Austrian economics in the silver market

"What is the nature of those little disks or documents?"

r/wsb is running around Wall Street like a four-year-old with a lighter, setting anything that will burn on fire. Warren Buffett once said: when the tide goes out, you see who’s swimming naked. When you let a pyro loose in your parlor, you see what’s flammable.

This new silver squeeze, which, as I predicted last week (when people were already talking about it—I don’t know who started the fire, but it sure wasn’t me) seems to be possibly (but nowhere near certainly) happening, is a very uncomplicated bank run.

Here I will explain this bank run in terms of very uncomplicated Austrian economics. My Austrian economics is not always quite orthodox, but this analysis is.

Epistemology of precious-metals finance

It is important to note that there is a large amount of well-written misinformation—the worst kind—on the Internet about precious-metals finance. For instance…

It is not true that bullion banks (as opposed to trading desks and hedge funds, which can take any position) are net short precious metals—rather, their assets and liabilities are always balanced in the metal itself—or that a shortage of coins and medals means a shortage of monetary bullion—the bottleneck is the mint. Yet it is not true that bullion banks are immune to a bank run—solvency in a bank does not ensure stability.

And these are the usual positions of the counter-establishment and establishment respectively. With such experts… some say that, in Chinese, the same character means both “idiocy” and “opportunity.” While idiots are not always an opportunity to profit, sometimes they are.

On gold and silver

The words for “silver” and “money” are the same in every language except English and Eskimo, so silver is clearly a potential money. But we can tell that silver is not currently
monetized, because the characteristic quality of money is a high stock-to-flow ratio: much more is stored than is created every year. (In fact, the world spent much of the 20th century burning off its old reserves of monetary silver as an industrial metal.)

While gold remains nontrivially monetized, silver’s monetary ratio today would not be unusual for an industrial commodity. Broadly speaking, the paradox of the two metals today is that while gold is a much better, more stable money than silver, silver is much easier to spontaneously remonetize—or, at least, to squeeze.

Silver is the Ethereum of precious metals—unlikely to win the Highlander race for monetary standardization, but still theoretically capable of winning. Yet because it can ignite more easily, it could serve as a fission primary to gold’s fusion secondary.

And of course, precious metals are still competing with crypto, fiat and risk assets—the last of which still stores by far the majority of savings.

Commodity and monetary equilibria

Today’s precious-metals markets are legally structured as commodity markets.

Treating monetary metals as commodities, as if they were corn or pork bellies, was part of the regulatory structure under which gold was restored to the private sector—after 40 years of being straight-up illegal. It was about the precious metals being demonetized—barbaric relics—all in keeping with the usual 20th-century arrogance.

Of course, precious metals are commodities. And they are either media of saving (like gold), or potential media of saving (like silver)—both industrial and monetary goods.

And because they are two types of good, they have two distinct pricing equilibria. Silver is currently fully demonetized—it is priced as an industrial good. Gold is partly, but not fully, monetized. Therefore, besides gold stockpiles being much higher than silver stockpiles, the gold-to-silver price ratio is at historical highs.

Industrial and monetary pricing are two different models of valuation—representing two different pricing equilibria. Precious metals are inherently chaotic because they can fluctuate across the whole spectrum between these models.

In the mindset of a commodities trader, a commodity is properly priced if demand for the commodity equals supply of it—that is, if consumption equals production. This is the microeconomic equivalent of 2+2=4—so who can blame our commodities trader?

If twice as much corn is grown as is eaten, the world develops unsustainable reserves of corn. It does need some reserves, but only to buffer seasonal and yearly fluctuations. Corn must flow smoothly at an even pace through the bowels of the economy, and our happy commodities merchants must discover the price that will pace this peristalsis.

Gold has nothing like this. There is some industrial consumption of gold. It would still take way over a century to industrially consume the world’s current gold stockpile. If corn was like this, we would long since have burst all our silos and resorted to storing it in our cheeks, like squirrels. (Silver’s equivalent period is a few years.)

Instead, gold is mainly used as a medium of saving—a money. Its price is the market cap of all the gold in the world, divided by the amount of gold in the world. Obviously, in an economy on a full gold standard, if more gold is mined than used up each year, it makes no sense to say that the price of gold is too high.

These pricing models have nothing to do with each other. As an industrial commodity, these metals have a price which should be set to equate production and consumption. As a medium of saving, their price depends wholly on their level of monetization—the percentage of total personal net worth stored in them. For gold this number is tiny, and for silver it is negligible.

Bullion banking

Yet since even silver, the Ethereum of precious metals, is a way to store serious value, even silver has a banking system.

Banking in silver and gold is called bullion banking. A bullion bank is just like a regular bank, except that its currency is precious metal. And like a regular bank, it practices fractional-reserve banking, aka maturity transformation.

But unlike a regular bank, a bullion bank cannot be bailed out—except with bullion. Since there is a lot more gold bullion than silver bullion around, even though gold is a better and more stable money than silver, silver is much easier to squeeze into orbit.

It is especially hard to understand bullion banking because it expresses itself in the language of commodities—the language of corn and pork bellies. You probably do not think of your bank account as a “future,” though in a sense it is.

A bank is a business that buys and sells promises of money—or in this case, bullion. (Not to be confused with bouillon, which is soup—always double-check your orders.) Let’s look at how gold flows through a gold bank.

Gold starts in a hole in the ground. Small, local mom-and-pop companies hire happy miners, for fair wages and good benefits, who sing blithely of their happy working conditions as they delicately lift the beautiful nuggets from that nasty dirty hole.

The happy miners are not happy unless they are paid. They cannot be paid today with the gold they mine today. They are not paid in gold, but in the sound and stable local currency—so solid it has the President-For-Life on the front. Bundles of this paper can, like anything else, be bought for dollars—which can be bought for gold.

So a gold mine does not just mine gold and sell it. To get the money to dig its mine, it has to sell promises of future gold—”forwards.” No one on Reddit is in the business of buying a half-ton of gold to be delivered in October 2023, for real crisp dollars now.

But a bullion bank is! A bullion bank can price a promise like that, no problem. You can’t just do it on the website, of course. You have to call—or at least, login as an existing customer. The bank, like any bank, has to know your credit is good.

The bank, owning your promise (which we’ll assume is good), is now long gold. The bank actually does not care whether gold goes up or down. In order to keep not caring, it has to neutralize its position—so it goes short the same amount of gold, typically by selling it as a Comex future (which promises delivery within 90 days). This sale also gets the bank its dollars back, of course.

So, as in a normal bank, the bullion bank’s assets exceed its liabilities—in bullion. But its assets and liabilities are not exactly like each other. For example, October 2023 is a lot more than 90 days from now.

Any bank is a maturity transformer—with short-term debts and long-term assets. An ordinary bank account is a short-term debt, just like a Comex future—except that your ATM offers delivery in 30 seconds, not 90 days.

During most minutes, you don’t withdraw most dollars from your bank account—even though you have every right to. Most Comex futures are not delivered either—they are rolled over into new futures, just as your checking account is rolled over into a new 30-second loan from you to the bank.

So both kinds of bank have done the same thing—they have made more promises than they can trivially fulfill. If everyone takes delivery of all Comex futures, the banks do not have the bullion to deliver now that they have promised to deliver now. If everyone goes to the ATM and withdraws their whole account, the banks do not have the dollars to deliver now that they have promised to deliver now. (Nor do the ATMs.)

In both cases, the banks are still solvent—their assets are worth more, in the currency of their liabilities, than their liabilities. They actually can fulfill their promises, even if all their promises actually need to be delivered at once, which happens like never. But if that does happen somehow—

They just have to—sell some shit. You must have had some guy who owed you money, and you had to remind him of that, which already wasn’t cool, and he was like—yeah, man—it’s cool—I just have to sell some shit. And you were like—uh—okay.

But it was cool. He did pay you back. But not right away—he had to find a guy who wanted some gold—not, like, now—in 2023—”it’ll show up, don’t worry about that.”

The Achilles heel of maturity transformation

The Achilles heel of maturity transformation is that once a lot of people start selling shit, its price has an unnerving tendency to decline.

The bank is not insolvent, because its assets are worth more than its liabilities. But “worth” is not an absolute Platonic quality of an object. An object’s true worth, its intrinsic value, may even be spiritual and unchanging. The same is true of an asset. However, its market price is only what some asshole is ready to pay for it.

The bank’s liabilities are bullion, deliverable now—or at least, real soon now. The bank’s assets are promises of future bullion, not any time soon. How can we compute the price of a promise of future bullion? Easy—this is finance 101.

The price of a promise is the amount of the promise—times the probability that the promise will be redeemed—times the discount rate for the term of the promise. The discount rate is just the inverse of the interest rate. If the interest rate is 2% a year, a promise of 100 dollars a year from now is worth about $98 now—that’s your discount.

Because we live in a zombie economy of post-capitalism in which all interest rates are fixed by the government, we are used to all these variables being fixed. And indeed, in this twilight world all banks are zombie banks and cannot die; and there are no runs.

But this is only the world of paper money. When you’re banking with bullion, you’re not playing paintball. This is especially true in the razor-thin market for 21st-century fully-demonetized silver, where there are essentially no government reserves. Governments cannot print gold, but they still have a lot of it to throw around.

In bullion, there is also an interest rate. This is called the “lease rate,” as if bullion was an Audi. The discount rate in bullion is the price of future bullion in present bullion, just like the explanation in dollars above.

Bank runs are systemic. When the bank has to sell its future bullion to deliver present bullion, the market price of future bullion in present bullion falls. When a lot of people start selling promises, the market price of promises goes down.

Which means that the bullion interest rate (the “lease rate”) goes up. It is not a real bank run, a systemic bank run, until you get that interest-rate spike.

And it also means that, even without the soundness of the promises it owns changing, the bank has become insolvent. Its assets are now worth less than its liabilities—so now, anyone who holds its liabilities really wants to be first in line to collect. At this point it is burning like an Iraqi tank and the turret will pop off in about 15 seconds.

A banking apologist will look at this and see a disaster, a market failure. Clearly, it’s no good for things to catch fire and explode. Austrian economics is not YOLO economics. At least, it’s not supposed to be YOLO economics.

But whose fault is it? What the banking system did, by transforming demand for present gold into demand for future gold, was to create a false economic signal of spurious demand for future gold.

This false signal increased the price of future promises, creating a false signal of low interest rates, and naturally increasing the production of promises. When the illusion collapses, there are more promises than anyone wants. So the real interest-rate signal, now exposed because the tide has gone out, is unusually—but not unfairly—high.

This classic bank run is actually the popping of a bubble—a bubble in promises. It is a transition from an unstable equilibrium to a stable equilibrium. A good rule of thumb is that if an Internet board can blow it up, it’s probably not stable. You might want to think again next time before you drive your nitroglycerine down Wall Street that fast. The paving is not what it once was.

Maturity transformation and monetary dilution

Let’s go back to the two valuation models of bullion: monetary and commodity.

Because commodity prices are set by supply and demand, production and destruction, they have a rational anchor which the market tends toward. As an onion trader, if I feel the onion market is too high, I short the onion market.

I do this by printing out a fake coupon for fake onions, and selling it. If I make a profit, this means I was engaging in productive economic activity that helped set the price of onions correctly, better than Gosplan ever could.

My counterfeit onions are not a crime—they are a liability. They just means I have to cover my short, which I will—with cheaper, properly-priced onions, making a profit. I have earned this profit. I have helped the onion consumers of America escape the tax of the sinister onion cartel.

But monetary demand is different. The price of gold is not and should not be set by production and destruction. It is set by dividing a pool of savings over a pool of metal.

If I print out a fake coupon for gold, and sell it, I have created what Ludwig von Mises called a “money substitute.” It is not counterfeiting per se, because the coupon has my phone number on it—I have created a corresponding liability.

The systemic effect of this synthetic gold is to distort the market for gold, in a way that the market for onions cannot be distorted. Perhaps the demand I create for gold in my attempts to repay the liability counters this dilutive effect—perhaps it doesn’t.

Generally, fractional-reserve banking can create as many claims to present assets as people are willing to create promises of future assets. This is why people say banks “create” money. A bullion bank is not a supernova and cannot create gold, but it can create synthetic present gold out of promises of future gold.

There is no conspiracy

The above is a combination of standard bullion-banking theory and standard Austrian economics. It is entirely free from mysteries and conspiracies. It is perfectly consistent with a silver squeeze and/or a silver bank run. But I am not sure it is the whole story.

The trouble is that if we interpret bullion banking as strictly the business of financing bullion mining, the numbers don’t work out. Especially in gold, the “hedge book” of forward mining sales is much smaller than the outstanding volume of “paper gold.” The paper-gold volume (for example, open interest on Comex) also seems to fluctuate considerably—the hedge book does not.

So, besides mining, there seems to be some other source of promises of future bullion. To describe this as “borrowing” bullion is misleading—who actually “leases” gold? Unlike an Audi, it is useful for exactly nothing—unless you use it up. Silver is used exactly this way, as a catalyst, in certain chemical reactions… but…

All we know is that, while the bullion banks proper keep balanced books, someone is selling them promises of future bullion; and said sellers have good enough credit to convince the banks that their promises are good, letting them resell these promises by issuing claims to current bullion.

This is not a conspiracy. It is just banking. Why should the bankers care how their counterparties are going to get this bullion, so long as their credit is good? The promises are not even promises of bullion, anyway—just promises to pay whatever bullion is worth. The bank does not care who is making these promises or why. It gets the promises in its inbox, and turns them into synthetic bullion in its outbox.

So besides the risk of a classic bank run with its interest-rate spike and drop in the price of future metal, there is also the risk of a pattern of systematic failure in the promises of metal that the bank holds.

If these promises are ultimately backed by actual metal, in the ground or otherwise, metal-price increases should not endanger their honor. If they are the result of pure financial alchemy, who knows? Margin is a good thing, but it is not a perfect solution to the problem of counterparty risk.

A hypothesis

It is worth elaborating on one remarkable feature of this dual equilibrium.

If I inject synthetic gold into the gold market, I sustainably lower the market price of gold (although I have to reverse the effect when canceling my fake). This is not true for onions. This mechanism cannot be sustainably used to manage the price of onions.

Done at sufficient volume, shorting a monetary commodity actually creates its own profit. It is necessary to carry this short, taking on risk, and to find a way to cover it.

Moreover, the monetization of the precious metals is a feedback loop—they go up as savings move into them; savings move into them as savers see them going up. This loop can continue indefinitely—any precious metal can store all the world’s savings.

But if traders in these markets see the metals as commodities markets—which they do—they can use the mechanisms of the onion market to try to price metals like onions. These mechanisms are perfectly designed to combat and control such feedback loops.

This means that when savings flow into bullion, the natural response of the market is to create new synthetic bullion, buffering what it perceives to be a price distortion. And of course, the monetization of precious metals is indeed a price distortion. It elevates price far above the meeting point of supply and demand, building enormous stockpiles, which would indeed be ridiculous in the onion market.

But this natural response is a natural response only because it has in the past proven profitable. This uncoordinated response is a challenge to any monetary attack on the commodity equilibrium—it makes money, assuming the attack is weak and fails. It is instinctive because it it has always worked in the past—which means all the attacks of the past have been weak. There’s a first time for everything, though.

No predictions here

Is Reddit—and the small army of money tagging along behind it—weak? Not so far. But we can never forget the words of the Big Lebowski: the bums will always lose.

Certainly the silver market has never faced a decentralized corner like this. The city has never seen a horde of barbarians this big. But the horde of barbarians has never seen a city this big, either. There’s only one bet that can’t fail in 2021: long popcorn.

Gray Mirror is too cheap to be investment advice—but if you learned something about finance today, stick around. You might learn something else: