There is a big difference between the general perception of Paul Volcker’s performance as Fed Chairman and his actual performance.

Volcker is generally considered to have been a hard-nosed inflation-fighter, but based on the annual rate of growth in US True Money Supply (TMS) he currently holds the record as the most inflationary Fed Chairman of the past 60 years. Ben Bernanke is in second place, followed by Arthur Burns (Fed chief during most of the 1970s), Alan Greenspan, and then William McChesney Martin (Fed chief during the 1950s and 1960s). Refer to the following bar chart for specific details.

Note that the chart omits George Miller, who was Fed Chairman for only 17 months during 1978-1979, and Janet Yellen, who hasn’t been in the job for long enough to establish a proper record.

Volcker is widely regarded as a hard-nosed inflation fighter simply because a commodity-price collapse got underway within 6 months of his August-1979 appointment as Fed Chairman. However, thanks to the steep decline in the money-supply growth rate that began in late-1977 and the fact that the US had spent the 6 months prior to August-1979 in monetary DEFLATION (refer to the following TMS chart for details), a commodity price collapse was ‘baked into the cake’ prior to Volcker taking the top job at the Fed .

If a drover’s dog had been appointed Fed chief in August of 1979, the dog would now have the credit for killing inflation. The reason is that by that time “inflation” (using the popular, albeit wrong, meaning of the word) was already dead. Commodity speculators just hadn’t realised it yet, perhaps because they were distracted by what was happening in the Middle East.

In the early 1980s, with a commodity bubble having recently burst and with both stocks and bonds having historically low valuations, the stage was set for the great ‘Volcker inflation’ to boost the prices of financial assets.

First Mining Finance Corp. is the new venture of Keith Neumeyer, the founder of First Quantum Minerals (FM.TO) and First Majestic Silver (FR.TO). I don’t yet have an opinion on the new company’s speculative/investment merits, because I haven’t yet taken a close look at its assets and because I won’t know its market valuation until after it IPOs sometime in the next couple of months (almost any company can be a good investment or a bad investment, depending on the market price of its shares). The reason I’m mentioning the company in this post is that I stole the following chart from its corporate presentation.

Regardless of whether or not the market ends up pricing First Mining Finance Corp. shares at an attractive level, the following chart of the TSX Venture Exchange Composite Index (a proxy for the junior end of the mining sector) suggests that junior Canadian resource shares are now collectively being priced at close to their most attractive levels ever. I didn’t expect that the buying opportunity would get this good, but there it is.

Large profits are likely to be made by speculators who accumulate financially-sound junior resource stocks with economic mineral deposits over the next few months and are prepared to hold for at least a year.

In finance, a “black swan” is a major event that ‘comes out of the blue’. In a 13th February article in the New York Times, Mark Spitznagel succinctly explains why a large stock market decline is coming to the US and why it won’t be a black swan.

The coming large stock market decline won’t be a black swan because, while its timing is unpredictable, the market’s valuation has reached a level that has always been the precursor to a large decline. This point is made in the above-linked article via a chart of Tobin’s Q Ratio (re-produced below), which is similar to a price-to-book ratio for the entire stock market. Since 1900, Tobin’s Q Ratio was only higher than its current level near the peak of the dot-com bubble.

More information on Tobin’s Q Ratio, including the following long-term chart comparison of the “inflation”-adjusted S&P Composite Index and the Q Ratio, can be found in Doug Short’s article posted HERE.

Why does the Q Ratio periodically get so far out of whack? After all, shouldn’t a market economy contain negative feedback that prevents such massive oscillations?

The answer is that we aren’t dealing with a free market; we are dealing with a market subject to intervention by non-market forces, chief among them over the past several decades being the central bank. As neatly explained by Mr. Spitznagel:

“When rates are naturally low, caused by an abundance of patient savers, businesses have the incentive to spend on investment and production; this creates a negative feedback on the ratio. When they are artificially low, and savers are impatiently leveraging, businesses instead have the incentive to spend on stock buybacks and dividends in order to attract the investors who yearn for yields beyond what the artificially distorted market is offering. This drives the ratio, and stock markets, ever higher. Bubbles are not natural and inevitable.”

Furthermore, it’s not as if the Q Ratio has somehow been skewed such that it is painting a far different picture from other value-based indicators with good long-term track records. For example, the message of the Q Ratio is echoed by the messages of the Shiller P/E ratio (the Cyclically-Adjusted P/E, or CAPE) and the Wilshire5000/GDP ratio, the latter of which is depicted below. Notice that the Wilshire5000/GDP ratio is now about 15% higher than it was at the 2007 major peak, although, like Tobin’s Q Ratio, it hasn’t made it back to the all-time high reached at the crescendo of the dot-com bubble.

The point is that nobody should be surprised when the next bear market in US equities turns out to be of historic proportions. But of course, almost everyone will be surprised.

One of the most persistent beliefs in the world of economics today is that the Fed’s QE (Quantitative Easing) adds to bank reserves but does not directly boost the US money supply. The popularity of this belief is remarkable considering that anyone who bothers to do a few simple monetary calculations will quickly see that it is completely wrong. The fact of the matter is that every dollar of QE adds one dollar to bank reserves AND one dollar to the economy-wide money supply.

Before I briefly explain the process by which the Fed’s QE injects money directly into the economy, I’ll show the simple calculations that anyone commenting on monetary matters should do. The calculations are based on the fact that new US dollars can only be legally created by the commercial banking system and the Fed.

The commercial banks create money when they make loans or monetise assets. More generally, commercial banks create money via an increase in credit. The increase in total Bank Credit over a period is therefore a rough, but reasonable, estimate of the MAXIMUM amount of new money that could have been created by the commercial banking system over the period. Note that changes in Bank Credit are recorded in the Fed’s H.8 Release.

At the end of August-2008, which was just prior to the start of the Fed’s first QE program, total Bank Credit was around $9T (9 trillion dollars). At the end of January this year it was around $11T. This means that the commercial banks have collectively created a maximum of 2 trillion new dollars since August-2008. They might have created significantly less than 2 trillion new dollars, but they have not created significantly more than that.

Let’s now consider what happened to US True Money Supply (TMS) over the same period, noting first that TMS is the sum of physical currency in circulation, demand deposits at private depository institutions and savings deposits at private depository institutions. TMS only counts money within the economy. It does not count bank reserves.

From the end of August-2008 through to the end of January-2015, TMS increased by $5.1T. Since we know that commercial banks created a maximum of $2T over this period, we know that at least $3.1T came from somewhere other than the commercial banking system. And since we also know that new US dollars can only be created by the commercial banks and the Fed, we therefore know that the Fed’s QE must have directly created a minimum of 3.1 trillion new dollars.

I’ll now move along to the process by which the Fed’s QE boosts the money supply.

The first point that must be understood is that the Fed conducts its asset purchases and sales via Primary Dealers (PDs). In many cases the PDs are banks, but in such cases the PD part of the business is separate. Of particular relevance, the PD part of one bank will maintain demand deposit accounts at other banks and these demand accounts receive the payments when the Fed buys assets from the PD.

Next, for the sake of explanation let’s assume that PDA (Primary Dealer A) is a subsidiary of Bank A and maintains a demand deposit at Bank B. When PDA sells assets to the Fed, the Fed deposits payment in the form of newly-created dollars into PDA’s demand account at Bank B. Since customer deposits are liabilities of banks, if the process ended with the Fed depositing new dollars in PDA’s account at Bank B it would increase Bank B’s liabilities by the amount of the deposit. To make the process balance-sheet-neutral for Bank B and the banking system as a whole, the same amount that was deposited in PDA’s demand account at Bank B is added to Bank B’s reserves at the Fed. In effect, the Fed adds dollars to demand accounts within the economy that are covered by reserves at the Fed.

One dollar of QE therefore involves one dollar being added to a demand deposit within the economy (part of the money supply) and one dollar being added to a reserve account at the Fed.

Let’s now take a look at how the mechanics of the QE process as outlined above explain the change in the money supply since the beginning of the Fed’s QE back in 2008.

I mentioned above that if we only consider the amount of money created by the commercial banks then we find that at least $3.1T is unaccounted for. If my analysis is correct then the Fed’s QE must have directly added a minimum of $3.1T to the money supply.

A very rough approximation of the amount of new money added by the Fed over a period is the change in Reserve Bank Credit, which can be determined by referring to the Fed’s H.4.1 Release. The increase in Reserve Bank Credit from August-2008 until January-2015 was $3.6T, which is in the right ballpark. However, a more accurate calculation of the amount of new money created by the Fed can be done using the knowledge that a) each new dollar added to the economy by the Fed will be associated with one dollar of additional reserves, and b) reserves at the Fed will remain at the Fed unless they are removed by the Fed or they are converted into physical notes/coins (in response to increased demand by the public for physical currency). The amount of money created by the Fed since August-2008 should therefore be equal to the net increase in Non-Borrowed Reserves at the Fed plus the increase in Physical Currency in Circulation over the same period.

The figure comes to $3.4T, which is roughly what it needs to be to explain the increase in True Money Supply.

A separate question is: Why hasn’t the large Fed-promoted increase in the US money supply led to a substantial increase in the ‘general price level’?

This is a question for another time as this post is already too long, but suffice to say right now that:

1) There has been a significant increase in the ‘general price level’ as a result of the monetary inflation, just not as significant as would normally be the case.

2) The general price level’s smaller-than-normal response to the money-supply increase of the past several years is probably related to the Fed’s abnormally-large role in the money-creation process. During more normal (pre-2008) times, almost all new money is created by the commercial banks. Consequently, the first receivers of the new money tend to be within the ‘general public’ (home buyers/sellers, private businesses, etc.). However, during the period since August-2008 about two-thirds of all new money has been directly created by the Fed. This means that the first receivers of most of the new money have been bond speculators, and that the second, third, fourth and fifth receivers of the new money have probably been bond speculators or stock speculators.

In conclusion, when I say that the Fed’s QE directly boosts the money supply I’m not stating an opinion or giving my interpretation of how the monetary system works. I’m stating a fact.