I am still not sure that the parties currently discussing hypothetical gold-price scenarios agree on the conditions that "causes all the longs to liquidate" (though I think I have now clarified that only 1/Nth or more need to stand, and others liquidating in the discussed scenario). There is analysis of what might happen once the process begins, but I think the environment matters, and here is why.The economy and all within it are a complex system in which there are risks that people try to manage. Provided that that system, including rule of law, contract enforcement, etc remain functional in the current mode of operation, mechanisms that exist within the system for managing risk might well be effective, but should elements of the system stop functioning for some reason, the "rules" no longer apply. In the scenarios discussed, I am not sure there is agreement on the state of rule of law, solvency of governments and large banks, etc. that precipates a large fraction of gold futures (or option, or unallocated acct) holders to stand for delivery.
"For example, if total gold liability exposure is X tons of gold, the bank might hold 1/20th or 1/50th of X in physical bullion, but might also be long a sufficient number of futures and forwards to hedge price risk. So if the price spikes out of control, on paper the bank is covered because they already locked in their price for enough bullion to cover all their obligations if they ever had to. If we apply accepted accounting practices, this scenario makes the bank look squaky-clean: They are fully hedged and have no price risk whatsoever. Unless, that is, the system melts down and the counterparty to their hedge trasaction doesn’t deliver, in which case you get the domino-effect that was feared if AIG had defaulted in 2008."
Exactly. One needs to be explicit about the counter-party risk environment before one can discuss price-discovery mechanisms and pricing. Given Jeff’s comments on the lack of regulation of many players, we have justification for being nervous.
Victor, I think Jim has a good point about gold vs fiat in your banking analogies, and Erik above points out that we must consider the remaining longs (or bank creditors) beyond the reserve ratio. Your assertion that pricing does not change in the case of bank runs may be false, and even more so in the case of the gold analogy. You cannot draw a box around the bank and its creditors and consider it in isolation if you want to have the model reflect reality. People make the same mistake about the second law of thermodynamics, and use it when inapplicable.
Since, in our current system (haha), currency is created whenever someone enters into debt with a bank, and destroyed whenever someone retires a loan, when bank runs are occuring (massive withdrawls and either voluntary or involuntary retiring of debt), the money supply is contracting. If we are to believe the monetarists who subscribe to the quantity theory of money, then that reduction of money supply rapidly has an effect on prices denominated in the currency in question. This is the deflationary scenario in which prices decline as money supply shrinks. So prices do change (if we believe the monetarists). The value of money increases. If the frac-gold-bank analogy were perfect, then the same would apply there, ie the value of gold would increase under the same conditions. I believe your example requires that none of the withdrawn assets be used to pay down debt, else money supply changes and thus prices. The gold-bank equivalent would be that none of the delivered gold would be used to satisfy leasing obligations. Please correct me if you feel I am wrong in this.
The analogy is also not perfect, as Jim points out, because of the difference in the nature of the goods in the bank/market. One good, fiat currency, is created and destroyed at man’s whim. The other, gold, is not. Both can and have served as place-holders for the money-concept, ie as currency, and co-temporaneously as well. Both can be hoarded and dis-hoarded to act as demand and supply to the market, but the goods are different in nature, and man, who is the arbiter of value in the market, understands this difference, and, all else equal, will impart greater money-value to the good that is less easily created or destroyed. Further, in the case of fiat, we operate under a coercive system in which a very small subsegment of society is (madness!) entitled to enter into debt (and expand the supply of fiat currency) on behalf of the rest of society, and there is little feedback-coupling to this segment - negative consequence for bankers in our current limited-liability-and-insured-frac/Fed/BIS central system is almost non-existent, so the net incentive for excess is everywhere.
"The big problem I see there is that bankers tend to think in terms of what allows them to manage perceived risk according to the accounting rules imposed on them, not true risk if the system melted down."
Yes. One needs to differentiate in one’s analysis whether one is thinking inside-the-box/system, or outside it, i.e. once natural cause and effect are again free to exert their influence on markets. There is uncertainty in nature. For the last hundred years or so we have in our hubris assumed that we were smart enough to create organizations that could reduce net, overall, long-term risk. We were wrong. LTCM is a grand example, and Victor may be right that we were closer to a system-reset then than in 2008. The most effective way to deal with uncertainty is through emergent-self-organized spontaneous order, which requires freedom, not coercion. I stand with Mandlebrot, Taleb and others in this assertion.
Erik, I think your final conclusion above is flawed: "If the day comes when ‘all the futures longs decide to stand for delivery’ [ed: note it just requires >1/Nth], what that will really mean is that they SELL 90% of their long position, so as to be able to stand for delivery of the amount of metal equal to the amount of money they actually have. All the spec longs selling 90% of their holdings all at once so they can stand for delivery of the rest would definitely shock the market to the downside."
I think that is a very specific example, and not at all likely, but, again, one must agree on preconditions in hypothetical analysis, and I think you mistake market leverage for account margin requirements in that (unless, by coincidence, you are talking about both 10% physical reserves and a 10% fiat-margin requirement imposed by the clearing-house).
I think the scenario being discussed is "strong longs standing" ie those who have 100% fiat backing for their gold positions, and not the historical situation in which highly-margined speculative long players are forced to liquidate under price-pressure. Erik I think you were closer to the truth when you suggested prices would move until the market cleared.
Victor, I think the preconditions you have in mind are some sort of exogenous event in which weak speculative long gold players also have exposure elsewhere, and in some financial crisis seek to liquidate their long gold positions to cover other obligations at the same time as the "strong longs" are standing. I think you are right that there could be a tug of war going on in that case, but I am not sure we can easily predict who wins, and therefore which way prices move. It depends on lots of factors, so you’d have to elaborate on assumptions to get agreement here I think.
Erik, I shouldn’t take the sarcasm bait, but I and a large and growing contingent of society believe that the bankers will, ultimately, be meted justice and sanity in our money and our markets will return, and this very blog discussion is evidence of that. How exactly, and when? Anyone’s guess.
best regards,
bbacq
