Quantitative Easing and Gold

Posted 28 Nov 2008

I had an interesting chat with a reader TH about what the central bank officials and politicians hope to accomplish.  This article addresses that question and is fairly complicated so you may need to read it multiple times.  Bernanke warned the investment community of what he would do in a Nov 21, 2002 address before the National Economists Club in Washington DC.

For decades, perhaps even centuries, the world has been in an inflationary credit expansion.  The zenith was reached and now the world is in a deflationary credit contraction.  Holders of capital are seeking the safest and most liquid assets.

 The central bank officials and politicians are attempting to prevent this natural and probable consequence of economic law.  They may as well attempt to repeal the law of gravity.  Short of marching everyone off to the gulag, which they may try, they will fail.

Bernake's address was titled 'Deflation:  Making Sure "It" Doesn't Happen Here'.  He argues there are two bulwarks against deflation in the United States.  First, the resilience and structural stability of the U.S. economic system and second, the Federal Reserve System.

First, as we are seeing with the increasing nationalization of industries through bailouts the 'resiliency' and 'structural stability' of the US economic system is being increasingly undermined.  Voluntary price discovery is being replaced with the coercive force of government.  

This will only lead to less efficient markets and allocations of capital.  The US economic system and therefore its earning and productive power is quickly evaporating.  This loss of earning and productive power negatively affects the quality of its currency.

Second, is the parasitical Federal Reserve System.  The Federal Reserve System's interference in the market regarding the supply and cost of money grossly distorts the pricing mechanism as individuals engage in human action to discover price through value and utility calculations.  On June 16, 2008 I discussed this on the Korelin Economics Report.  Next we turn to Bernanke's toolbox.

The first problem with Bernanke is his poor use of words.  Like most babbling idiots, or perhaps it is done intentionally to confound and confuse, his language is vague and indecisive.  For example, he defines deflation as 'a general decline in prices'.

 The Austrian school of economics defines deflation as a decrease in the money supply.  In application, Bernanke's definition confuses effects (decline in prices) with the cause (decrease in the money supply).  Deflation is no more a decline in prices than wet streets are rain.

Quantitative easing is a tool of monetary policy.  The effect is an increase in the quantity of currency without regard to maintaining its quality.  Quantitative is relating to, measuring, or measured by the quantity of something rather than its quality.  Not all 'dollars' are defined equally.  

Even traditional economists and government reports index in terms of '1986 dollars' or '1977 dollars' to account for the differences in quality of the currency or its purchasing power.  Because there is no definition of the dollar it is subject to payment risk.

A commodity currency such as gold is not subject to this risk.  For example, 1 ounce of gold in 1986 is equal to 1 ounce of gold in 1977 or 577.  The quality of the money is consistent and comparable.  The names of the national currencies arose to define a particular type and weight of metal of a given purity.  For example, a 'dollar' was 371.25 grains of .999% silver.

However, now the term 'dollar' has no definition.  The quality of the money is called into question in direct proportion to its quantity.  The inconsistent quality of currency undermines the confidence in it.  As the Adjusted Monetary Base erupts the distrust of the currency increases.

The alphabet soup lending facilities (TALF, etc.) and bailouts by the various governments throughout the world could be considered quantitative easing.  In effect, the current policy is transmogrifying commercial debt risk which the world does not want to buy into sovereign debt risk which the world does want to buy.  

The Bank of Japan practiced quantitative easing by maintaining short-term interest rates at close to their minimum attainable zero values and flooding commercial banks with excess liquidity.  Bernake suggests (1) keeping a buffer zone of interest rates from 0%, (2) ensure financial stability and (3) cut rates to stimulate the economy when the economy deteriorates.  Then he makes his infamous helicopter state.

Bernanke said, "What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.

We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.  Of course, the U.S. government is not going to print money and distribute it willy-nilly."

It is true the currency will not be distributed 'willy-nilly' like being thrown out of the helicopter.  Instead, it will be directed towards the favored factions like the Wall Street banks while retirement plans are looted.  

The problem is with the premise that there will be borrowers for the newly created liquidity.  Japan ran into a problem with interest rates being at 0% but there being no borrowers.  When negative real interest rates occur the holders of capital seek the next level down in the liquidity pyramid:  gold and silver.  

The deflationary credit contraction continues in spite of the monetary policy and quantitative easing the central bank officials and politicians engage in.

These are good reasons to have a portion of your wealth in the precious monetary metals of gold and silver.

or large amounts I recommend GoldMoney which can also function as a currency in ordinary daily transactions.  

If interest rates for currencies are going to 0% then why hold paper that is subject to counter-party risk when you can hold gold?  Gold is the ultimate insurance, is no-one's liability, the ultimate store of value and is always accepted.  Gold is the penultimate of safe and liquid assets.