US Money Supply and the Demand for Gold

In a previous article entitled "Is Gold Still a Store of Value" I concluded with the statement "I am willing to bet that the money supply will be increased to whatever level it needs to be to avoid any meaningful short term economic slow down". My belief was that a recession would be politically unpalatable and that the only way to postpone a financial melt-down would be to surreptitiously default on debt obligations through a massive injection of liquidity into the economy. During that same article I had mentioned that the total supply of US dollars (M3) was increasing at the rate of 7.4%, the highest level in a decade.

The latest available figures for M3 (week ending 18 August 97) show that the US money supply has increased by 9.1% during the last 12 months. We have therefore almost reached the inflationary levels achieved between 1976 and 1980 when the M3 growth rate averaged 11.4%. Despite the popular notion of measuring inflation by comparing the price changes over time of a select group of "real things", inflation is purely a monetary phenomenon. During the 1970's the excess liquidity was pumped into commodities and other tangible assets, whereas during the 1990's the money has been channeled into financial assets such as shares and bonds, creating the illusion for the many who carefully watch the CPI and PPI that inflation is under control. In addition, the massive flight of capital from Europe and Japan to the US which has occurred since 1995 has further exaggerated the situation by boosting the relative value of the US dollar. This has in turn significantly reduced the price of imported goods in the US and consequently the pricing power of US domestic manufacturers who are in competition with these imported goods, further contributing to low CPI and PPI increases.

Despite the current high levels of inflation, the demand for gold remains low. Gold is accumulated, not consumed like all other commodities, therefore the figures which are regularly published showing that the commercial demand for gold has greatly exceeded the newly mined supply of gold for many years are misleading. Almost all gold mined in the history of the world comprises today's above-ground gold stock. Approximately 75% of this stock (85,000 tonnes) is held for monetary purposes and is an available source of supply at any time at a certain price. The recent fall in the gold price to 12 year lows indicates a willingness of the holders of this monetary gold to sell their gold at these low levels. In fact, in his August 25th newsletter James Turk shows that the demand for gold is now at its lowest level since the official link between gold and the US dollar was removed in 1971. Irrespective of the so-called deficit between the supply of newly mined gold and the commercial demand for gold, or the level of speculator short selling, or the volume of gold loans, a substantial rally in the gold price will not occur until there is an increase in the monetary demand for gold.

An important factor in forecasting the monetary demand for gold is the supply of US dollars. Dollars and gold are competing forms of money, and the current trough in the demand for gold can also be considered as a peak in the demand for dollars. However, the prevailing high rates of money supply growth cannot be sustained without substantially diminishing the purchasing power of the US dollar. When this reduction in purchasing power begins to be recognised, it is almost certain that many people will seek to protect their wealth from being confiscated through inflation by converting some of their financial assets into gold. Due to the relative size of the markets concerned, a small percentage shift out of financial assets (debt, currencies, shares) into gold would cause a large percentage increase in the gold price.

A clue as to whether high rates of money supply growth will be maintained can be found in the January 14th 1997 speech given by Alan Greenspan at the Catholic University, Leuven, Belgium. A transcript of the speech, complete with astute annotations by Larry Parks, can be found at : http://www.fame.org/fedwatch/fw-001-frame.htm. Following is an extract from this speech, with comments by Larry Parks shown bracketed and in italics :

"Central banks can issue currency [i.e., create money out of nothing], a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank.

[When he speaks of "discounting loans," he is talking about loans that may be in default, e.g., the borrower may be broke and the loan may be worthless. In this case, the Fed may purchase the loan for less than its face value, i.e., "discount" it, and pay for it, again, with money that the Fed creates. Further, the Fed may create money, in Mr. Greenspan's words, "without limit." The "other assets" may be anything, e.g., real estate that a bank has purchased].

That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims [dollars] without limit. [i.e., create an unlimited amount of money out of nothing. It is significant that Mr. Greenspan repeats over and over that the Fed may create money without limit.] To be sure, if a central bank produces too many [i.e., if it creates too much money], inflation will inexorably rise as will interest rates, and economic activity will inevitably be constrained by the misallocation of resources induced by inflation. If it produces too few, the economy's expansion also will presumably be constrained by a shortage of the necessary lubricant for transactions. Authorities must struggle continuously to find the proper balance."

It is clear from the speech that the US Federal Reserve will act to head off an impending financial crisis before it becomes a crisis and that their most potent weapon is money supply. In particular, note that the Fed has the ability to purchase loans from private banks with newly created dollars. A down turn in the US share market which resulted in leveraged investors defaulting on their loans could be handled via the purchase of these loans by the Fed at some arbitrary discount. The first ramification of this is that we effectively have only two options for the medium term : inflation or hyper-inflation (the possibility of deflation caused by debt defaults has been eliminated). The second and more insidious ramification is that all risks associated with the making of loans have been transferred from the banking system to US citizens who save money and/or pay taxes. Banks are free to lend whatever they want to whomever they want without fear of non-repayment.

It will be interesting to watch the reaction of the US monetary agents to any significant down turn in the US stock and bond markets. These markets began a correction in early August and during the first half of this month approximately 50 billion dollars were added to the US money supply. As Mr. Greenspan stressed in his speech, the Fed can create money without limit. Put another way, there is no limit to the amount by which the purchasing power of the dollar can be eroded.