Commodity Money: It’s Back! (and it sucks)

You may recall hearing that earlier this year, J.P. Morgan began to accept gold as collateral for some types of loans. The story can be found here. Here is an excerpt:

Gold hasn’t reinvented itself as a currency yet. But it is getting closer.

J.P. Morgan Chase & Co. said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.

By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasuries, adding to a movement that places gold at the top tier of asset classes. It also is trying to capitalize on all the gold now owned by hedge funds and private investors that is sitting idle in warehouses.

O.K., so gold is not quite “money” (in the sense that it circulates widely as a medium of exchange). That is, if gold was money, one would not need to use it a collateral for a money loan, right? (You could use the gold to buy the stuff you wanted directly.)

But the use of gold as collateral in short-term lending arrangements nevertheless has the effect of increasing the liquidity of gold.

It is interesting too, to observe that the practice appears to be extending to other commodities, including copper and soybeans. Where is this happening? Apparently, in China; see China’s copper collateral — and covert credit and China and the magic financing (soy) beanstalk.

Evidently, the use of commodities as collateral constitutes an attempt by the private sector to get around China’s highly regulated credit market. It is China’s “shadow banking” system. Short term financing (at low rates) supported by “high-grade” collateral (like the private-label AAA MBS securities used as collateral in the U.S. repo market prior to 2008).

The problem, of course, is what happens to the shadow-banking sector when the value of the collateral plummets. (In case you haven’t been paying attention, gold and copper prices have recently declined rather dramatically.) What happens is that creditors no longer want to roll over their short-term financing–they want their money back (and hey, you can keep the copper). Debtors, in a desperate attempt to acquire the cash to repay their loan, begin to dump copper on the market–the effect of which is to make matters worse.

And this is what is happening now; see: China Copper Prices Drop as More Bonded Copper Reaches Domestic Market.

I think that this experience gives us some hint as to why commodity money systems are not the panacea that some like to make them out to be. Sometimes, it even appears that the private sector prefers government money. Look, for example, at the way private-label MBS products were driven out of the U.S. repo market by U.S. treasuries in the recent financial crisis. It’s a tricky business, trying to figure all this out. See also this discussion by Steve Williamson: Commodities and Money.

About David Andolfatto 91 Articles

Affiliation: Simon Fraser University and St. Louis Fed

David Andolfatto is a Vice President in the Research Division of the Federal Reserve Bank of St. Louis. He is also a professor of economics at Simon Fraser University.

Professor Andolfatto earned his Ph.D. in economics from the University of Western Ontario in 1994, M.A. and B.B.A. from Simon Fraser University. He was associate professor at the University of Waterloo before moving to Simon Fraser University in 2000.

His current research is focused on reconciling theories of money and banking. His past research has examined questions relating to the business cycle, contract design, bank-runs, unemployment insurance, monetary policy regimes, endogenous debt constraints, and technology diffusion.

Visit: MacroMania, David Andolfatto's Page

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