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Posted on 6 Mar 2018 by BullionStar

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".

JP Koning
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  • “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.”

    Perhaps the truth is that the money was merely a fictional notion that never even ventured beyond accounting ledgers as a quiet replacement for losses unacknowledged.

    • Loses are on on the savings accumulated of the American people. These charges are not paid by the government; they are paid by you. You provide the money through taxes and inflation. The cost currently is about $5,000 for each family of four. All families pay through inflation but not all pay taxes. The cost to each taxpaying family, therefore, is higher. Onaverage, over $5,000 is extracted from your family each year, not to provide government services or even to pay off previous debt.Nothing is produced by it, not even roads or government buildings. No welfare or medical benefits come out of it. No salaries are paid by it. The nation’s standard of living is not raised byit. It does nothing except pay interest.

      Furthermore, the interest is compounded, which means, even if the government were to completely stop its deficit spending, the total debt
      would continue to grow as a result of interest on that portion which already exists. In 2006, interest on the national debt was already consuming 39% of all the revenue collected by personal income taxes.’

      Amazing, isn’t it? Without interest on the national debt, we would
      save enough to cut our personal income taxes by a third and we
      could reduce corporate taxes as well. Unfortunately, under present
      policies and programs, that is not going to happen, because Congress
      does not live within its income. Many expenses are paid, not
      from taxes, but from selling government bonds and going deeper
      into debt each year. So, even though we could save enough to
      slash personal income taxes, it would not be enough.

    • JP Koning

      “…a quiet replacement for losses unacknowledged.”

      That might be true of some of the AIG stuff the Fed did (Maiden Lane I-III). But AIG wasn’t QE, it was part of the Fed’s lending operations. QE is conducted at market prices and only safe, liquid, and boring assets are purchased. So there would have been no replacement of losses.

  • Cybair

    My opinion is that the price of gold is kept low because of the creation of paper gold. I don’t have the right numbers but some people estimate the quantity of paper gold to be around 10 times the amount of physical gold held to garantee the paper holders. Now, if you increase the total amount of gold ten times (physical+paper), this increases the supply while demand remains the same. So, the price should drop or remain the same, depending on the quantity of paper gold “created”.

    In other words, the banking system “prints” gold just like they “print” fiat money. It cost them nothing to “print” gold and they get the full price of physical gold in exchange for a piece of paper. As long as the paper holders don’t redeem their gold, this scam can go on forever.

    • That is correct. In the first three federal reserve acts congress created it rescinded the federal reserve acts on the 5th anniversary of the act due to massive inflation.
      Now Congress cannot rescind the the act because Q E now pays the national debt for Congress thereby necessitating Congress would have to raise taxes to pay it. That would cost them their reelection. Details are provided in my blogs at Seeking Alpha

  • The real reason gold prices to not rise is because the federal reserve system which is not a federal system issues naked old shorts for which , with its global reserve currency it is allowed unlimited credit naked . no one who owns physical gold is ready to actually deliver physical gold at the short price so the shorts are never executed upon and expire unused. there by controlling the price without a market existing.

  • Doolie

    The effect of rigging the gold market explains more than this article does.

    • JP Koning

      The idea that QE would have pushed gold up to $20,000 but some sort of conspiracy to cap gold prices prevented this is a weak one. Not only did gold fail to rise, but other inflation hedges like corn, wheat, silver, oil, and copper also lagged. This is broadly indicative of QE impotence. After all, rigging each of these markets would be impossible.

      • Doolie

        My point is not about QE and its effect, its about overarching unadulterated gold price rigging.

        E.G. When a $4,966,400,000 worth of paper gold sell off hits the markets in a period of a few minutes and the priced of gold is smashed and such events occur relentlessly, it is absolutely pointless to discuss what effect QE or anything has on the gold price.

  • milanolarry

    Simple. Because central banks suppress the price of gold.

  • Roger Hudson

    I’m more inclined to the idea that gold doesn’t ‘go up’ ( which is really fiat money going down) is because the global gold market is the most manipulated asset market in the world, the BIS, central banks, national treasuries all working away to keep the fiat money show on the road.

    • JP Koning

      As I said below to Doolie, if you take the position that QE would have pushed gold up to $20,000, but central bank manipulation prevented this, you also need to explain why so many other inflation hedges also failed to rise in response to QE. Did the BIS manipulate these markets, too? Probably not. The best answer is the boring one: QE was impotent.

  • Arnoud

    When you dump your stocks you get money but due to high supply money is not worth anything so you turn to undervalued gold market .. ( qe did rise stocks thats probably where the money went, when overall market risk starts to increase and stocks cap out gold should still start rising I guess)

  • Joaquim Saad
  • George

    So you all believe Gold has a rosy future depending on how specific variables play out ? Not one comment on gold at $500.00, or $200.00, hummmmmm.
    Well here it is. In a devaluation such as you all are waiting for, ( example: dollar decline, or equity market drop, or having uncertain political actions, etc.) none of you see the DEVALUATION being so massive that a precipitous move that will bring Precious Metals to that very low level? Yes below cost of mining. This will happen, and you all will be saying, AHHHHHHHH, is that how devaluation works. LMAO This prosperity you all view, looking out the window today, is being propagated on DEBT. So when everything reaches a real parity level, as it will, everything will devalue, all boats will go DOWN. Do you remember ECO 101 boys.

  • George

    Just to clarify, there is a smelly, BIG, entity sitting in the seat next to you all, that not one of you want to take into account, and it will DEVALUE, even the stones, (you know those pebbles you tried to get out of the mud using that cost you like $15.00 a ton) in your driveway, let alone the metal in your safe box. This enity, is growing bigger, and bigger, and is owned by enemies to your way of business, social thinking, and politics, not to mention military alliance. HOw many of you have ever had a mortgage on there home, or how many of you ever had a mortgage on a commercial building, or a mortgage (margin calls) on equities you hold? DEBT is massive, and will DEVALUE your backside when this downside starts, in a big way.

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