The Price of Gold and the Federal Reserve

I read a Zero Hedge article on the price of gold and the removal of gold form bullion banks. What was not made very clear in that article was why there is a depression in the price of gold along with increased demand. Using a statistical economic framework, I think there is a correlation. First, I need to begin by borrowing from Hayek’s theories on money. The key point here is that private money created is indistinguishable from specie or reserve notes issued by a central banks. This is a cornerstone of the fractional reserve banking system. I don’t even really want to call it that name, because the phenomena is not necessarily a construct of man, but rather man’s response to statistical economic laws.

We create money as a means of exchanging action–utility. This money that is created has its value determined through exchange. In a sense the money introduced becomes aware of the economy and the economy becomes aware of the money. This can be represented in a statistical economic sense using Langevin diffusion. This is a method of stochastic sampling, like what is used in methods of numerical quadrature, such as Markov Chain Monte Carlo.  In the economy, certain individuals collect some of this money as a society begins to accumulate wealth, we call them bankers.

For arguments sake we are going to take the money supply to be constant. In this society as wealth accumulates the marginal utility of money will tend to increase. Using a Cobb Douglas production function this is mathematically analogous to the heating of an ideal gas in constant volume tank. \lambda M= N T where \lambda is the marginal utility of money (analog to pressure), M is the money supply (analog to volume), N is the number of individuals in the economy (analog to particles), and T is the marginal utility of information in both the economic sense and physical sense. This is also known as temperature, it is a measure of the statistical action of the cohort being studied. It is not a physical property but rather a statistical property.

In our simple economy, the Cobb-Douglas production function represents a path where the uncertainty of the system is maximized based on the set of external constraints. This is the second law. The increase in marginal utility of money creates a force on the constraints of the system. The more action in the system the harder the force on the constraints. It’s like heating water in a sealed pot, eventually the water is going to find a way to expand. This is again a statement of the second law, where the system will evolve to the configuration that maximizes its entropy. To respond to this trend toward maximum entropy in the economy, we formalize the structure and call it fractional reserve banking. Where individuals accumulate money and then lend that money out to create more money.  Bitcoin will too soon experience this. In the precious metal markets we call this specie that is lent out paper gold or silver.  When we trade these paper notes they are indistinguishable from specie.

The system of money will expand to the point where we know the least about it based on our knowledge of the constraints on the system. Please note the expansion in the money supply occurs endogenously within the economy. It is not necessarily through exogenous effects. The exogenous factors (mining more gold/silver/bitcoin turning on the printing press, ships sinking at sea/lost wallets/burning bills) do affect the money supply but only at the margin. The main factor in the money supply comes form the action of the individuals that transact with that money and the force that action exerts on either expanding or contracting the money supply, inflation or deflation.

This is important to understand and I think is the root of the problems we face: The action of the individuals within the economy determines if there is inflation or deflation. So what is up with Gold and Silver? I think what we are seeing is a run on the bullion banks, where the entropy of the gold market is collapsing. Entropy is a measure of the systems degeneracy or as Adam Smith’s vernacular market specialization. Bankers are theoretically specialists at holding onto money and theoretically at knowing whom to allocate money. (I am still in pretend world here.) This gets to a point that Smith said about markets diversifying only to the extent of the market. This is simply the second law, that the system will achieve a state where the entropy is maximized based on the constraints of the system.

We are watching the gold and silver markets cool off, their marginal utility (price measured in dollars) is falling while the action (goods and services exchanged) is falling. This is putting pressure on the quantity of paper notes, basically the shorts are staying while the longs are evaporating. We are also seeing (using myself as an example here) withdrawal of specie from the market and placed into savings, thus the market is losing knowledge of vast quantities of physical gold.  This brings up a point that Keynes misses. Stimulating the economy by penalizing savings does not create growth. Money leaving savings is a consequence of increased action within the economy. The rate of savings, tautologically the quantity of money in circulation, is a function of the constraints on the economy.  It does not carry a moral imperative that the savers aren’t doing their part to stimulate the economy so lets penalize them by eroding their accumulated wealth to make them want to do their part for the public good. This is in a nutshell Keynesian economics. It seeks to force policy against the second law, and as Sir Arthur Eddington says “…there is nothing for it but to collapse in deepest humiliation.

With precious metals we are seeing deflation. It is not good or bad. It just is. To test this one will need to quantify the number of longs and shorts along with the quantity of gold/silver held by the banks as the measure of the money supply.

Now for the Fed. The Fed is a major player but is not the major player. The big kahuna in dollars is the shadow banking sector where money is made or destroyed instantly. The main method of this is done through rehypothecation.  Zero Hedge does a good job explaining this. However my take is a little different. The under capitalization, what the BIS is afraid of, is actually called “deflation” and they want to enact policy that prevents this and supports the banks. Sound familiar? This is cargo cult all over again. If repo markets are bad and as such must be restricted (e.g. Dodd-Frank) the marginal utility of money will increase until the market finds another way of increasing its entropy (eg derivatives, which BTW are a US invention and coincidentally we also have the most controls on the repo market). I do not see any of this as bad. It is a response to the constraints on the economy. It is and that needs to be acknowledged.

What is bad is that the central banks prop up the banks that fail when the money supply contracts, by giving them money, aka bailouts. Worse is when the taxpayers give their money to these banks.  The bank failures are a reduction of entropy in the system in response to the cooling of the economy and reduced marginal utility of money. This is simply a consequence of the second law. Schumpeter calls it creative destruction.  What the Fed is worried about is that they no longer have marginal control over the money supply. That is done entirely through the repo market. What the Fed does have control over is the access to liquid collateral used as the basis of the repo market, T-Bills. Right now the Fed is manipulating the repo market (roughly 2-3x the entire Fed balance sheet and M2) by restricting the repo markets’ access to capital.  The effect this is causing is an effort to increase the marginal utility of money by restricting access to it. This is the sort of policy of the National Recovery Administration saying there is a price of certain commodities (here T-Bills and dollar bills) that the Government (Fed is sort of government but not really) where they know the best social price which is above the market price, and that anyone that trades at that market price deserves to be punished.  This knowledge of the best social price of T-Bills is holding a gun to the head of the banks and the rest of us, saying do what your supposed to or else even if you can’t.  This is an overall destabilizing policy increasing overall fragility as a consequence of the fatal conceit of the pretense of knowledge.

There is much more that can and will be said on this topic, but for now this is enough. I look forward to your feedback on this subject as these thoughts are preliminary.

One response

  1. Pingback: A Network Analogy for Currency « Statistical Economics

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