Tag Archives: money supply

Why QE didn’t send gold up to $20,000

This blog post is a guest post on BullionStar's Blog by the renowned blogger JP Koning who will be writing about monetary economics, central banking and gold. BullionStar does not endorse or oppose the opinions presented but encourage a healthy debate. 

Why didn't quantitative easing, which created trillions of dollars of new money, lead to a massive spike in the gold price?

The Quantity Theory of Money

The intuition that an increase in the money supply should lead to a rise in prices, including the price of gold, comes from a very old theory of money—the quantity theory of money—going back to at least the philosopher David Hume. Hume asked his readers to imagine a situation in which everyone in Great Britain suddenly had "five pounds slipt into his pocket in one night." Hume reasoned that this sudden increase in the money supply would "only serve to increase the prices of every thing, without any farther consequence."

Another way to think about the quantity theory is by reference to the famous equation of exchange, or

  • MV = PY
  • money supply x velocity of money over a period of time = price level x goods & services produced over that period

A traditional quantity theorist usually assumes that velocity, the average frequency that a banknote or deposit changes hands, is quite stable. So when M—the money supply— increases, a hot potato effect emerges. Anxious to rid themselves of their extra money balances M, people race to the stores to buy Y, goods and services, that they otherwise couldn't have afforded, quickly emptying the shelves. Retailers take these hot potatoes and in turn spend them at their wholesalers in order to restock. But as time passes, business people adjust by ratcheting up their prices so that the final outcome is a permanent increase in P.

In August 2008, before the worst of the credit crisis had broken out, the U.S Federal Reserve had $847 billion in money outstanding, or what is referred to as "monetary base"—the combination of banknotes in circulation and deposits held at the central bank. Then three successive rounds of quantitative easing were rolled out: QE1, QE2, and QE3. Six years later, monetary base finally peaked at $4.1 trillion (see chart below). QE in Europe, Japan, and the UK led to equal, if not more impressive, increases in the domestic money supply.

U.S. monetary base (banknotes and deposits at the Fed)

So again our question: if M increased so spectacularly, why not P and the price of gold along with it? Those with long memories will recall that while gold rose from $1000 to $2000 during the first two legs of QE, it collapsed back down to $1000 during the last round. That's not the performance one would expect of an asset that is commonly viewed as a hedge against excess monetary printing.

How Regular Monetary Policy Works

My claim is that even though central banks created huge amounts of monetary base via QE, the majority of this base money didn't have sufficient monetary punch to qualify it for entry into the left side of the equation of exchange, and therefore it had no effect on the price level. Put differently, QE suffered from monetary impotence.

Let's consider what makes money special. Most of the jump in base money during QE was due to a rise in deposits held at the central bank, in the U.S.'s case deposits at the Federal Reserve. These deposits are identical to other short-term forms of government debt like treasury bills except for the fact that they provide monetary services, specifically as a medium for clearing & settling payments between banks. Central banks keep the supply of deposits—and thus the quantity of monetary services available to banks—scarce.

Regular monetary policy involves shifting the supply of central bank deposits in order to hit an inflation target. When a central bank wants to loosen policy i.e. increase inflation, it engages in open market purchases. This entails buying treasury bills from banks and crediting these banks for the purchase with newly-created central bank deposits. This shot of new deposits temporarily pushes the banking system out of equilibrium: it now has more monetary services than it had previously budgeted for.

To restore equilibrium, a hot potato effect is set off. A bank that has more monetary services then it desires will try to get rid of excess bank deposits by spending them on things like bonds, stocks, or gold. But these deposits can only be passed on to other banks that themselves already have sufficient monetary services. To convince these other banks to accept deposits, the first bank will have to sell them at a slightly lower price. Put differently, it will have to pay the other banks a higher price for bonds, stocks, or gold. And these buyers will in turn only be able to offload unwanted monetary services by also marking down the value, or purchasing power, of deposits. The hot potato process only comes to a halt when deposits have lost enough purchasing power, or the price level has risen high enough, that the banking system is once again happy with the levels of deposits that the central bank has injected into the system.

What I've just described is regular monetary policy. In this scenario, open market operations are still potent.  But what happens when they lose their potency?

Monetary Impotence: Death of the Hot Potato Effect

A central bank can stoke inflation by engaging in subsequent rounds of open market purchases, but at some point impotence will set in and additional purchases will have no effect on prices. When a large enough quantity of deposits has been created, the market will no longer place any value on the additional monetary services that these deposits provide. Monetary services will have become a free good, say like air—useful but without monetary value. Deposits, which up to that point were unique thanks to their valuable monetary properties, have become identical to treasury bills. Open market operations now consists of little more than a swap of one identical t-bill for another.

Zimbabwe 100 trillion dollar notes together with gold bullion
100 Trillion Dollar Notes are not yet required to purchase gold. Why hasn't the increased money supply significantly increased the gold price?

When this happens, subsequent open market purchases are no longer capable of pushing the banking system out of equilibrium. After all, monetary services have become a free good. There is no way that banks can have too much of them. Since an increase in the supply of deposits no longer has any effect on bank behavior, the hot potato effect can't get going—and thus open market purchases have no effect on the price level, or on gold.

This "monetary impotence" is what seems to have overtaken the various rounds of QE. While the initial increase in deposits no doubt had some effect on prices, monetary services quickly became a free good. After that point, the banking system accepted each round of newly-created deposits with a yawn rather than trying to desperately pass them off, hot potato-like.

And that's why gold didn't rise to $20,000 through successive rounds of QE. Gold does well when people find that they have too much money in their wallets or accounts, but QE failed to create the requisite "too much money".

Gold Price: USD 65,000/oz in 5 years?

16 June 2021 is exactly five years from today. What will the gold price be on 16 June 2021?

Currencies are Worthless

As the world’s fiat paper currencies have lost 99% or more of their purchasing power over the last 100 years, its critical to understand that fiat paper currencies are not a suitable unit of account for accurately measuring prices.

In fact, gold is a far superior measuring stick of value than paper currencies.

A paper currency doesn’t measure anything. It merely has an arbitrary value placed upon it by the population using it. It’s not backed by anything and it can fail at any time. From historical experience, we know that the unbacked fiat paper currencies used today will ultimately destruct and become worthless. All unbacked fiat currencies throughout human history have failed.

A more accurate measurement would be to measure fiat currencies in gold. If we look at the US Dollar measured in gold, we can see that the US Dollar has utterly failed in retaining its value, as its value has plunged about 98% over a mere 50 years. It cannot therefore be seen as a store of value.

Chart of US Dollar measured in Gold. USD price instead of Gold Price.Source: Gold Price Charts, BullionStar

Extrapolating into a likely future, a future in which you will need a stack of USD 100 bills to buy a carton of milk and a couple of eggs, underlines that the US Dollar gold price is meaningless as an indicator of value. When discussing the price of gold, the key is to recognise that gold retains its purchasing power over time. If a 1 oz gold coin can buy an exclusive men’s suit today at USD 1,300 and the same 1 oz gold coin buys an exclusive men’s suit at USD 2,600 tomorrow, this only means that gold is still reflecting USD 1,300 in today's purchasing power and hasn’t gained in value. It’s the US Dollar that has depreciated vis-à-vis gold. Similarly, if the gold price goes to USD 650 and it can still buy the same suit, then it’s merely the US Dollar that as appreciated vis-à-vis gold.

With a gold price of USD 65000, what will the USD be for Milk, Egg and Bread

As a society, we should by now have transcended the idea of measuring value in fiat currencies. Currencies are not a reliable measuring stick. Just imagine if the centimeter, meter, yard or foot were to fluctuate in length.

100 cm 100 years ago has become 2 cm today. Think about it. This is what has happened with our currencies.

The Gold Price                                  

The gold price is an interesting term because the gold price doesn’t reflect what’s happening on the physical gold market whatsoever.

In today’s marketplace, a lot of things are regarded as “gold”. On the London Gold Market alone, there’s 600 times more gold traded each day than there is gold mined globally on that same day.

All sorts of paper gold passes for “gold” on the financial markets. The vast majority, certainly more than 95%, and likely more than 99% of this paper gold is not backed by any physical gold.

“Gold” is created out of thin air as paper obligations. The demand for and supply of this paper gold has little to do with the physical gold market.

During the last couple of year, demand for real physical gold has been insatiable , however the price of gold has not reflected this huge demand. Physical gold has been flowing from the Western vaults to Asia. The Chinese in particular have been vacuuming the London vaults for gold. However, this substantial physical demand hasn't been reflected in higher gold prices because whereas Easterners have been buying physical gold, Westerners have been selling paper gold.

Given that the price of “gold” is set on the OTC paper market in London and on the COMEX futures market in New York, the US Dollar denominated gold price continued to fall between 2012 and 2015 despite the massive physical demand, and instead, it created a physical shortage of gold.

Whether physical demand is up or down 5 tons in China or India matters little when there’s 5,500 tons of paper gold traded each day in London  as visualized in this infographic. London, and to a lesser extent COMEX in the US, are the price discovery markets for gold. However, paper gold on these markets is almost exclusively cash settled with less than 1% of the contracts/futures settled with delivery of physical gold.

The gold price is therefore not dependent on the market fundamentals of physical gold but this may very well change in the future.

With China picking up all physical gold available every time the price slides, widespread shortages are a likely outcome if the gold price ever were to decrease significantly again. Given that the historic vaulting capital of the world, London, has already been running out of stockpiled gold, there just wouldn't be enough physical gold to satisfy demand if the price were to ever plunge significantly again.

It's actually been a healthy development for the physical market’s demand/supply balance  that the gold price has increased 22% in USD Year-to-Date 2016. However, we have to understand that the largest potential for a revaluation of the gold price paradoxically may be preceded by a decrease in gold prices.

When trend seeking Western investors sell their paper gold and the price slides, Easterners take the opportunity to buy physical gold at bargain prices, thereby stressing the physical market with shortages as a result. Such shortages may very well be what ultimately breaks the neck of the paper markets. Because when there is no longer any physical gold available at the price dictated by the paper markets, there will be a disconnect between the price of paper gold and the price of physical gold. Paper gold will go towards zero whereas the price of physical gold will skyrocket.

Such a revaluation of physical gold will bring the fiat paper currencies to their knees as their worthlessness as a store of value will become clear to all.

USD 65,000/oz

What will the price of gold be in 5 years’ time?

Gold is savings - Gold is wealth, and as such, the price denominated in something as inferior as the US Dollar isn't very important.

For the sake of reflection, we can play with the idea of what the price of gold would have to be if the US Dollar were to go on a fully-backed gold standard.

The US gold reserve officially stands at 8,133.5 tons although it has never been properly independently audited. At USD 1,300/oz, this would be equivalent to 340 billion dollars. The total US money supply is about 17,000 billion dollars. For each "gold backed" dollar today, there are therefore 49 unbacked dollars. The gold price would thus have to increase 50-fold to USD 65,000 if the US Dollar were to be fully gold-backed by 16 June 2021.