San Francisco School of Economics

E-mail:

Dear Paul:

In 35 years our paths have crossed for the second time. In 1974/75 you and I were Visiting

Fellows at Princeton University. Now, in 2009, both you and I are attending the Santa

Colomba Conference on the present debt crisis at the invitation of Bob Mundell.

In 1975 you conducted a seminar on the international monetary system and invited me to

contribute a paper on gold which I did. Those were halcyon days by comparison. The United

States, after the turbulence of 1971, successfully consolidated the international position of the

dollar and could confidently lift the 42-year old ban on the ownership and trading in gold. On

December 31, 1974, trading of gold futures contracts started in New York and Chicago. It

showed a robust contango at full carrying charge, that is to say, the gold basis (the spread

between the futures and the cash price) was at its peak. It indicated that monetary gold was

available in great abundance to meet any demand for any reason. It showed that the gold

futures markets could serve as the fulcrum in seeking out the equilibrium between the supply

of and demand for gold. They could act as a safety valve, releasing occasional pressures that,

in the absence of paper gold, may be a threat to the monetary system. It looked as if the gold

problem has been solved for once and all.

But as I feared, and as the intervening 35 years have proved, rather than moving towards

equilibrium we have been constantly moving ever farther away from it, as measured by the

gold basis. The secular vanishing of the gold basis is a most ominous danger signal. It

indicates that monetary gold is increasingly unavailable, and in case of a crisis it can no

longer be relied upon to come to the rescue. Basis started out at 100 percent of the prevailing

interest rate, but has been steadily eroding all the way to zero percent today. Permanent gold

backwardation (negative gold basis) is staring us in the face. The gold basis is trying to tell

you something. It heralds the greatest monetary crisis of all times. It warns about the possible

collapse of the international monetary and payments system.

Let me explain. Gold is the only

2

introduced in 1971, thanks to the availability of paper gold. Imperfect as though these

stratagems were, they served as a pacifier to the bond market. But as the threat of permanent

backwardation indicates, all offers to put monetary gold at the disposal of the international

monetary system could be abruptly withdrawn. In that event there would be no ultimate

extinguisher of debt. The world is totally unprepared for such a momentous development. I

ask you: are there contingency plans in the U.S. Treasury and in the Federal Reserve what to

do if backwardation makes monetary gold unavailable for the indirect retirement of debt?

The message to debt holders would be: