Is the US ‘Stealing’ Your Gains?

Three of the world’s most important currencies just made new lows against gold overnight. The US dollar, the euro and the pound all fell against the world’s barometer of financial idiocy and incompetence.

Gold started flashing warning signals following the release of the Federal Reserve’s minutes a few days ago. Barely two weeks have passed since the supposed ending of money printing Mark II and some members are keen to push the button again. Seriously.

From the Fed’s minutes:

‘Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated, it would be appropriate to provide additional monetary policy accommodation.’

And overnight, in a testimony to the House Financial Services Committee, Bernanke said ‘additional policy support’ might be forthcoming if the economy continued to weaken. He obviously thinks the first few rounds helped.

Dear reader, we have a question for you. Is there any other occupation in the world apart from central banking that allows one to be wrong – time and time again – and still be taken seriously?

It’s a measure of how historically and financially ignorant the world has become that most people would agree with Bernanke when he says with a straight face (and after a pause) that gold is not money. Check out his exchange with Congressman Ron Paul here.

As usual, Paul wastes most of his allotted time getting to the point. But when he does Bernanke’s answers are revealing. We suspect gold climbed a few dollars after hearing what he had to say.

While QEIII is inevitable, we would caution against betting on it too soon. There are still one or two Fed voting members with a modicum of common sense. Richard Fisher, President of the Dallas Fed, reckons more printing is pointless. In a speech delivered soon after Bernanke’s, he said:

‘I firmly believe that the Fed has already pressed the limits of monetary policy. So-called QE2, to my way of thinking, was of doubtful efficacy, which is why I did not support it to begin with. But even if you believe the costs of QE2 were worth its purported benefits, you would be hard pressed to now say that still more liquidity, or more fuel, is called for given the more than $1.5 trillion in excess bank reserves and the substantial liquid holdings above the normal working capital needs of corporate businesses…US banks and businesses are awash in liquidity. Adding more is not the answer to our problems.’

It’s hard to argue with Fisher. Check out the chart below, which shows the money multiplier in the US. It shows the amount of commercial bank money (as defined by the narrow M1 definition of money – basically currency and deposits) in the system compared to central bank reserves.

Back in the late 1980s, commercial banks created about $3 of M1 money for every dollar of central bank reserves. As the Fed has become an increasingly dominant player (or intervener) this ratio has fallen. (It also reflects the fact that people hold less cash than they did previously.)

But during the financial crisis the money multiplier collapsed and has continued to do so.

The ratio is now saying that every dollar created by the Fed translates into less than $1 of commercial bank money. In other words, the Fed’s policies are not working. They are creating more and more money but the commercial banks are just holding excess reserves. They have no one to lend to.

The Fed’s policies are doing nothing for employment (apparently one of their mandates) or price stability (the other mandate). The real economy continues to deteriorate while more liquidity flows and accumulates in the broken financial system.

This chart is just one visualisation of how the system of fractional reserve banking and perpetual debt is breaking down. The simple model of central bank reserves being expanded into commercial bank reserves no longer works.

Why? Because the world is flooded with unproductive debt. There is little capacity or need to take on more debt.

Give it a few more years and we’ll be rethinking many of the post-WWII monetary theories that we now take for granted.

Like fractional reserve banking.

Like using government bond yields as the risk-free rate.

How do you value equities using a 10-year bond yield as the risk-free rate when your government is a profligate fool? You don’t. And you certainly don’t think of the government’s debt instruments as risk free.

Perversely, a growing distrust of governments could result in rising equity prices. Indeed, this is what is happening in the US. Continued government and central bank meddling is causing untold damage. But the market is not far off its highs. Investors would prefer to take their chances investing in the private sector, not the public sector.

For the Australian investor though things are a little different. A few weeks ago, in our Sound Money. Sound Investments letter, we posed the question: Is inflation in the US deflationary for the rest of the world?

What we meant is for countries that don’t use monetary policy to manipulate their currency against a falling greenback, (e.g., China and most of Asia) inflationary US policy will result in a rise in that currency.

For example, Australia maintains a sensible interest rate policy and as a result, the Aussie dollar has increased massively against the greenback in the past few years.

If a fall in the US dollar reflects a loss of international purchasing power – and if a loss of purchasing power is a definition of inflation – then a rising Aussie dollar reflects the opposite, no?

That is, a rising AUD represents an increase in international purchasing power, which is one definition of deflation. Therefore, a falling US dollar, which is inflationary for the US, is actually deflationary for other parts of the world. By devaluing their dollar, the US is trying to ‘steal’ demand for other nations. To the extent that hits Australia, that exerts a deflationary force.

We admit there are many other factors to take into account. But it’s one reason why the Aussie stockmarket is well below its highs and Aussie dollar gold has underperformed gold in US dollars.

You might lament the fact that this is the case. But in the US the gains are simply money illusion. It will cause trouble down the track.

And while Australia’s market might be struggling, we still have our old mate China, chugging along and growing more distorted every year. More on that tomorrow.

Regards,

Greg Canavan
Daily Reckoning Australia

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