchange. You can now buy Oil for either $60 or 0.50gram gold. The MOE you use to buy oil is the one you simultaneously have the most of and the least use for in other economic trade7
EDIT THIS***
There are many ways to envision how this plays out in a free market. The arbitrage trade, the substitution effect, Gresham’s law etc. For this note, as long as buyers have a choice to pay for oil with either $60 or 0.50g gold; be assured that either the price of Gold goes up in dollars or the price of dollars goes down in Gold.
If however, some external force (restraint of trade, sanctions,war etc) prevents the new Y=Z equilibrium from establishing, then ownership of the three resources (Oil, USD, and Gold) as well as any other asset that uses energy as a cost input will rebalance instead. Price fixing (via not permitting Gold swaps for USD) eventually creates scarcity.
WHY IT WORKS FOR PUTIN.. THIS IS ABOUT OIL, NOT DOLLARS OR GOLD. AS LONG AS OIL IS THE ENERGY OF ECONOMIC CHOIXE EVERYTHING ELSE IS MERELY A MEDIUM OF EXCHANGE TO EITHER BUY IT OR TO BUY SOMETHING IT CREATES ECONOMICALLY.. WERE PRICING OIL, NOT DOLLARS OR GOLD
MATHEMATICALLY THE MORTEOIL HE HAS THE LOWER THE PRICE IN GOLD SHOULD BE.. BUT THE LESS OIL HE HAS, THEN BY CHARGING MORE FOR IT IN GOLD, HE MARKS HIS NOW BIGGER PORTFOLIO UP MORE. THE QUESTIO NIS. WHAT CAN HE BUY WIT HTHAT GOLD? IF NOONE ELSE WANTS IT, HES I NA SHITLOAD OF DEFLATIOARYU TROUBLE.. ENTER CHINA…
Ultimately it all harkens back to a February post of his about the coming shortage of collateral. Which he was right about.
Back then he said , “A crisis is unfolding. A crisis of commodities. Commodities are collateral, and collateral is money…” -source. He hadn’t spoken of Gold since that February post. But in this current note, he is sounding the collateral alarm again but for Gold.
The 2 for 1 Gold/oil swap is illustrative hyperbole even if Zoltan says it isn’t. A move like that would be economic suicide for Russia. We candebate what can and can’t happen all day, but right now his point is: If you can think it, then its a tail risk worth handicapping.
It is instructive to know the worst case scenario when contemplating a more likely scenario. Zoltan’s scenario is completely reasonable if not already happening at different price points. For example…
Ghana has a buyer of Gold for Fuel, the Saudi Emirates reportedly. That buyer in turn must have someone who will exchange Gold for another good they want. Ghana meanwhile doesn’t have to sell CEDI for USD anymore. Gold up, CEDI up, USD down.
We think you will agree, dialing down Zoltan’s Gold-mageddon scenario is not much better for rehypothecated western bank shorts, even at current market prices if things like what just happened with Ghana continue.
Banking’s Rehypothecation Crisis
If Russia or another country were to finalize its energy dealings with Gold as settlement medium even at current prices... well... that’s a whole lot of dollars people won’t be needing to use, and a whole lot more Gold needed to be on hand. This would happen even if Russia priced oil be bought using 1 full gram of gold per barrel.
The End of Rehypothecation…
In other words, there would likely be a crisis of good Gold collateral for open futures contracts. Rehypothecation is all about multiple claims on limited collateral. And as we saw in February, Pozsar is all about collateral.
Which brings us back to his statement:
[B]anks have been managing their paper gold books with one assumption, which is that [Nation] states would ensure gold wouldn’t come back as a settlement medium.
Remember, he is telling us banks use gold rehypothecation as a profit center predicated on the assumption by governments, gold would never come back as a medium of exchange for settlement between countries8. The monetary market-structure needed to support fiat made sure of it.
But Gold is coming back as an MOE. That probably makes banks with paper gold risk a little nervous.
Golden Sardines are for Trading Only
Because of the tacit government bargain between nation-states and banks; Bullion dealers were comfortable rehypothecating gold (and silver) due to permanent fiat hegemony. They believed Gold would not be used as a final settlement medium in business ever again. Thus, it would not ever be needed for physical delivery enmasse. Gold had become the proverbial sardines: traded but never eaten9. Yet here we are with Hungarian economists describing the end of banking if gold competes with the USD as settlement medium.
If a crisis like the one Pozsar describes were to occur a death knell would sound for any bank with rehypothecated Gold shorts. Multiple claims on Bullion would come in as available collateral shrank. The price of Gold would skyrocket due to physical demand earmarked to close oil deals10 with Brics producers.
Paper gold contracts would not cut it in a trust-less world. Deferred delivery of gold would be extremely expensive accelerating the dollar's demise. Ask the Silver producers who got squeezed by Warren Buffet11.
The banks could conceivably be destroyed, if that worst-case were to happen in Gold12.
LME NICKEL AS EXAMPLE
If this all doesn’t quite hit home yet, think of it this way. Why did LME Nickel blow up its clients? A lack of good collateral and too many open shorts was the reason for us. In essence a short squeeze pure and simple. but a huge one. Rehypothecated shorts got killed. This is what would happen to gold, but much, much worse if permitted to.
A couple commodity firms wouldn’t be panic-buying nickel to cover for a short client if that happened. The world would be demanding its physical gold back. The exchanges would be treated like banks being run on. Shutting them would implode the economy. Leaving them open and making delivery could bankrupt the country. The giant sucking sound would be what Gold remained in the West going East. What would that look like in the futures markets?
How it Could Manifest if it Actually Happened
The western Gold futures curve would go backwardated. That is unheard of for any length of time in Gold. Money should never backwardate. But that is what happens when governments throttle it and demote it to collectible status. The shit then will truly hit the fan. Bankers understand this.
Backwardation in money is economic death for any country continuing to use that asset as money by depletion of that asset, or economic deflation because noone will loan13 money out for term.
True modern (financializable) money cannot backwardate, ever14. The future value of money is money plus money. That job is handled by interest rates. But Gold would backwardate simply because you cannot pay off someone with dollars to defer their delivery of gold. Nobody wants the dollars. They want the gold. This is where the fallacy of the gold/dollar correlation lies. As long as people want Gold priced in dollars, then gold is not money. To the extent something does backwardate, that means it is not fully monetized. If gold bacwardated during this crisis (it would) while still being unmonetized in the west (it wouldn’t be) that would be the death of the global economy, and possibly entail World War 3.
How It Could End: Fix the Money
One solution to Gold backwardation if it persisted would be the immediate 100% remonetizaton of all Gold globally. Confiscation would ensue in varying forms. The Comex and the LBMA would shut down. Force majeure would be declared. If that happened, a global depression could conceivably set-in almost overnight. Mercantilism would go parabolic and whole countries would close as they re-balanced their books.
Will it happen? It is already happening at a glacial pace. One thing that makes it not happen would entail complete separation of East and West trade and involve scarcity on both sides of the wall and a black market that slowly sucked the lifeblood out of the worse economy.
The other way can be an alternative energy source that obviates Oil. Replacing oil means collapse of natural resource rich countries and their hopes for egalitarian currencies. Whoever controls that new energy decides what the money is.
IT’S ALREADY HAPPENING
We think if you connect the dots of what has happened these last few years between: the implementation of Basel 3, JPM’s Gold risk being broken out, EU Bankers saying they’d reprice Gold if they had to, and Oil for Gold trades going down between Russia, China, and others; you will see a pattern of slow remonetization of Gold as money. May be too slow, and that is what has the Brics up in arms now.
This is why, when all is said and done, even if Russia gets blown out of the water, money will never be the same again. The East has made it clear their money is not valued objectively, and until it is, they want their natural resource contributions of the economic pie to have more weight.
The West, in turn, even if it wins this Russian war, will do so while incurring much economic pain. They will compromise to make sure it doesn’t happen again.
GOLD AS MONEY WILL HAPPEN
Which is why, even in the best case scenario, money will never be the same again.
Bretton Woods 2 crumbled when the G7 countries seized Russia’s foreign exchange reserves. Keeping money inside financial institutions like the IMF was considered risk free. That is clearly no longer the case. Bretton Woods 3 will have to fix that.
“We are witnessing the birth of Bretton Woods III – a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West.” - March 2022
We completely believe after this war is over, money will never be the same regardless of who wins. Compromises will be made on both sides.
In fact we’d bet that CBs have dissuaded major players from accumulating Gold in the past just to protect the lack-of-use-case promise at request of bullion banks.
That should raise an eyebrow from lawyer types who see (unwinnable) RICO accusations in their future caseload. But our focus here is the mechanism by which real metals price discovery may return given what Pozsar said.
Bond people understand this very well. They taught it to us.
A medium of exchange is an intermediary instrument or system used to facilitate the sale, purchase, or trade of goods between parties. For a system to function as a medium of exchange, it must represent a standard of value. Further, all parties must accept that standard.
Gold is already a better store of value than paper money. What gold is not anymore is a more convenient medium of exchange. When the dollar became the globally accepted MOE post WW2, gold was relegated to SOV use only.
liquidity of use increases value. When a company goes public, its price goes up by virtue of transparent access to demand side investment. Once Gold is on the menu, it’s going to get ordered more for dinner so to speak
what do you need to buy wheat? What can you buy finished goods that are necessary for your economy? What will the sellers of those items take in return for them? That’s what you want to use.
i.e. they would rarely, if ever have to actually deliver real metal to an end-user that took delivery and would not return it quickly.
There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”
incidentally, that is mercantilism on steroids
he deferred delivery one year by loaning the silver he wished to take delivery on back to them for a 40% fee as determined by futures backwardation.
it wont happen like that, but unnoticed it definitely could. Exchanges would shut down and declare force majeure well before then
Imagine if you will, that 99% silver coins were used as money and the other coins were still in circulation but not money.
if it does, then it is not money by financialized standards. If it is kept on as money in backwardation, global arbitrage will impoverish the country that permits futures markets in the asset with physical deliverability. Greshams law will apply. it is becuase of Silver’s importance and industrial use that it can no longer be money in this finaniclaized sense. Is it a store of value? Yes. Is it a medium of exchange, Yes. Can it be used globally for unlimited finanical leverage? No. So i nthe modern sense of the word, it cant be money. It is worth more than money, more on that some other time
Outstanding and much appreciated!! Hoping he is right and that this is coming soon. Despite whatever hardship it might bring, it is much needed for the health and well-being of the world. Corrupted "money" has in many ways corrupted this world and put it under the control of the arrogant, sociopathic megalomaniacs who corrupted it and parasitized WeThePeoples of the world by forcing exchange of their corrupt "money" for the Peoples' work / for the labor of their hands and ingenuity / for their real goods and services -- by paying for it with what is, at the core, worthless paper and electrons that they could and still can create with NO work at all. We must return to honest MOEs, as "honest" as they can be.
Thanks for posting this, of great value, in a time when folks I thought could not be shaken, have turned apprehensive, to almost every scenario or option. To share this as you have will lives, and peoples diminishing fortunes.
My Sincerest Gratitude, good luck, see you on the other side.