Zero Hedge Reads

Keith Weiner The Swiss Franc Will Collapse

Submitted by Monetary Metals on 01/28/2015 00:28 -0500

By

I have worked to keep this piece readable, and as brief as possible. My grave diagnosis demands
the evidence and reasoning to support it. One cannot explain the collapse of this currency with
the conventional view. They will print money to infinity, may be popular but its not accurate.
The coming destruction has nothing to do with the quantity of money. It is a story of what
happens when interest rates fall into a black hole.

Yields Have Fallen Beyond Zero

The Swiss yield curve looks like nothing so much as a sinking ship. All but the 20- and 30-year
bonds are now below the water line.

Look at how much its submerged in just one week. The top line (yellow) is January 16, and the
one below it was taken just a week later on January 23. Its terrifying how fast the whole interest

rate structure sank. Here is a graph of the 10-year bond since September. For comparison, the 10year Treasury bond would not fit on this chart. The US bond currently pays 1.8%.

The Swiss 10-year yield was as high as 37 basis points on Friday January 2. By the next
Monday, it had plunged to 28, or -25%. By January 15the day the Swiss National Bank (SNB)
announced it was removing the peg to the eurothe yield had plunged to just 7 basis points. It
has been nonstop freefall since then, currently to -26 basis points.
What can explain this epic collapse? Why is the entire Swiss bond market drowning?
Drowning is a fitting metaphor. In my dissertation, I describe several harbingers of financial and
monetary collapse. The first is when the interest interest rate on the long bond goes to zero. I
discuss the fact that a falling rate destroys capital, and that lower rates mean a higher burden of
debt. If the long bond rate is zero then the net present value of all debt (which is effectively
perpetual) is infinite. Debtors cannot carry an infinite burden. As well see, any monetary system
that depends on debtors servicing their debt must collapse when the rate goes to zero.
I think the franc has reached the end. With negative rates out to 15 years, and a scant 33 basis
points on the 30-year, it is all over but the shouting.

Not Printing, Borrowing

Lets take a step back for a moment, and look at how the recent chapter unfolded. It began with
the SNB borrowing mass quantities of francs. Most people say printed, but its impossible to
understand this unprecedented disaster with such an approximate understanding. Its not printing,
but borrowing.
Think of a homebuyer borrowing $100,000 to buy a house. He never gets the cash in his bank
account. He signs a bunch of paperwork, and then at the end of the day he has a debt obligation
to repay, plus the title to the house. The former owner has the cash.
It works the same with any central bank that wants to buy an asset. At the end of the day, the
bank owns the asset, and the former owner of the asset now holds the cash. This cash is the debt
of the central bank. It is on the banks balance sheet as a liability. The bank owes it.
This is vitally important to understand, and it can be quite counterintuitive. If one thinks of the
franc (or dollar, euro, etc.) as money, and if one thinks that the central banks print money, then
one will come to precisely the wrong conclusion: that there is nothing owed, and indeed there is
no debtor. In this view, the holder of francs has cash, which is a current asset. End of story.
This conclusion could not be more wrong.
Certainly, the idea of the central bank repaying its debt is absurd. By law, payment is deemed
made when the debtor pays in currencyi.e. francs in Switzerland. However, the franc is the
very liability of the SNB that were discussing. How can the SNB pay off its franc liabilities
using its own franc liabilities as means of payment?
It cant. This is a contradiction in terms. Thus its critical to understand that there is no
extinguisher of debt in the regime of irredeemable paper currency. You may get yourself out of
the debt loop by paying in currency, but that merely shifts the debt. The debt does not go out of
existence, because paying a debt with an IOU cannot extinguish it. Unlike you, the central bank
cannot get itself out of debt.
However, it can service its debt. For example, the Federal Reserve in the U.S. pays interest on
reserves. Indeed, the bank must service its debts. It would be a calamity if a payment is missed, if
the central bank ever defaulted.
The central bank must also maintain its liabilities, which is what it uses to fund its assets. If the
commercial banks withdraw their depositsand they do generally have a choicethe central
bank would be forced to sell its assets. That would be contrary to its policy intent, not to mention
quite a shock to brittle economies.
Make no mistake, a central bank can go bankrupt. This may seem tricky to understand, as the law
makes its liability legal tender for all debts public and private. A central bank is also allowed to
commit acts of accounting (and leverage) that would not be tolerated in a private company.
Regardless, it can present misleading financial statements, but even if the law lets it get away

with that, reality will have its revenge in the end. The emperor may claim to be wearing
magnificent royal robes, but hes still naked.
If liabilities exceed assets, then a bankeven a central bankis insolvent and the consequences
will come soon enough. The cash flow from the assets will sooner or later become insufficient to
pay the interest on the liabilities. No central bank wants to be in a position where it is obliged to
borrow, not to purchase asset but to service a negative cash flow. That is a rapid death spiral. It
must somehow push down the interest rate on its liabilities (which are typically short term) to
keep the cost of financing its portfolio below the revenue generated on the assets.
This becomes increasingly tricky when two things happen. One, the yield on the asset goes
negative. Thus, the even-more-negative (and even more absurd) one-day rate of -400 basis points
in Switzerland. Two, the issuance of more currency drives down yields even further (described in
detail, below).
Events force the hand of the central bank. It goes down a path where it has fewer and fewer
choices. That brings us back to negative interest rates out to the 15-year bond so far.

The Visible Hand of the Swiss National Bank

So the SNB issued francs to fund its purchase of euros. Next, it spent the euros on whatever
Eurozone assets it wished to buy, such as German bunds.
Its well known that the SNB put on a lot of this trade to keep the franc down to 0.83 (the
inverse of keeping the euro down to CHF1.2) l. It also helped push down interest rates in Europe.
The SNB was a relentless buyer of European bonds.
That leads to the question of what it did in Switzerland. The SNB was trading new francs for
euros. That means the former owner of those euros then owned francs. These francs have to stay
in the franc-denominated domain. What asset will this new franc owner buy?
I frame the question this way deliberately. If you have a 100-franc note, you can put it in your
pocket. If you have CHF100,000, you can deposit it in a bank. If you have CHF100,000,000 (or
billions) then you are going to buy a bond or other asset (depositing cash in a bank just pushes it
to the bank, who buys the asset).
The seller of the asset is selling on an uptick. He gives up the bond, because at its higher price
(and hence lower yield) he now finds another asset more attractive on a risk-adjusted basis. Risk
includes his own liquidity risk (which of course rises as his leverage increases).
As the SNB (and many others) relentlessly push up the bond price, and hence push down the
yield, the sellers of the ever-lower yielding bonds have fresh new franc cash balances.
The Quantity Theory of Money holds that the demand for money falls as the quantity rises. If
demand for money falls, then by this definition the prices of all other thingsincluding

consumer goodsrises. It is commonly held that people tradeoff between saving money vs.
spending money (i.e. consumption). The prediction is rising consumer prices.
I emphatically disagree. A wealthy investor does unload his assets to go on an extra vacation if
he doesnt like the bond yield. A bank with a trillion dollar balance sheet does not dole out
bigger salaries if its margins are compressed.
So what does trade off with government bonds? If an investor doesnt want to own a government
bond, what else might he want to own? He buys corporate bonds, stocks, or rental real estate,
thus pushing up their prices and yields down.
And then, in a dysfunctional monetary system, you can add antique cars, paintings, a second and
third home, etc. These things serve as surrogates for investment. When investing cannot produce
an adequate yield, people turn to non-yielding non-investment assets.
The addition of a new franc at the margin perturbs the previous equilibrium of risk-adjusted
yields across all asset classes. Every time the bond price goes up, every owner of every francdenominated asset must recalculate his preferences.
The problem is that the SNB does not create any more productive investment opportunities when
it spills more francs into the Swiss financial system. Those new francs have to chase after the
existing assets.
Yields are falling. They necessarily had to fall.

An Increasing Money Supply and Decreasing Interest Rate

The above discussion describes the picture in every developed economy. Interest rates have been
falling for 34 years in the U.S., for example.
In a free market, the expansion of credit would be driven by a market spread: available yield
cost of borrowing. If that spread is too small (or negative) there will be no more borrowing to
buy assets. If it gets wider, then banks can spring into action.
However, central banks distort this. Instead of the cost of borrowing being a market-determined
price, it is fixed by the central bank. This perverts the business model of a bank into what is
euphemistically known as maturity transformationborrowing short to lend long. Its not
possible for a bank to borrow money from depositors with 5-year time deposit accounts in order
to buy 5-year bonds. The bank has to borrow a shorter duration and buy a longer, in order to
make a reasonable profit margin.
If the central bank sets the borrowing cost lower and lower, then the banks can bid up the price
of government bonds higher and higher (which causes a lower and lower yield on the long bond).
This is not capitalism at all, but a centrally planned kabuki theater. All of the rules are set by a
non-market actor, who can change them for political expediency.

The net result is issuance of credit far beyond what could ever happen in a free market. This
problem is compounded by the fact that the central bank cannot control what assets get bought
when it buys bonds. It hands the cash over to the former bond holders. Its trying to accomplish
somethingsuch as keeping the franc down in the case of the SNB, or preventing bankruptcies,
in the case of the Fedand it has no choice but to keep flooding the market until it achieves its
goal. In the US, the rising tide eventually lifted all ships, even the leaky old tubs. The result is a
steeper credit gradient, and the bank can eventually force liquidity out to its target debtors.
The situation in Switzerland makes the Feds problems look small by comparison. Unlike the
Fed, which had a relatively well-defined goal, the SNB put itself at the mercy of the currency
market. It had no particular goal, and therefore no particular budget or cost. The SNB was
fighting to hold a line against the world. While it kept the franc peg, the SNB put pressure on
both Swiss and European interest rates.
Something changed with the start of the year. We can understand it in light of the arbitrage
between the Swiss bond, and other Swiss assets. The risk-adjusted rate of return on other assets
always has to be greater than that of the Swiss government bond (except perhaps at the peak of a
bubble). Otherwise why would anyone own the higher-risk and lower-yield asset?
Therefore, there are three possible causes for the utter collapse in interest rates in Switzerland
beginning 10 days prior to the abandonment of the peg:
1) the rate of return of other assets has been leading the drop in yields
2) buying pressure on the franc obliged the SNB to borrow more francs into existence, fueling
more bond buying
3) the risk of other assets has been rising (including liquidity risk to their leveraged owners)
#1 is doubtful. Its surely the other way around. Its not falling yields on real estate driving
falling yields on bonds. Bond holders are induced to part with their bonds on a SNB-subsidized
uptick. Then they use the proceeds to buy something else, and drive its yield down.
One fact supports conclusion #2. Something forced the SNB to remove the peg. Buying pressure
is the only thing that makes any sense. The SNB hit its stop-loss.
The rate of interest continued to fall even after the SNB abandoned its peg. Why? Reason #3,
rising risks. Think of a bank which borrowed in Swiss francs to buy Eurozone assets. This trade
seemed safe with the franc pegged to the euro. When the peg was lifted, suddenly the firm was
faced with a staggering loss incurred in a very short time.
The overreaction of the franc in the minutes following the SNBs policy change had to be the
urgent closing of Eurozone positions by many of these players. The franc went from 0.83 to
1.15 in 10 minutes, before settling down near 0.96. For those balance sheets denominated in
francs, this looked like the euro moved from CHF1.20 to CHF0.87, a loss of 28%. What would
you do, if your positions instantly lost so much? Most people would try to close their positions.

Closing means selling Eurozone assets to get francs. Then you need to buy a franc-denominated
asset, such as the Swiss government bond. That clearly happened big-time, as we see in the
incredible drop in the interest rate in Switzerland. Francs which had formerly been used to fund
Eurozone assets must now be used to fund assets exclusively in the much-smaller Swiss realm.
In other words, a great deal of franc credit was used to finance Eurozone assets. This is a big
world, and hence the franc carry trade didnt dominate it. When those francs had to go home and
finance Swiss assets only, it capsized the market.
And the entire yield curve is now sinking into a sea of negative rates.

The Consequences of Falling Interest

Meanwhile, unnaturally low interest is offering perverse incentives to corporations who can issue
franc-denominated liabilities. They are being forced-fed with credit, like ducks being fatted for
foie gras. This surely must be fueling all manner of malinvestment, including overbuilding of
unnecessary capacity. The hurdle to build a business case has never been lower, because the cost
of borrowing has never been lower. The consequence is to push down the rate of profit, as
competitors expand production to chase smaller returns. All thanks to ever-cheaper credit.
Artificially low interest in Switzerland is causing rising risk and, at the same time, falling
returns.
The Swiss situation is truly amazing. One has to go out to 20 years to see a positive number for
yieldif one can call 21 basis points much of a yield.
Its not only pathological, but terminal. This is the end.
In Switzerland, there is hardly any incentive remaining to do the right things, such as save and
invest for the long term. However, theres no lack of perverse incentives to borrow more and
speculate on asset prices detaching even further from reality.
Speculation is in its own class of perversity. Speculation is a process that converts one mans
capital into another mans income. The owner of capital, as I noted earlier, does not want to
squander it. The recipient of income, on the other hand, is happy to spend some of it.
We should think of a falling interest rate (i.e. rising bond market and hence rising asset markets)
as sucking the juice (capital) out of the system. While the juice is flowing, asset owners can
spend, and lots of people are employed (especially in the service sector).
For example, picture a homeowner in a housing bubble. Every year, the market price of his
house is up 20%. Many homeowners might consider borrowing money against their houses.
They spend this money freely. Suppose a house goes up in price from $100,000 to $1,000,000 in
a little over a decade. Unfortunately, the debt owed on the house goes up proportionally.

With financial assets, they typically change hands many times on the way up. In each case, the
sellers may spend some of their gains. Certainly, the brokers, advisors, custodians, and other
professionals all get a cutand the tax man too. At the end of the day, you have higher prices
but not higher equity. In other words, the capital ratio in the market collapses.
To understand the devastating significance of this, consider two business owners. Both have
small print shops. Both have $1,000,000 worth of presses, cutters, binding machines, etc. One
owns everything outright; he paid cash when he bought it. The other used every penny of
financing he could get, and has a monthly payment of about $18,000. Both shops have the same
cost of doing business, say $6,000. If sales revenues are $27,000 then both owners may feel they
are doing well. What happens if revenues drop by $3,500? The all-equity owner is fine. He can
reduce the dividend a bit. The leveraged owner is forced to default. The more your leverage, the
more vulnerable you are to a drop in revenues or asset values.
Falling interest, and its attendant rising asset prices, juices up the economy. People feel richer
(especially if their estimation of their wealth is portfolio value divided by consumer prices) and
spend freely. Unfortunately, it becomes harder and harder to extract smaller and smaller drops of
juice. The
marginal productivity of debt falls.
Think about it from the other side, the borrower. The very capacity to pay interest has been
falling for decades. A declining rate of profit goes hand-in-hand with a falling rate of interest.
Lower profit is both caused by lower interest, and also the cause of it. A business with less profit
is less able to pay interest expense. Who could afford to pay rates that were considered to be
normal just a few decades ago? It is capital that makes profit, and hence capacity to pay interest,
possible. And it is capital thats eroded by falling rates.
The stream of endless bubbles is just the flip side of the endless consumption of capital. Except,
there is an end. There is no way of avoiding it now, for Switzerland.

How About Just Shrinking the Money Supply?

Monetarists often tell us that the central bank can shrink the money supply as well as grow it,
and the reason why its never happened is, well the wrong people were in charge.
I disagree.
To see why, lets look at the mechanism for how a central bank expands the money supply. It
issues cash to an asset owner, and the asset changes hands. Now the bank owns the asset and the
seller owns the cash (which he will promptly use to buy the next best asset). A relentlessly rising
bond price is lots of fun. Its called a bull market, and everyone is making profits as they reckon
them (actually consuming capital, as we said above).
How would a contraction of the money supply work? It seems simple, at first. The central bank
just sells an asset and gets back the cash. The cash is actually its own liability, so it can just retire
it. And voila. The money supply shrinks.

Not so fast.
There is an old saying among traders. Markets take the escalator up, but the elevator down.
Central bank buying slowly but relentlessly bid up the price of bonds. Tick by tick, the bank
forced it up. What would central bank selling do? What would even a rumor of massive central
bank selling do?
Bond prices would fall sharply.
The problem is that few can tolerate falling bond prices, because everyone is leveraged. Think
about what it means for everyone to borrow and buy assets, for sellers to consume some profits
and reinvest the proceeds into other assets. There is increasingly scant capital base supporting an
increasingly inflatedas in puffed-up with air, without much substanceasset market. A small
decline in prices across all asset classes would wipe out the financial system.
Market participants have to be leveraged. Dirt cheap credit not only makes leverage possible, but
also necessary. How else to keep the doors open, without using leverage? Spreads are too thin to
support anyone, unlevered.
Banks are also maturity mismatched, borrowing short to lend long. The consequences of a rate
hike will be devastating, crushing banks on both sides of the balance sheet. On the liabilities
side, the cost of funding rises with each uptick in the interest rate. On the asset side, long bonds
fall in value at the same time. If short-term rates rise enough, banks will have a negative cash
flow.
For example, imagine owning a 10-year bond that pays 250 basis points. To finance it, you
borrow at 25 basis points. Well, now imagine your financing cost rises to 400 basis points. For
every dollar worth of bonds you own, you lose 1.5 cents per year. This problem can also afflict
the central bank itself.
You have a cash flow problem. You are also bust.

The Bottom Line

The problem of falling rates is crushing everyone, but raising the rate cannot fix the problem. It
should not be surprising that, after decades of capital destructioncaused by falling ratesthe
ruins of a once-great accumulation of wealth cannot be repaired by raising the interest rate.
I do not see any way out for the Swiss National Bank and the franc, within the system of
irredeemable paper money. However, unless the SNB can get out of this jam, the franc is
doomed. I cant predict the timing, but I believe the fuse is lit and the powder keg could go off at
any time.
One day, a bankruptcy will happen. Soothing voices will assure us it was unexpected. Then
another will happen, perhaps triggered by the first or perhaps not. Then the cascading begins.

One partys liabilities are anothers assets. ABCs bankruptcy wipes out DEFs asset. Since DEF
is leveraged, it cannot absorb much loss until it, too, is dragged under.
Somewhere in the midst of this, people will turn against the franc. Today, its arguably the most
loved paper currency. However, I dont think it will take too many capital losses in Switzerland,
before there is a selling stampede. The currency will fall to zero, in a repeat of a pattern that the
world has seen many times before.
People will call it hyperinflation (I dont prefer that term). Call it what you will, it will be the
death of the franc. It will have nothing to do with the quantity of money.
Two factors can delay the inevitable. One, the SNB may unwind its euro position. As this will
involve selling euros to buy francs, the result will be to put a firm bid under the franc. Two,
speculators will of course know this is happening and eagerly front-run the SNB. After all, the
SNB is not an arbitrager buying when it can make a spread. It is a buyer by mandate (in this
scenario) and must pay the ask price. Even if the SNB does not unwind, speculators may buy the
franc and wait for it to happen. And of course, they could also buy based on a poor
understanding of whats happening, or due to other perverse incentives in their own countries.
Bankruptcies aside, the franc is already set on a hair-trigger. Something else could trip it and
begin the process of collapse. There is little reason for holding Swiss francs in preference to
dollars. The interest rate differential is huge. The 10-year US Treasury pays 1.8%. Compare that
to the Swiss bond which charges you 26 basis points, and the difference is over 208 points in
favor of the US Treasury. Once the risk of a rising franc is taken out of the market (by time or
price action) this trade will commence. A falling franc against the dollar will add further kick to
this trade. A trickle could become a torrent very quickly.
I would not be surprised if the process of collapse of the franc began next week, nor if it lingered
all year. This kind of event is not susceptible to a precise prediction of when.
What is clear is that, once the process begins in earnest, it will be explosive, highly non-linear,
and over quickly (I would guess a matter weeks).

I plan to publish a separate paper revisiting my Gold Bonds to Avert Financial Armageddon
thesis in light of the Swiss crisis. I will save for that paper my assessment of whether or how gold
bonds can provide a way out for the Swiss people trapped in the terminal phase of irredeemable
paper money.

Gold Bonds to Avert Financial Armageddon

5 Replies

This paper has been published in a number of places, notably including the Gold Standard Institute.
I submitted it to the Wolfson Economics Prize. Now it can live here permanently on my own blog
site.

After the near-collapse of the financial system in 2008, a growing number of people have come to
realize that our monetary disease is terminal. It is that group to whom I address this paper. I
sincerely hope that this group includes leaders in business, finance, and government.
I do not believe that my proposal herein is necessarily realistic (i.e. pragmatic). There are many
interest groups that may oppose it for various reasons, based on their short-sighted desire to try to
continue the status quo yet a while longer. Nevertheless, I feel that I must write and publish this
paper. To say nothing in the face of the greatest financial calamity would go against everything I
believe.
***
It seems self-evident. The government can debase the currency and thereby be able to pay off its
astronomical debt in cheaper dollars. But as I will explain below, things dont work that way. In
order to use the debasement of paper currencies to repay the debt more easily, governments will
need to issue and use the gold bond[1].
I give credit for the basic idea of using gold bonds to solve the debt problem to Professor Antal
Fekete, as proposed in his paper: Cut the Gordian Knot: Resurrect the Latin Monetary Union. My
paper covers different ground than Feketes, and my proposal is different as well. I encourage
readers to read both papers.
The paper currencies will not survive too much longer. Most governments now owe as much or
more than the annual GDPs of their nations (typically far more, under GAAP accounting). But the
total liabilities in the system are much larger.
Even worse, in the formal and shadow banking system, derivative exposure is estimated to be more
than 700 trillion dollars. Many are quick to insist that this is the gross exposure, and the net is
much smaller as these positions are typically hedged. But the real exposure is close to the gross
exposure in a crisis. While each party may be hedged by having a long leg and a balancing short
leg, these will not net out. This is because in times of stress the bid (but not the offer) is withdrawn.
To close the long leg of an arbitrage, one must sell on the bid (which could be zero). To close the
short leg, one must buy at the offer (which will still be high). When the bid-ask spread widens that
way, it will be for good reason and it does not do to be an armchair philosopher and argue that it
should not occur. Lots of things will occur that should not occur.
For example, gold should not go into backwardation. This is another big (if not widely appreciated)
piece of evidence that confidence in the ability of debtors to pay is waning. Gold and silver went into
backwardation in 2008 and have been flitting in and out of backwardation since then. Backwardation
develops when traders refuse to take a risk free profit. That is, the trade is free from all risks
except the risk of default and losing ones metal in exchange for a defaulted futures contract. See
my paper on When Gold Backwardation Becomes Permanent for a full treatment of this topic.
The root cause of our monetary disease has its origins in the creation of the Fed and other central
banks prior to World War I, and in the insane treaty signed in 1944 at Bretton Woods in which many
nations agreed for their central banks to use the US dollar as if it were gold, and this paved the way

for President Nixon to pound in the final nail in the coffin. He repudiated the gold obligations of the
US government in 1971, thereby plunging the whole world into the regime of irredeemable paper.
The US dollar game is a check-kiting scheme. The Fed issues the dollar, which is its liability. The
Fed buys the US Treasury bond, which is the asset to balance the liability. The only problem is that
the bonds are payable only in the central banks paper scrip! Meanwhile, per Bretton Woods, the
rest of the worlds central banks use the dollar as if it were gold. It is their reserve asset, and they
pyramid credit in their local currencies on top of it.
It is not a bug, but a feature, that debt in this system must grow exponentially. There is no ultimate
extinguisher of debt. In my paper on Inflation, I define inflation as an expansion of counterfeit credit.
I define deflation as a forcible contraction of counterfeit credit, and the inevitable consequence of
inflation. Well, we have had many decades of rampant expansion of counterfeit credit. Now we will
have deflation, and the harder the central banks try to fight it by forcing yet more expansion of
counterfeit credit, the worse the problem becomes. With leverage everywhere in the system, it
would not take many defaults to wipe out every financial institution. And there will be many defaults.
One default will beget another and once it really begins in earnest there will be no stopping the
cascade.
Another key problem is duration mismatch. Today, every bank and financial institution borrows short
to lend long, many corporations borrow short to finance long-term projects, and every government is
borrowing short to fund perpetual debts. Duration mismatch can cause runs on the banks and
market crashes, because when depositors demand their money, banks must desperately sell any
asset they can into a market that is suddenly no bid. In two papers (Fractional Reserve is Not the
Problem and Falling Interest Rates and Duration Mismatch), I cover duration mismatch in banks and
corporations in more depth.
Most banks and economists have supported a policy of falling interest rates since they began to fall
in 1981. But falling interest rates destroy capital, as I explain in that last paper, linked above. As the
rate of interest falls, the real burden of the debt, incurred at higher rates, increases.
Related to this phenomenon is the fact that the average duration of bonds at every level has been
falling for a long time (US Treasury duration began increasing post 2008, but I think this is an artifact
of the Feds purchases in their so-called Quantitative Easing). Declining duration is an inevitable
consequence of the need to constantly roll debts. Debts are never repaid, the debtor merely pays
the interest and rolls the principal when due. As the duration gets shorter and shorter, the noose
gets tighter and tighter. If there is to be a real payback of debt, even in nominal terms, we need to
buy more time. At the US Treasury level, average duration is about 5 years. I doubt thats long
enough.
And of course the motivation for building this broken system in the first place is the desire by nearly
everyone to have a welfare state, without the corresponding crippling taxation. It has been long
believed by most people a central bank is just the right kind of magic to let one have this cake and
eat it too, without consequences. Well, the consequences are now becoming visible. See my
papers The Laffer Curve and Austrian Economics and A Politically Incorrect Look at Marginal Tax
Rates) discussing what raising taxes will do, especially in the bust phase like we have now.
In reality, stripped of the fancy nomenclature and the abstraction of a monetary system, the picture is
as simple as it is bleak. Normally, people produce more than they consume. They save. A frontier
farmer in the 19th century, for example, would dedicate some work to clearing a new field, or building
a smokehouse, or putting a wall around a pasture so he could add to his herd. But for the past

several decades, people have been tricked by distorted price signals (including bond prices, i.e.
interest rates) into consuming more than they produce.
In any case, it is not possible to save in an irredeemable paper currency. Depositing money in a
bank will just result in more buying of government bonds. Capital accumulation has long since
turned to capital decumulation.
This would be bad enough, as capital is the leverage on human effort that allows us to have the
present standard of living. We dont work any harder than early people did 10,000 years ago, and
yet we are vastly more productive due to our accumulated capital.
Now much of the capital is gone, and it cannot be brought back. It will soon be impossible to
continue to paper over the losses. The purpose of this piece is not to propose how to save the dollar
or the other paper currencies. They are past the point where saving them is possible. This paper is
directed to avoiding the collapse of our civilization.
If we stay on the present course, I think the outcome will look more like 472 AD than 1929. We must
solve three problems to avoid that kind of collapse:
1. Repayment of all debts in nominal terms
2. Keep bank accounts, pensions, annuities, corporate payrolls, annuities, etc. solvent, in
nominal terms
3. Begin circulation of a proper currency before the collapse of the paper currencies, so that
people have something they can use when paper no longer works
I propose a few simple steps first, and then a simple solution. All of this is designed to get gold to
circulate once again as money. Today, we have gold souvenir coins. They are readily available,
and have been for many years, but they do not circulate.
A gold standard is like a living organism. While having the right elements present and arranged in
the right way is necessary, it is not sufficient. It must also be in constant motion. Gold, under the
gold standard, was always flowing. Once the motion is stopped, restarting it is not easy. This
applies to a corpse of a man as well as of a gold standard.
The first steps are:
1.
2.
3.
4.

Eliminate all capital gains taxes on gold and silver

Repeal all legal tender laws that force creditors to accept paper
Also repeal laws that nullify gold clauses in contracts
Open the mint to the (seigniorage) free coinage of gold and silver; let people bring in their
metal and receive back an equal amount in coin form. These coins should not be
denominated in paper currency units, but merely ounces or grams

Each of these items removes one obstacle for gold to circulate as money, along side the paper
currencies. The capital gains tax will do its worst damage precisely when people need gold the
most. At that point, the nominal price of gold in the paper currencies will be rising very rapidly. Any
sale of bullion will result in a tax of virtually the entire amount, as the cost basis from even a few
weeks prior will be much lower than the current price. This amounts, in the US, to a 28%
confiscation of gold. This tax will force people to keep gold underground and not bring it to market.
It will contribute to the acceleration of permanent backwardation.

It is important to realize that gold is not going up. Paper is going down. There is no gain for the
holder of gold; he has simply not lost wealth due to the debasement of paper.
Current law forces creditors to accept paper as payment in full for all debts, and there are also laws
that nullify gold clauses in contracts. Repeal them, and let creditors and borrowers negotiate
something mutually agreeable.
Finally, the bid-ask spread on gold bullion coins such as the US gold eagle or the South African
krugerrand is too wide. If the mint provided seigniorage-free coinage service, then people would
bring in gold bars and other forms of bullion until the bid-ask spread narrowed appropriately. One of
the attributes that gives gold its moneyness is its tight spread (even today, it is 10 to 30 cents per
$1600 ounce!) But currently, this tight spread only applies to large bullion bars traded by the bullion
banks and other sophisticated traders. This spread must be available to the average person.
As I said earlier, these steps are necessary. Gold certainly will not circulate under the current
leftover regime from Roosevelt and Nixon. But it is not sufficient to address the debt problem.
Accordingly, I propose a simple additional step. The government should sell gold bonds. By this, I
do not mean gold backed paper bonds. I mean bonds denominated in ounces of gold, which pay
their coupon in ounces of gold and pay the principal amount in ounces of gold. Below, I explain how
this will solve the three problems I described above.
Mechanically, it is straightforward. The government should set a rule that, to buy a gold bond, one
does not bid dollars. One bids paper bonds! So to buy a 100-ounce gold bond, then one could bid
for example $160,000 worth of paper bonds (assuming the price of gold is $1600 per ounce). The
government retires the paper bond and in exchange replaces it with a newly-issued gold bond.
The government should start with a small tender, to ensure a high bid to cover ratio. And a series of
small auctions will give the market time to accept the idea. It will also allow the development of gold
bond market makers.
With gold bonds, it would be possible to sell long durations. With paper, there is no good reason to
buy a 30-year bond (except to speculate on the next move by the central bank). The dollar is
expected to fall considerably over a 30-year period. But with gold, there is no such debasement.
The government could therefore exchange short-duration debt for long-duration debt.
At first, the price of the gold bonds would likely be set as a straight conversion of the gold price,
perhaps adjusted for differing durations. For example, a 100 ounce gold bond of 30 years duration
might be bid at $160,000 worth of 30-year paper bond.
But I think that the bid on gold bonds will rise far above par, for several reasons I will discuss
below.
The nature of the dynamic will become clear to more and more people in due course. In the present
regime, there is a common misconception that the yield on a bond is set by the markets expectation
of how much consumer prices will rise (the crude proxy for the loss of value for the dollar). But this
is not true. Unlike in a gold standard, in an irredeemable paper standard, people are
disenfranchised. They have no say over the rate of interest. The dollar system is a closed loop, and
if you sell a bond then you either hold cash in a bank, which means the bank will buy a bond. Or you
buy another asset. In which case the seller of that asset holds cash in a bank or buys a bond. This
is one of the reasons why the rate of interest has been falling for 30 years despite huge
debasement. All dollars eventually go into the Treasury bond.

The price of the paper bond today is set by a combination of central bank buying, and structural
distortions in the system. But it is a self-referential price, in a game between the Treasury and the
Fed. The price of the bond does not really come from the market. And this impacts every other
bond in the universe, which all trade at varying spreads to the Treasury.
An alternative to paper bonds would be very attractive to those who want to save and earn income
for the long term, pension funds, annuities, etc. Not only will the price of gold continue to rise (i.e.
the value of the paper currency will continue to fall towards zero), but also a premium for gold bonds
would develop and grow. The quality asset will be recognized to be worth more, and at the least
people would price in whatever rate of the price of gold they expect to occur over the duration of the
bond.
This dynamica rising price of gold, and a rising exchange value of gold bonds for paper bonds
will allow governments and other debtors to use the devaluation of paper as a means to repay
their debts in nominal terms, but affordably in real terms.
This is impossible under paper bonds! This is because the process of debasement is a process of
the Treasury borrowing more money. Debt goes up to debase the dollar. This path leads not to
repayment of the debt cheaply, but to exponentially growing debt until a total default.
So we have solved problem number one. With a rising gold price, and a rising exchange rate of gold
bonds for paper bonds, we have set up a dynamic whereby every paper obligation can be met in
nominal terms. Of course, the value of that paper will be vastly lower than it is today. This is the
only way that the immense amounts of debt outstanding can possibly be honored.
This also solves problem number two. If every financial institution is repaid every nominal dollar it is
owed, then they will remain solvent. To be sure, pension payments, bank accounts, corporate
payroll, and annuities etc. will be of much lower real value. But there is a critical difference between
smoothly losing value vs. abruptly losing everything, along with catastrophic failure of the financial
system.
I want to address what could be a misconception at this point. Does this work only for governments
that have gold reserves in the vaults? No, this is not about gold reserves. While that may help
accelerate a gold bond program, the essential is not gold stocks but gold flows. The government
issuer of gold bonds must have a gold income (or a credible plan to develop one quickly).
And this leads to problem number three. Gold does not circulate today. Who has a gold income?
That is where we must look to begin the loop. There is one kind of participant today who has a gold
income: the gold miner. Beset by environmentalist lawsuits, regulations, permits, impact studies,
fees, labor law, confiscatory taxes, and other obstacles created by government, these companies
still manage to extract gold out of the ground.
The gold miners are the group to which we must turn to help solve the catch-22 of getting gold to
circulate from the current state where it does not. I think there is a simple win-win proposition to
offer them. In exchange for exemptions from the various taxes, regulations, environmentalism, etc.
they have a choice to pay a tax in gold bullion.
There are other kinds of entities to consider taxing, but the problem is that they all would need to buy
gold in the open market in order to pay the tax. As the price begins to rise exponentially, this will be
certain bankruptcy for anyone but a gold miner.

And now, look at the progress weve made on the problem of getting gold to circulate. We have gold
miners paying tax in gold to governments who are making bond coupon payments in gold to
investors who now have a gold income. We can see how gold bond market makers will enter the
scene, and earn a gold income to provide liquidity for bonds that are not on the run. These bond
market makers could pay a tax in gold also.
And we have released other creditors from any restriction in lending and demanding repayment in
gold. And anyone else in a position to sign a long-term agreement involving a stream of payments
over a long period of time, such as landlords, can incorporate gold clauses in their contracts. And if
the tenant has a gold income, perhaps from owning a gold bond, he can manage his cash flows and
confidently sign such a lease.
Note that the lender, unlike the employee, the restaurant, or most other economic actors, is in a
position to demand gold. While everyone else would like to be paid in gold, they havent got the
pricing power to demand it. The lender can say: if you want my capital, you must repay it in gold!
If enough gold bonds are issued soon enough, we may reverse the one-way flow of gold from the
markets into private hiding, that is inexorably leading to inevitable permanent backwardation and the
withdrawal of all gold from the system.
One of the key points in my backwardation paper is that the value of the dollar collapses to
zeronot as a consequence of the quantity of dollars rising to infinity, but because of the desire of
some dollar holders to get gold. If they cannot trade paper for gold, then they will trade paper for
commodities without regard to price and trade those commodities for gold. This will cause the
price of the commodities in dollar terms to rise to levels that make the dollar useless in trade (and
collapse the price of commodities in gold terms).
If we reverse the flow of gold out of the markets, we may be able to prevent this disaster from
occurring. The dollar will then continue to lose value in a continuous (if accelerating) manner, as
people migrate to gold.
This is the best outcome that could possibly be hoped for. If it occurs along with a reduction in
spending so that spending does not exceed (tax) revenues, we will avert Armageddon and be on the
path to a proper and real recovery. To be clear, times will be hard and the average standard of living
will decline precipitously.
But this is infinitely preferable to total collapse.
It is now up to farsighted leaders, especially in government, to take the first concrete steps towards
saving Western Civilization.

[1] Wherever I refer to gold, I also mean silver. For the sake of brevity and readability I will only say
gold in most cases.