By Antal E. Fekete
Twenty-five years ago I visited New York Commodities Exchange at the World Trade Center and watched the feverish activity in the gold pit from behind the glass wall in the gallery.

A gentleman standing next to me whom I did not know remarked: "One day this make-believe charade will come to a bad end. All that these guys are doing down there is creating ever more claims to the same lump of gold -- just as governments have been doing before they met their ignominious fate."

Later that day I went to see the director of research of Comex. Our chat lasted about an hour. He intimated that he was greatly disturbed by the mystery of the gold basis, which has been steadily declining year in and year out. Perhaps it was his inability to solve the puzzle that caused him to quit a few months later.

I must confess that I could not solve that puzzle myself until the twin towers of the World Trade Center came tumbling down many years later. For me it was a symbolic event, conjuring up the unknown gentleman and bringing back his cryptic remark.

We are watching a game of musical chairs. When the music stops, paper claims to gold will be dishonored and the gold futures markets will tumble down just like the twin towers.

In my recent article "Dress Rehearsal for the Last Contango" I observed that "a very strange phenomenon has been manifesting itself for 35 years, since the inception of gold futures trading. The basis as a percentage of the rate of interest, rather than remaining constant, has been vanishing and, by now, it has dropped to zero." In the rest of that article I drew attention to the apocalyptic consequences of the prospect of the permanent backwardation in gold that is threatening the world, which is ignored by the makers of monetary policy, as I had opportunity to convince myself during my recent encounter with Paul Volcker, the chairman of President Obama's Economic Recovery Advisory Board.

As I see it, the debt tower will topple when hit by permanent gold backwardation, just as the twin towers of the World Trade center did. The reason is that the availability of gold is indispensable for maintaining our system of irredeemable debt. Only then are bondholders, like the participants of the game of musical chairs, satisfied that there are plenty of vacant chairs available, so let's get on with bond trading and gold futures trading, and let the music roar on.

But once permanent backwardation in gold establishes itself, gold is no longer available at any price. Bondholders will scramble to sell their irredeemable bonds before they lose all remaining value. There is no other way to pacify bondholders than letting the game of musical chairs go on -- that is, to continue the charade of gold futures trading, putting ever more claims on the same lump of gold.

The response to my recent article was overwhelming. I have never realized how many people out there are following my writings on the Internet. I want to thank every one of you and assure you that I take this responsibility most seriously. Even if I cannot answer every message I get, I will continue to do my best to explain the results of my research in simple, understandable terms.

Let me spell out for my readers what the vanishing of the gold basis means from the point of view of the puppet-masters of the gold futures markets.

It means that they are fighting a losing battle. They are desperately trying to coax gold out of hiding by offering ever higher bribes -- not in terms of the price but in terms of the basis. A low basis means that they offer to take your cash gold and let you have gold futures in exchange at a discount price. (The discount is contango minus the basis, so that the two are inversely related: As the basis falls, the discount increases.) This will allow you to invest an amount equal to the price of gold (less 5 percent, the margin on the gold future) in any way you want and, having paid the reduced contango, you can keep the profits. The point is that you will still benefit from any advance in the gold price, just as you would if you owned cash gold. You can have your cake and eat it too.

Remember, in a full carrying charge market, such as the gold futures markets were at inception, no such bribe money was offered.

But, lo and behold, people who are willing to take the bribe are few and far in between now. So the pot is sweetened. The basis is lowered. Maybe at one point gold will be coaxed out of hiding, once the bribe is high enough.

No such luck. When the basis gets as low as zero, it means that the discount on gold futures has gone so high that it is equal to the opportunity cost of holding gold. Therefore, again, if you give up your cash gold in exchange for gold futures, you can invest an amount equal to the price of gold (less 5 percent) in any way you wish, but now they let you keep your profit in its entirety. And you can still benefit from any advance in the gold price, just as you would if you had the cash gold in your hands.

This is where we are now. Indications are that the game fish still does not bite. What now? Where do the futures markets in gold go from here?

Well, the pot can be further sweetened. The basis can be pushed down into negative territory. Gold could be forced into backwardation. Let's see what that means.

It means that you can sell cash gold and buy it back for future delivery at an outright discount. Somebody wants your gold so badly that he is willing to pay you for the privilege of holding it for a few days, a few weeks, or a few months, paying your storage and insurance fees. You get your gold back at a cheaper price. You make a risk-free profit on this deal. If the gold price goes up in the meantime, you benefit fully, just as if you have held on to the cash gold.

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