Early last year I gave banking behemoth Goldman Sachs (GS) credit for looking in the right direction for clues regarding gold’s likely performance, which is something that most gold bulls were not doing. In November I again gave them credit, because, even though I doubted that the US$ gold price would get close to GS’s $1050/oz price target for 2014, their overall analysis had been more right than wrong. It was clear that up to that point the US economy had performed better than I had expected and roughly in line with the GS forecast, which was the main reason that gold had remained under pressure; albeit, not as much pressure as GS had anticipated.

But this year it was a different story. Here’s what I wrote in a TSI commentary in January-2015:

“This year, GS’s gold market analysis begins on the right track by stating that stronger US growth should support higher real US interest rates, which would be bearish for gold. Although we expect that the US economy will ‘tread water’ at best and that real US interest rates will be flat-to-lower over the course of this year, GS’s logic is correct. What we mean is that IF the US economy strengthens and IF real US interest rates trend upward in response, there will be irresistible downward pressure on the US$ gold price.

However, the analysis then goes off the rails. After mentioning something that matters (the real interest rate), the authors of the GS gold-market analysis then try to support their bearish case by listing factors that are either irrelevant or wrong. It actually seems as if they’ve taken the worst arguments routinely put forward by gold bulls and tried to use the same hopelessly flawed logic to support a bearish forecast.

For example, they argue that the demand for gold will fall because “inflation” levels are declining along with oil prices. They are therefore unaware, it seems, that “price inflation” has never been an important driver of the gold market and that the latest two multi-year gold rallies began with both “inflation” and inflation expectations low and in declining trends. They also appear to be unaware that the large decline in the oil price is very bullish for the gold-mining industry.

Their analysis then gets even worse, as they imply that the price weakness of the preceding three years is a reason to expect future weakness, whereas the opposite is closer to the truth. They go on to cite outflows from exchange-traded funds (ETFs) and reduced investment in gold coins as bearish influences, apparently unaware that the volume of gold coins traded in a year is always too small to have a noticeable effect on the price and that the change in ETF inventory is a follower, not a driver, of the gold price.

Finally, just when it seems as if their analysis can’t possibly go further off track, it does by asserting that lower jewellery demand and a greater amount of producer hedging will add to the downward pressure on the gold price. The facts are that jewellery demand has always been irrelevant to gold’s price trend and that gold producers are part of the ‘dumb money’ (meaning: they tend to add hedges at low prices and remove hedges at high prices, that is, they tend to do the opposite of what they should be doing based on gold’s intermediate-term risk/reward).”

I concluded by stating that in 2014 the GS analysts were close to being right for roughly the right reasons, but that in 2015 they could not possibly be right for the right reasons. They would either be right for the wrong reasons, or they would be wrong.

At this stage it looks like they are going to be wrong about 2015, but not dramatically so. My guess is that gold will end this year in the $1100-$1200 range, thus not meeting the expectations of GS and other high-profile bears and at the same time not meeting the expectations of the bulls. However, GS is on record as predicting a US$1000/oz or lower gold price for the end of next year. I think that this forecast will miss by a wide margin, but I’m not going to make a specific price forecast for end-2016. Anyone who thinks they can come up with a high-probability forecast of where gold will be trading 15 months from now is kidding themselves.

Officially, the US has a fractional-reserve banking system (as does almost every other country), meaning that a fraction of deposits are backed by cash reserves held in bank vaults or at the Fed. In reality, the US has a zero-reserve banking system.

I don’t mean that there are no reserves in the banking system, as currently there are huge reserves courtesy of the Fed’s QE programs. What I mean is that there is no relationship between bank reserves and bank lending and that bank reserves do not impose any limit on bank deposits. It has been this way for about 25 years.

To further explain, the most important aspect of a fractional reserve banking system is that a bank can create new deposits by lending out existing deposits up to the point where its total deposits are a predetermined multiple of its reserves. The aforementioned multiple is called the “money multiplier” and the maximum “money multiplier” is the reciprocal of the minimum reserve requirement. For example, in a system where a bank’s reserves are required to be at least 10% of its total deposits, the potential “money multiplier” is 10. In the current US system, however, there is effectively no lower limit on reserves, which means that the so-called “money multiplier” can correctly be thought of as either non-existent or infinite.

Regardless of their deposit levels, US banks are able to reduce their required reserve levels to zero. This is possible for two reasons. First, only demand deposits are subject to reserve requirements. Second, banks employ software that shuffles money between accounts to ensure that they fulfill the regulatory reserve requirement regardless of their actual deposit and reserve levels. For example, you might think you have a demand deposit, but for regulatory purposes what you might actually have is a zero-interest CD.

The absence of any relationship between US bank reserve levels and US bank credit is illustrated by the following chart. The chart compares total US bank credit and total bank reserves (vault cash plus reserves held at the Fed) from the beginning of 1989 through to mid-2008 (just prior to the start of the QE programs that swamped the normal relationships). During this period, bank credit shot up from $2,400B to $9,000B while total bank reserves oscillated between $50B and 65B. Notice that the volume of bank reserves was actually a little lower in 2008 with bank credit at $9.0T than in 1989 with bank credit at $2.4T.

An implication, even prior to the QE programs that inundated the banks with reserves, is that the US fractional-reserve banking system will never go into reverse due to a shortage of reserves. In other words, US banks will never contract their balance sheets due to a lack of reserves. Another implication is that having a huge pile of “excess” reserves will never cause banks to expand credit. Instead, regardless of their reserve levels banks will expand or contract credit to the extent that their overall balance sheets can support additional leverage and they can find willing/qualified borrowers.

I opened a blog post on 7th October with the statement that gold was money in the distant past and might again be money in the future, but isn’t money in any developed economy today. I then explained this statement. The post stirred up a veritable hornet’s nest, in that over the ensuing 24 hours my inbox was inundated with dozens of messages arguing that I was wrong and a couple of messages thanking me for pointing out the obvious (that gold is not money today). The negative responses were mostly polite*, but in many cases went off on a tangent. Rather than trying to respond individually, this post is my attempt to rebut or otherwise address some of the comments provoked by the earlier post on the same topic.

In general, the responders to my earlier “Gold Is Not Money” post made the same old mistakes of arguing that gold is an excellent long-term store of value, which is true but has nothing to do with whether gold is money today, or confusing what should be with what is. Some responders simply asserted that gold is money because…it is. Not a single responder provided a practical definition of money and explained how gold fit this definition. That’s despite my emphasis in the earlier post that before you can logically argue whether something is or isn’t money, you must first have a definition of money.

Due to the fact that many different things (salt, tally sticks, beads, shells, stones, gold, silver, whiskey, pieces of paper, etc.) have been money in the past, a reasonable definition of money MUST be based on money’s function. Also, the definition must be unique to money. In other words, when defining money you must start with the question: What function does money perform that nothing other than money performs?

“General medium of exchange”, meaning the general enabler of indirect exchange, is the function performed by money and only by money within a particular economy. Now, there are certainly pockets of the world in which gold and other items that we don’t normally use as money in our daily lives do, indeed, perform the monetary function. For example, there are prisons in which cigarettes are the most commonly-used medium of exchange. It is certainly fair to say that cigarettes are money within the confines of such a prison, but I want a definition that applies throughout the economy of a developed country. Gold is not money in the economy of any developed country today, although there could well be small communities in which gold is money.

I’ll now address some of the specific comments received in response to my earlier post, starting with the popular claim that there’s a difference between currency and money, and that although gold is no longer a currency it is still money. The line of thinking here appears to be that currency is the medium that changes hands to complete a transaction whereas money is some sort of esoteric concept. This is hardly a practical way of thinking about currency and money. Instead, it appears to be an attempt to avoid reality.

A more practical way of thinking about the difference between currency and money is that almost anything can be a currency whereas money is a very commonly-used currency. In other words, “currency” is a medium of exchange whereas “money” in the general medium of exchange. The fact is that gold is sometimes used as a currency, but it is currently not money.

Moving on, some people clearly believe that gold is money because the US Constitution says so. Actually, the US Constitution doesn’t say so, as the only mention of gold is in the section that limits the powers of states and is specifically about the payment of debts, but in any case this line of argument is just another example of confusing what should be with what is. The bulk of what the US Federal Government does these days is contrary to the intent of the Constitution.

Some people apparently believe that gold is money (or money is gold) because JP Morgan said so way back in 1912. My response is that JP Morgan was absolutely correct. When he made that statement gold was definitely money because at that time it was the general medium of exchange in the US. However, today’s monetary system bears almost no resemblance to the monetary system of 1912. For example, when JP Morgan said “Money is gold” the US was on a Gold Standard and the Federal Reserve didn’t exist.

Several people informed me that gold must be money because some central banks are buying it or holding it in large quantities. OK, does this mean that something is money if central banks are buying/holding it regardless of whether or not it is being used as money throughout the economy? If so, then Mortgage-Backed Securities (MBSs) must now be money in the US because the Fed has bought a huge pile of MBSs over the past few years, and T-Bonds must now be money throughout the world because most CBs hold a lot of T-Bonds. Obviously, something does not become money simply because CBs hold/buy it.

A similar mistake is to claim that gold must be money because major clearing houses accept gold as collateral. The fact is that the same clearing houses also accept the government bonds of most developed countries as collateral. General acceptance as collateral clearly does not make something money.

Lastly, some readers came back at us with the tired old claim that gold has intrinsic value whereas the US$ and the rest of today’s fiat currencies don’t. At the risk of seeming arrogant, you can only make such a claim if you are not well-versed in good economic theory. All value is subjective, which means that no value is “intrinsic”. Most people subjectively assign a high value to gold today, but they also subjectively assign a high value to the US$. In any case, even if the “intrinsic value” statement had merit it wouldn’t be a valid argument that gold is money.

In conclusion, gold is something that is widely perceived to have substantial value. Furthermore, good arguments can be made that its perceived value will be a lot higher in a few years’ time. However, it is currently not money.

*Those that weren’t polite have had the honour of being added to my “blocked senders” list.

Last week I wrote about the incorrect portrayal of the late-September spike in the Fed’s “Reverse Repo” (RRP) operations. Breathless commentary in some quarters had portrayed the RRP spike as an attempt by the Fed to ward-off a crisis, which didn’t make sense. One of the main reasons it didn’t make sense is that a reverse repo takes money OUT of the banking system and is therefore the opposite of what the Fed would be expected to do if it were trying to paper-over a financial problem.

I subsequently saw an article by Lee Adler that provides some more information about the RRP spike. If you are interested in the real reasons behind it then you should read the afore-linked article, but in summary it has to do with a “Fed stupid parlor trick and the temporary shortage of short term T-bills along with the resulting excess of cash.”

According to Mr. Adler: “The two salient facts are that the Fed regularly does two quarter end term repo operations that add to the end of quarter amounts outstanding. They are not a response to any market conditions. The Fed reveals in its FOMC meeting minutes and elsewhere that it instructs the NY Fed to conduct these quarter end operations. It has done so every quarter this year. The NY Fed posts a statement laying out the operations a few days in advance of the end of the quarter.”

I’ve indicated the quarter-end RRP spikes on the following chart. The latest quarterly spike was larger than the preceding three due to the fact that the weekly update of the Fed’s balance sheet happened to be published on the day after the end of the September quarter. Notice that the volume of outstanding RRPs plunged during the first week of the new quarter.

If the pattern continues then there will be another RRP spike during the final week of December, regardless of what’s happening in the financial world at the time.