Gold and the Expanding Money Supply
Yesterday, Paul van Eeden explained to you how he discovers gold’s intrinsic value. The key, according to him, is using his “Actual Money Supply” measure, which he described in his essay “The True Value of Gold.” Below, we continue the conversation…
The Daily Reckoning: Today, we’re here again with Mr. van Eeden.
Paul, thanks for joining us.
Paul van Eeden: Thank you for having me again…
The Daily Reckoning: Since the Fed’s started inflating its balance sheet by trillions, there have been many calls, especially here in the DR, that, eventually, gold will have to shoot into the stratosphere. Why, in your opinion, has this “gold to the moon” scenario not played out?
Paul van Eeden: That’s a very complicated question. One of the reasons is that the people who were expecting the gold price to go up dramatically were looking almost exclusively at the Federal Reserve balance sheet. They looked at the tremendous expansion of the Federal Reserve balance sheet and they said, ‘Well, if the Federal Reserve balance sheet goes from $500 billion to $3 trillion, what’s that — a sixfold increase? — then that should imply a sixfold increase in the value of gold.’
Well, no, it doesn’t. Because you have to look at how that money flows into the economy and into the “Actual Money Supply” that’s available to the economy.
Right now the mineral exploration industry is about as out of favor as it’s ever been — which means mineral exploration companies are cheap…
See, the Federal Reserve balance sheet counts deposits that commercial banks have at the Federal Reserve Bank. When the Federal Reserve creates money, they typically do so by buying U.S. government Treasuries in the open market. So let’s say the Fed goes and buys $1 billion worth of U.S. government Treasuries. The counterparty to the Fed is a bank. There’s a select group of banks that can be counterparties to the Fed.
So the bank is selling a government Treasury to the Fed, and the Fed pays the bank. But the money that the Fed pays doesn’t actually go into the bank’s general bank account, where it can spend it; it goes into that bank’s account at the Federal Reserve Bank. That money the bank has on deposit with the Federal Reserve is unavailable to the bank. The bank cannot draw on that money. It cannot spend that money. The only thing the bank can do is use that money as a reserve asset when it does its reserve asset calculations. That’s it. It cannot withdraw it ever.
The only way that money gets out of the Federal Reserve account is if the Fed sells any Treasury or debt instrument back to the bank. The bank can now use that money in its deposit account at the Fed to pay for that Treasury; that’s how the money comes out of the money supply.
So the creation and destruction of money, the mechanism by which the Fed is creating and destroying this money, is intimately tied to the commercial bank accounts at the Federal Reserve, called reserve accounts. But because that money cannot be spent by the bank or by you or by me or by anybody, that money isn’t functionally in the money supply.
Let’s say that an investment company has $1 billion worth of government Treasuries, and they want to sell these Treasuries. So the Federal Reserve buys $1 billion worth of Treasuries from the bank, that money gets into the reserve account; the bank buys a Treasury from an entity, from the investment company and pays the investment company. That money that was created by the Fed wasn’t created and went straight to into the economy; it got stuck there in the reserve accounts. So you cannot look at the increase in the reserve account balances and make an extrapolation or make a deduction as to what that means to the money supply. You have to actually count the money supply to see what impact it has, and that data is on my website. I update it every week.
So what went wrong for these guys is they looked at the Federal Reserve Bank balance sheet and they said, “My God, look at the money printing. This is massive, this is hyperinflation, this is Armageddon.” But it wasn’t, because it wasn’t in the money supply. What the Fed was doing was actually changing the structure of Federal Reserve Bank balance sheets, and they were creating the ability for banks to create money in the economy.
The Daily Reckoning: So just to reiterate, the potential is there for the money supply to increase, but going off of your Actual Money Supply measure, which you explained yesterday, you just don’t buy the hyperinflation story.
Paul van Eeden: Right. But the banks cannot create the money if the demand for the money isn’t there or if the match between credit demand and creditworthiness isn’t there. So the other part you have to understand and think about is when the Federal Reserve prints money, as I said, it goes into the reserve bank account.
The entity that actually creates the money supply is not the Federal Reserve Bank. It’s the normal commercial banks. It’s when you take out a car loan, that creation of the loan is the creation of money. When you pay back a car loan, that’s deflation, that’s destruction of money. That’s how the money supply increases and decreases. So all the Federal Reserve Bank did was enable the banks to create a whole bunch of money. But the rate at which the banks actually created the money depended on the economic demand for that money. And we can measure what the increase in the money supply is very accurately. So while everybody was talking about this massive hyperinflation and the gold price going to $2,000, $3,000, $5,000 an ounce, I was looking at the money supply and saying there’s no basis for that.
The Daily Reckoning: So what do you expect now? If you’re not buying gold above $1,000 because you think it’s too expensive, what are you eyeing that looks cheap?
Paul van Eeden: That’s a hard question. I’m not here to give anybody that kind of investment advice. If somebody believed me when I was bullish on gold and said it was going to go from $350 to $700 for the following reasons… and it happened for the reasons I outlined… and then when it went to $700-800 an ounce, I said — and I said this publicly – “Gold has reached my target, so my interest, my bullishness on gold, is over.” I don’t care that gold goes from $900 to $1,800. As I said, it’s overpriced now, my interest is over. But if they didn’t believe me at that point — and they don’t believe me when I now said it’s grossly overvalued — then why would I give them any advice now?
Anything I say can and will be misinterpreted by people like that. I just go back to what I told you yesterday. I think gold is worth about $1,000, and it’s trading today for $1,250. I have no interest in buying physical gold at $1,250 when I think it’s worth $1,000. You and your readers can interpret that any way you like. I couldn’t give a damn how you interpret it.
Now, understand something else, because this is where people get genuinely confused. I’m in the investment business. And my specialty in the investment business is very small, very early-stage mineral exploration companies. And I am buying very small mineral exploration companies in this market, even though I believe that gold is overpriced and could easily come down $200, $300, $400 an ounce.
Even though I believe copper is overpriced and could easily come down a $1 pound, I’m still buying small exploration companies. But let me be very clear about the reason why. These small exploration companies don’t own any copper or gold. They’re trying to find some. If you don’t have any gold and you discover a million ounces, you create shareholder value irrespective of what the gold price is.
Now these companies are in a very severe bear market — a bear market we haven’t seen for 15 years. So they’re trading at attractive prices, which is why I’m buying them. But just like gold, I have no idea when this market is going to turn around, I don’t know that things are going to get better for them in the next one, two, three years. In fact, to be very candid, I don’t expect the market to get better in the next two or three years.
But as an investor, I also know that you have to buy things when they’re out of favor and cheap, so that you can sell them when they’re in favor and expensive. Right now the mineral exploration industry is about as out of favor as it’s ever been — which means mineral exploration companies are cheap, and I’m buying them. But I’m not buying them because I think their prices are going to go up in the next six or 18 months. So those readers who know me well will always find a bit of a dichotomy between my views on gold and my activities in the mineral exploration industry.
I’m always buying and selling in the mineral exploration industry, always, in good years and bad years. In good years, I sell more than I buy. In bad years, I buy more than I sell. But I’m always buying and selling these things. That’s different from my views on gold. When gold is overpriced, I don’t buy it at all, I’m talking about physical gold, I don’t buy physical gold at all. When gold is underpriced, I buy physical gold.
The Daily Reckoning: One of the reasons many people, including some of our readers, think gold is so low is because the market’s being manipulated. Would you care to comment on that?
Paul van Eeden: This whole manipulation thing started in the mid- to late-1990s with Bill Murphy and the GATA group, the Gold Anti-Trust Action Committee, I’m sure you’ve run into them. Now let’s just go back and think about this for a second. Back in 1996, gold peaked at $416 an ounce, and by 1999, gold had dropped to around $250 an ounce, which is when GATA really got a head of steam on it. So the gold price went from $250 an ounce to $1,920; all the time, GATA said the gold price was being manipulated downward. Can you explain this to me? How do you make a case that the gold price is being manipulated down if it goes from $250 to $1,920? I’m not being facetious, but is there any way you can explain to me how that is possible?
That story is 15 years old. During the time that story was popular, the gold price went from $250 to $1,920 an ounce. So now you have to ask yourself is the gold price being manipulated downward, or was that the short squeeze they were talking about? I don’t think that was the short squeeze, because we never had failure to deliver; there never was a genuine someone caught short who couldn’t deliver. Since that time, gold’s gone from $1,900 to $1,200 an ounce. So where’s the short squeeze?
How do you tell me the bullion banks sold the gold and it cannot be delivered and will not be delivered, it will be defaulted on, and yet the gold price goes from $1,900 an ounce to $1,200 an ounce. It doesn’t make any sense. On the other hand, if we look at the gold price, go back to the late 1990s, when I started to write about the gold price. This was when gold was $400 going to $250. And I figured out that when gold went from $400 to $250, it wasn’t really a bear market in gold at all. It was actually just a bull market in dollars. But because we price gold in dollars, if the dollar exchange rate goes up, the price of gold in dollars must come down if gold stays evenly priced in all the other currencies.
Let’s make the case clear: Gold trades all over the world. If the gold price is constant in all the currencies of the world, but it’s quoted only in U.S. dollars, and the U.S. dollar exchange rate goes up versus other currencies, then the gold price must come down in U.S. dollars so it remains the same in all the other currencies, right? That’s what happened in the late 1990s. So if you look at the price of gold in the late 1990s when it went from $420 to $250, that was a bull market in the U.S. dollar exchange rate. That’s all it was. There never was a bear market in gold in the 1990s. It’s a myth, it’s a fallacy. There was a bull market in U.S. dollars. The U.S. dollar exchange rate went down.
So when gold went from $400 to $250, it was easy for me to see that that wasn’t sustainable, because that was just a bull market in dollars. Now I have to analyze the dollar. Is this bull market in dollars sustainable, for real, or not? My conclusion in the late 1990s was that the bull market in U.S. dollars was overdone and the U.S. dollar was going to decline. And it was that decline in the U.S. dollar that would bring gold back up to $700 an ounce. That happened. That bear market in the U.S. dollar occurred from 2001-08.
That’s what brought the gold price up exactly to what I said it would be. Now, at that point, you had a bear market in the U.S. dollar and everybody’s saying, “Oh, my God, look at this! The Federal Reserve is now going to pump money into the economy! The Federal Reserve is now going to debase the U.S. dollar.” So what happens now is you get speculation in the market about an event that’s going to happen in the future but hasn’t happened yet. That event is the destruction of the U.S. dollar by the Federal Reserve Bank. Based on that speculation, people pile into the gold market.
I don’t think the United States economy is going to grow at a stellar clip, but I think the worst is over.
When I say “people,” I’m talking about multibillion-dollar hedge funds, pension funds, investors, everybody piling into the gold market because the Federal Reserve Bank and Ben Bernanke are destroying the U.S. dollar by creating all this inflation. Keep in mind that’s a speculation, because at the time they bought the gold, that had not yet happened. What had happened was that the Federal Reserve had expanded the Federal Reserve Bank balance sheet. But as we explained earlier, that money was not flowing directly into the economy. So the destruction of the dollar wasn’t actually busy happening, but it was that speculation that sent the gold price up.
Two years ago, the Federal Reserve started making announcements indicating that the expansion is probably nearing an end. And it was right exactly at that time the gold price peaked? Why? Because people said, “Oh, hold on a second, the hyperinflation never happened, and now the Federal Reserve is talking about ending expansion. I guess we didn’t need all that gold after all.”
So they stopped buying gold. What happened to the gold price? It started coming down. Now that to me is a much more logical story than, “Oh, my God, from 1995-2008, the Federal Reserve and the other governments were suppressing the gold price and manipulating it down, which is why it went from $250 to $1,900 an ounce. The other thing we got happening is a short squeeze. People won’t be able to pay back the gold loans that they took, gold is going to go to the moon.” But the gold price is going from $1,900 an ounce to $1,200. That doesn’t make sense.
The Daily Reckoning: Very interesting. Wrapping up… do you have any final thoughts on the U.S. economy going forward?
Paul van Eeden: I think the worst is over for the U.S. economy. I don’t think the United States economy is going to grow at a stellar clip, but I think the worst is over. And I think with time, the worst is going to be over for the European economy.
The biggest risk we have right now is the Chinese economy, because the Chinese banking system is in far worse shape than the U.S. banking system ever was. It might blow up, it might not. I have no idea, but that’s the risk. But the worst is over for the U.S. So I think that there’s no immediate reason to expect the price of gold to go up dramatically, except for potentially a blowup in China. But here’s the rub: If China does blow up, where would the flight capital go? It would go to the U.S. dollar, right?
What happens if the flight capital goes to the dollar? Dollar goes up, gold goes down. The dollar is then the safe haven, not gold. People who speculated on gold being the safe haven in the past five years felt really smart for the first three years and are feeling a lot less smart right now.
The Daily Reckoning: Paul van Eeden, founder of Cranberry Capital. Thanks so much for sharing your thoughts on the subject with us.
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