The Fed wants to increase liquidity. But given the weakening in economic activity, this is not easily done. Obviously, if the Fed were to decide to set the interest rate target to nil, then it could have the freedom to pump as much money as it likes. But by doing that it runs the risk of seriously undermining the bottom line of the economy.
The inability of the Fed to do what it wants to do is bad news for bubbles. But it is good new for economic activities that are truly wealth creating. In this case, a failure by the Fed is the path to economic recovery. Now the bad news: economic recovery permits the Fed to once again succeed in expanding the money supply, which results in new bubbles and the cycle starts all over again. FULL ARTICLE
{ 26 comments }
Dr. Shostak,
I like to consider myself an Austrian-minded investor, but I have been one of the few in the gold-bug community arguing that the money supply is not increasing (my belief has fallen on deaf ears since everyone uses M3 as a measure of the money supply). Though I have made the argument that money supply is not increasing, I could not quite wrap my mind around how or why from an economic theory standpoint this could be taking place right now with the Fed lowering rates. You just provided the answer. I just wanted to thank you and congratulate you on what I consider to be fantastic work on this issue of the money supply and the current state of the economy.
Best,
Allen
Can you help me understand the relationship between what you are describing happening with the fed funds rate, etc., to the Mises Institute’s graph of the “true money supply”?
http://mises.org/content/nofed/chart.aspx?series=TMS
Thanks.
Thank you for yet another startlingly rational and deceptively simple explanation of what’s going on in the money markets.
One thing I didn’t necessarily understand however was the implication that paying taxes would reduce the amount of money held as reserves in the form of federal funds. If the Federal Government is running a deficit (which I believe it is) then those tax dollars presumably come right back into the federal funds market quicker than they went out don’t they? Only in the case that the Federal Government spends less than it takes in taxes and reatains the surplus in the treasury accounts would the central bank be required to pump money into the system in order to maintain the overnight Fed Funds rate.
What have I misunderstood here?
I like to consider myself an Austrian-minded investor, but I have been one of the few in the gold-bug community arguing that the money supply is not increasing (my belief has fallen on deaf ears since everyone uses M3 as a measure of the money supply). Though I have made the argument that money supply is not increasing, I could not quite wrap my mind around how or why from an economic theory standpoint this could be taking place while the Fed has been lowering the fed funds rate. You just provided the answer with your article. Thank you!
Sorry, repeat post!
If the true money supply has not been increasing, what’s the cause of precious metals going up? Does it mean what we are witnessing in the gold market is another bubble in the making and is prone to go down?
Shostak didn’t say the true money supply wasn’t going up – he said monetary liquidity was not going up. Those are 2 different things.
white bear says:
If the true money supply has not been increasing, what’s the cause of precious metals going up?”
stefan karlsson, another mises contributor, explains why mzm is the prefered money aggregate. the commodities rally makes sense using this figure, as opposed to the narrower monies. do a search using “mike shedlock” or “shostak” on his blog (http://stefanmikarlsson.blogspot.com/)
What I gather from your very informative article is that the U.S. economy still has a great deal of substance. It is just that every time there is wealth generation the parasitic interventionists swarm to its host and begin feeding.
The feeding frenzy is what excites everyone and it is also referred to as a bubble.
It is tragic to know that there is profound insight into the cause and effect of interventionism and yet most of our fellow human beings are deliberately kept in a state of ignorance.
Dr. Shostak, I hope your insights and analysis reach a wide audience.
Thank you for this amazingly clear article.
Can someone explain how liquidity affects short-term rate spreads?
I’m not compelled by this argument because it doesn’t equate with anything that is going on in the rest of the economy. Commodity prices and even the highly biased and manipulated government inflation measures are screaming excess money. The one statistic that contradicts it is the M1 money supply/”high powered money” number, but due to changes in the late 90′s about how banks account for checking accounts these numbers are not comparable to historical numbers and are no longer relevant as useful measures of the money supply. Like most of the changes to government accounting over the last 25 years they have all been in one direction: they tend to make money supply and inflation increases look smaller than they actually are, because this benefits those running the government and the Fed.
It’s too bad that some who have been educated in Austrian economics have missed something so basic as this. But I guess if even those with some knowldege can be fooled then the rest of the sheep have no chance.
Mises TMS time series is missing data for months 1984-02 and 1984-03.
In my opinion it makes sense that gold booms are inverse to the TMS. It was the case during the 1970s. See my own rendering:
http://xexix.net/misestms-vs-gold.png.
1984-02/03 was linearly interpolated. The Blue->Cyan bars are my bear market indicators, the pink blobs on top are ‘official’ recessions.
The explanation is that people are decreasing their demand for FED money, and increasing their demand for real money.
It seems like Austrian money theory does not offer any help when it comes to predicting how commodity will fare given inputs of any M1, M2, M3, MZM, AMS, or TMS.
http://tinyurl.com/yryq62
Gary North was just going gangbuster on a new kid on the block regarding the future direction of gold. He believes that the FED is deflating as evidenced by the negative M1 growth. There won’t be any inflation going forward, bragged by him in the article. Well. M1 has been sloping down since 2004 and how he suddently turned bearish on gold in 2008, not in 2004, puzzled me.
http://www.garynorth.com/public/3263.cfm
In an earlier article, he made reference to ABCT as to how he was so sure about deflation coming and that gold won’t go up until the recession ends.
On the other side, stefan karlsson was adamant about MZM driving commodity prices.
All the authors preached to be Austrian econ followers and they come up with diametrically different outcome when it comes to gold. Who is correct?
Whitebear,
The problem with gold analysis and fed action, is that the global economy is not taken into account. Correct analysis would include global monetary growth, not just US money growth. Gold is an international commodity with real demand. The US dollar is political hegemony with coerced demand.
My own opinion is that gold will continue to go UP relative to the housing market, the bond market (not now, but ~year from now), and the stock market. Gold is not just an inflation hedge, it is also a deflation hedge.
Both North and Karlsson are correct. The deflation will occur in the most recently malinvested sectors, while the inflation will be in the most recent underinvested sectors.
My previous link didn’t work because of the extra ‘.’ at the end.
http://xexix.net/misestms-vs-gold.png
This chart shows what a real gold bull market in the 70s looked like. We have only just begun the gold rush. The US is financially weaker than it was in the 70s. As soon as the middle east and china revalue their currency, the US economy will head into a tailspin. The only thing to reverse that will be a North American Union ~ a socially undesirable thing, but an economically viable one, since it will allow the US to parasitically live off Mexico and Canada (socializing losses on a larger population).
I shared your view with gold and thus had a majority of my portfolio in gold and gold stocks. It was like being splashed a bath of cold water when Gary North faced off with Saville with regards to gold’s future. I think it is undeniable that Gary North believes gold is done for in the next year or two until we are out of the next recession.
http://www.garynorth.com/public/3263.cfm
As you mentioned, gold will still fare well relative to other asset class like real estate, stocks, bonds in a deflationary environment. My main concern is whether it will fare better than cash in such an environment. If real estate drops 50%, bond drops 30%, stock drops 40% and gold only drops 10%, you can argue that gold has fared relatively better. Still, there is no arguing that gold has lost 10% against cash. That’s why it is important to understand if Gary North’s (may be Shostak as well) point of view has any substance. He thinks that gold will fall in the the coming recession (he implies 50%?,
) along with all asset class because he thinks that inflation will be nill or less than 0 due to a falling M1 dropping.
Robert Murphy publishes another article today that points to a decreasing total bank reserve. This is contrary to what everyone is thinking that the FED is attempting to inflate its way out of the mess. Is this another sign, as Gary North, and Frank Shostak point out that the banking system is still deflating (without regards to FED’s inflating efforts)? What would the implication be on gold? That’s the question that really needs to be answered, IMO.
“along with all asset class because he thinks that inflation will be nill or less than 0 due to a falling M1 dropping.”
Saville has done an excellent job of explaining why M1 is no longer a statistic of any relevance. If you want to measure true liquidity – the amount of free currency chasing after the world’s goods, services and assets, then MZM or Rothbard’s TMS are probably the best.
Focusing on M1 will lead to dreadfully wrong conclusions – like believing that there has been no inflation since 2004.
Whitebear,
North is a smart guy (a little wacky though, for my taste), but he was wrong about Y2K, and he will be likely wrong about gold. And besides, even he agrees that it will fall only in the short term, and then will resume its climb. If you are a long term investor, then you shouldn’t be jumping in an out of markets, but simply dollar-cost averaging your purchases of gold, and even better: silver.
Most of the money is created via fractional reserve banking, not fed reserve injections. If the reserves are not increasing, the money supply can still be increasing – that would mean that the effective reserve ratio is decreasing.
I know there are regulations and such, but if you’ve been paying attention to the news, regulations are stretched and distorted on a dime as soon as wall street starts shedding crocodile tears.
The door has been open to any institution to cry out for a bailout ‘or else the whole financial system will implode’. This seems to be the thoughts du jour on Kudlow, at least.
“Robert Murphy publishes another article today that points to a decreasing total bank reserve. This is contrary to what everyone is thinking that the FED is attempting to inflate its way out of the mess.”
The dollar is also beginning to be backed by crappy mortgages rather than crappy gov promises – a situation that has historically been super inflationary. We are in unchartered territory.
Not all academics are up to speed. The FED control of the fed funds rate is a mere control of ~40Bn dollar reserves. That is such a small amount. The bottom line is that out monetary policy is set more by Russia, China, Japan, Saudi Arabia central banks than the FED.
The FED has little ammo left, which is why it wants to directly pump money into banks and broker-dealers.
I do not disagree that there will be deflation, it just will not be in commodities. I’m more inclined to believe that there will just be disinflation, rather than outright deflation. Housing is ~40% of the CPI, so its drop is bound to have a major effect on ‘inflation’. Since manufacturing is floundering, the only thing the US can supply to the world (to reverse its trade balance), is agriculture. This will be our way of paying back for extravagance.
–
The other thing going for gold is simply supply. We reached ‘peak gold’ in 2001. Gold miners are finding it more difficult to mine gold. A good metric for analyzing the gold mining sector is cost in gold vs output in gold. Gold mining was getting more expensive in terms of gold, i think it might be leveling off now
Check this out:
http://www.goldsheetlinks.com/world.gif
xexix says:
“Gold is not just an inflation hedge, it is also a deflation hedge.”
this is not correct, and i seem to recall saville going to some lengths on this point in one of his archived articles at safehaven.com.
in deflation, ie contracting money supply, dollars become more valuable against all goods and services. in this environment, treasury securities are the ideal environment, the longer the duration the better, and cash outperforms gold. gold was only an effective deflation hedge during the great depression by virtue of its convertibility to dollars at a fixed rate.
perhaps you are attributing gold’s value in deflation to prudential risk. but even in that situation it would be better to possess physical cash.
deflation doesn’t occur in certain sectors alone, though it’s effects may be experienced differently. the same could be said for its twin, inflation.
finally, like whitebear, i think either the shostak/north/shedlock camp or the opposition karlsson/saville are right, not both. i’m more convinced by the latter.
oops! should read:
“treasury securities are the ideal investment,the longer the duration the better…”
“Housing is ~40% of the CPI, so its drop is bound to have a major effect on ‘inflation’”
House PRICES are not in the CPI at all or the inflation rate would have been WAY higher during the housing boom. Ask yourself his: were 40% of the house price increases reflected in the CPI? Of course they weren’t.
What is in the CPI is “homeowner equivalent rent” which is an extremely poor approximation of housing costs that proved to be absolutely useless as a measure of housing price inflation in the recent run-up. Housing prices had little to no effect on the reported CPI going up and will have little effect on the reported CPI going down.
Using government published statistics is fraught with danger because they are continually manipulated, which makes comparisons with other time periods meaningless, and they are always manipulated in order to make the Federal government and the Federal Reserve look better and to make the Fed’s job as the hub of the banking cartel easier.
Think about the consequences of including asset prices, including housing and the stock market, in the CPI. When and by how much would the Fed have had to restrict the money supply in order to keep a low and steady CPI, and what would that have done to the profits of the Fed member banks?How could the government achieve it’s goals of having every citizen own a home if interest rates were 20% and banks only loaned to people who they were sure would actually make their interest payments? How could the federal government continue to pay for a massive welfare state if the transfer payments were rising at the same or greater rate as tax revenues and if they had to borrow money to fund the deficit at positive real interest rates instead of negative? If any of those things happened the government deficit would go to the moon (like it did in the early 80′s when interest rates were 21% and the inflation rate was declining) and it would quickly go bankrupt. Changing the CPI to measure less than the real cost of living makes all of these problems magically go away – for a while.
When you start to ask these questions every thing starts to become real clear.
interestingly, the gary north article (http://garynorth.com/monetarystats.pdf) on why he prefers m1 as a money aggregate, is dated april 20, 2007. gold was then around $700/oz. now it’s 900ish. consumer prices have been racing ahead in almost all developed countries (save japan).
by matching the various m’s against the median cpi produced by the cleveland federal reserve bank and picking m1 as the tightest fit, he ignores the effect on monetary policy on asset prices, which aren’t part of the index basket. given his use of the term price inflation predictor, maybe he’s intentionally only referring to retail prices.
newson,
North’s approach is interesting, but I agree that it ignores asset price inflation. I think I’ll try regressing the price of gold on the various monetary aggregates and see what happens. If nothing good, you won’t here anything.
DS,
“House PRICES are not in the CPI at all or the inflation rate would have been WAY higher during the housing boom. Ask yourself his: were 40% of the house price increases reflected in the CPI? Of course they weren’t.”
I didn’t say house prices, I said ‘Housing’.
http://www.nowandfutures.com/cpi_lie.html
Housing, and its related services are ~40%.
I took your argument into consideration…if housing consitutes 40% of CPI, and it is being understated through things like owners equiv rent, and other hedonic adjustments, then REAL ‘inflation’ is much higher. This explains the gold rise. Now if house prices are falling, then the REAL ‘inflation’ could be decreasing. Fake CPI may obscure both the rise and fall.
“When you start to ask these questions every thing starts to become real clear.”
Indeed.
—
Newson,
“deflation doesn’t occur in certain sectors alone, though it’s effects may be experienced differently. the same could be said for its twin, inflation.”
That contradicts what Rothbard said. You can have inflation in some sectors and deflation in others at the same time. That is precisely what ‘malinvestment’ implies. Think of the oil bust of 85-86 that almost became a recession in the middle of the 80s housing boom, or the mining sector contraction of ’96-’99 during the dot.com bubble. Well those busts and contractions in the past are building up to be tomorrow’s booms.
New money flows in the path of least resistance. In this respect, fiscal policies are more responsible, not monetary.
“in this environment, treasury securities are the ideal investment, the longer the duration the better, and cash outperforms gold”
Treasuries are a great speculative vehicle during a rate cutting cycle, so you can play the going-to-cash mania. I wouldn’t use buy-and-hold for treasuries.
I bought a whole bunch of call options for bond ETFs in June ’07…That was a great speculation.
“finally, like whitebear, i think either the shostak/north/shedlock camp or the opposition karlsson/saville are right, not both. i’m more convinced by the latter.”
Well, I wish you good luck then.
Just one more thing:
http://www.shadowstats.com/imgs/sgs-gdp.gif
As this chart shows we’ve technically been in a ‘recession’ since 2000. What has fundamentally changed in gov policy that would reverse this trend?
Why has gold outperformed bonds in this 8 year recession?
I think the deflation camp is being contrarian for the sake of being contrarian. In a world of fiat money – inflation is the default bias. Our leaders are basically admitting to us the inflationary path they have chosen.
Happy Trading
“I took your argument into consideration…if housing consitutes 40% of CPI, and it is being understated through things like owners equiv rent, and other hedonic adjustments, then REAL ‘inflation’ is much higher. This explains the gold rise. Now if house prices are falling, then the REAL ‘inflation’ could be decreasing. Fake CPI may obscure both the rise and fall.”
Just to be clear, gold has been rising not because of housing going up or down but because the money supply has been increasing. The price of housing is an effect, not a cause. It’s rise did not make gold go up and it’s decline won’t make it go down. This is simply a symptom of too much money supply growth. The CPI is a statistic that can only usefully be viewed as the absolute least amount of inflation in the system. It is at best a measurement of the floor.
By the rest of your post you imply that you understand this process, so I apoligize if I seem like I’m busting your balls too much.
newson:
“deflation doesn’t occur in certain sectors alone, though it’s effects may be experienced differently. the same could be said for its twin, inflation.”
xexix: “That contradicts what Rothbard said. You can have inflation in some sectors and deflation in others at the same time.”
first, rothbard said nothing of the sort. i think you’re confusing deflation (cause) with falling prices (effect). austrians understand the deflation to mean contraction in the money supply. how this plays out in various markets is another issue.
your examples show nothing more than with inflation, bubbles grow, burst and are replaced by other sectorial bubbles. constant money supply growth doesn’t preclude sectorial recession.
second, regarding treasuries, i didn’t recommend buying them in my example, nor do i now, precisely because i don’t believe deflation is going to be a serious proposition. i was merely objecting to your view that gold is a deflation hedge, when it’s really only a hedge against inflation..
if you think i am touting the deflation story, you’re not carefully reading what i said. here’s goes again, i believe the saville/karlsson inflation scenario is the believable one, whilst the shostak/north/shedlock deflation view leaves me unconvinced.
to fundamentalist:
i recommend reading the interesting article by steve saville, which responds to gary north’s ad hominen comments.
the link is – http://safehaven.com/article-9872.htm
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