Isegoria

Money is the bubble that doesn’t pop, Mencius Moldbug says, as he examines the game theory of central banks and gold reserves:

If you are anyone who has large amounts of money, central banker or no, your goal is to spend that money in a way that does not move the market. Ideally, you would like to buy at a price set by supply and demand (not including you). You would rather not buy at a price set by supply and demand (including you). This is a tricky task in which many are paid much to succeed.

Market-moving purchases — as we’ll see later in the program — pose a special challenge to accounting. They create what George Soros calls reflexivity. Standard 14th-century Italian double-entry accounting, while perfect if you are running a bodega, is not capable of handling this matter. Because central bankers are not used to thinking about monetary game theory, and have no idea how to integrate this with their 14th-century accounting, they fail to see the optimal strategy.

The problem that breaks Florentine accounting is: if I drive the market up by buying, how should I value what I just bought? Should I mark it to the market price? If so, I am marking it to supply and demand (including me)? Or should I mark it to the price I could sell it for? If so, I am marking it to supply and demand (not including me). The larger the position, the larger the difference between demand (including me) and demand (not including me).

Suppose, for example, that you have 50 billion dollars, and you use this stash to buy the entire 2008 and 2009 peanut crops. You triple the price of peanut contracts. Congratulations! Your position is now valued at $150 billion. You’ve made a 200% profit. You’ve made money just by marking to market. You should be a spammer.

This is called “market manipulation,” or more specifically “cornering the market,” and it happens to be illegal. But even if it was not illegal, it would be unprofitable, because you cannot generally profit with this strategy — as you sell, you are driving the price back down. Your peanut contracts are valued at $150 billion — but can you get $150 billion for them? You can’t buy lunch with peanut contracts.

This is called the burying-the-corpse problem, the corpse being the vast quantity of peanuts that you have bought but don’t intend to eat. The accounting profit is indeed a mirage. Unless of course you can bury the corpse — ie, get some other fool to take all those peanuts off your hands, at anything like the inflated price you have created.

There is an easy way to avoid this entire weirdness. Spread it around. Diversify. Don’t make market-moving purchases. For the standard large investor, and doubly for the standard central banker, distorting the market with a purchase is considered a rookie mistake.

Thus the old-school CB answer to gold, now just beginning to fade. When asked why a return to the gold standard is impossible, the standard answer is: “there isn’t enough gold.”

What this means is that the stock of monetary gold is relatively small compared to the number of dollars it would have to absorb, were gold to replace the dollar as the international reserve currency. (Ie, not even considering the awful possibility that ordinary citizens decide to redirect their savings into the yellow dog and 100%-backed instruments, obviating the entire concept of a reserve currency.)

Thus, if CBs buy large quantities of gold, they drive the gold price up. Or more precisely, if they exchange large numbers of dollars for gold, they drive the gold-dollar ratio up. Or at least, so theory predicts. And for once, practice seems to match theory — at least, in China:

“Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not stimulate the market,” he said.

Indeed. Hu Liaoxian is even trying to jawbone the gold market down:

“We must keep in mind the long-term effects when considering what to use as our reserves,” she said. “We must watch out for bubbles forming on certain assets and be careful in those areas.”
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However, officials in Beijing are aware that China’s $2.3 trillion reserves are now so enormous that the central bank cannot buy much gold without distorting the price, so they have adopted a de facto policy of buying in a calibrated fashion each time prices fall back to their rising trend line – “buying the dips” in trading parlance. Experts say that China is putting a floor under the gold price but does not chase rallies once they are under way.

Either Mr. Cheng and Ms. Hu do not understand the game theory of monetary formation — or they do and they are playing it close to the chests. If they — or their colleagues — ever figure out the game, God help the dollar.

When a CB buys gold, four things happen. One: the CB insures itself against the chance of gold remonetization. Two: the chance of gold remonetization increases. Three: the gold price goes up. Four: the buyer looks good, because the assets he bought went up.

How is this different from buying the pound, or buying peanuts? Because the price increase in the pound, or in peanuts, is unsustainable. What goes up has to come back down. For their own different reasons, the pound and peanuts are incapable of absorbing total global monetary demand, and acting as a stable international currency. Therefore, a sophisticated investor of large money avoids generating phantom profits by distorting the market in pounds or peanuts.

With gold, it is different. What goes up can go back down, as it did in the ’80s. (In 1980, it looked rather as if gold was to be remonetized. Then Volcker saved the dollar with 20% interest rates. Of course, at the time America was also a net creditor.) But because we know that gold is a viable monetary system, we know that when gold goes up, it does not have to come down. If it doesn’t come down, that means gold has been (re-)monetized. Peanuts cannot be monetized — they cannot become arbitrarily expensive. Gold can. Therefore, the decision calculi for gold and peanut purchases are fundamentally different.

The gold price has been increasing at roughly 20% a year since 2001. Perhaps coincidentally, the global dollar supply is diluting at rates not too different from this. Betting on the continuation of this trend is not difficult — one the way to bet on it is to buy gold. Which causes the trend to continue. Reflexivity! The dollar itself is a bubble, held up by the monetary demand for dollars — and the dollar does not appear to be an especially stable currency.

Thus there is an entirely different Nash equilibrium out there — one in which all the central banks dump the dollar for gold. This causes the gold price to skyrocket, creating permanent profits for all the reserve-accumulating central banks.

Don’t believe me? Think about it. When remonetization is complete, by definition the CBs will be computing their accounts in gold. Since the price of gold in dollars, under this scenario, is much higher than it is today, it will look like the CB made an enormous profit on the transaction: in exchange for green pieces of paper, now of minimal value, it received good gold. Or it was foolish and held on to the green paper, in which case its bankers are lynched in the street.

This is a self-reinforcing feedback loop. The more gold the CBs buy, the more incentive they have to buy gold. Because if the game ends with gold winning, the game will be scored by how much gold you got for your dollars. This will be a consequence of how soon the CB exchanged its dollars for gold. Devil take the hindmost! A classic panic scenario. A melt-up for gold; a melt-down for the dollar.

In other words, when gold is remonetized, the numerator and denominator on the “gold price” are exchanged. The relevant price is now the “dollar price.” What is a dollar worth? How many milligrams of gold can you trade it for? This piece of paper is a financial security, n’est ce pas? Does this security yield gold, own gold, redeem itself for gold, etc? No? If you want it to be worth anything, you might want to change that…

Here is the difference between gold and peanuts. No one will ever ask how many peanuts a dollar is worth, because peanuts will never be a monetary good. For one thing, it is too easy to grow them. Gold can be monetized, and peanuts cannot be monetized, because of fundamental physical differences between gold and peanuts.

Every monetary system is a self-supporting market-manipulation scheme of this type. As Willem Buiter points out, money is the bubble that doesn’t pop. In a free market, a currency is stable if and only if the currency is reasonably watertight and does not dilute much. In this panic — the same panic “John Law” anticipated — we see the “dollar bubble” popping, and a new “gold bubble” forming. If someone finds a way to print gold, of course, the gold bubble will pop and some other good will accept its monetary demand — rhodium, perhaps. Or baseball cards.

So, if Cheng Siwei and Hu Xiaolian understood the game theory, they might go ahead and “stimulate the market.” China cannot prevent her purchases from stimulating the market. But she can ensure that when she stimulates the market, she stimulates it first — thus getting the best price. And thus ending up with the most gold.

Collectively, the central bankers of the world might agree that they do not want gold to be remonetized. Individually, it is in their interest to defect from this consensus. As the American Century decays, individual motivations tend to become more prominent. You and I are not in a free market — but the central banks are.

And there is another individual motivation that CBs might have for remonetizing. Suppose a large exporter, such as China, which undervalues its currency and runs a large trade surplus as a result, takes a huge radical step and goes all the way to a 100%-reserve gold currency. The ultimate hard currency. If this succeeds, China is the new England — the financial capital of the world, forever. Everyone else’s money? In a word: pesos. Hard currency is Chinese currency. China’s natural supremacy over the barbarian kingdoms of the West is restored.