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.

A few days ago the web site energyandgold.com published an interesting interview with Bob Moriarty. The interview is titled “Gold Bottom in, New Bull Market Will Make 2008-2011 Look Tame“, because that’s Bob’s outlook. Bob says a few nice words about me in the interview, but you shouldn’t hold that against him. He’s an astute observer of the markets.

I think Bob’s outlook is plausible, but I’m not expecting anywhere near as much upside in gold-related investments this year as he is. The rebounds from the 2008 bottoms in gold and gold-mining stocks were very quick, but that’s primarily because 2008 was a crash within a continuing cyclical bull market. It wasn’t a cyclical bear market.

The speed with which gold and the mining stocks recover from their 2011-2014 drubbings will be determined by both fundamentals and psychology. Even if the fundamentals become unequivocally gold-bullish in the near future (they are currently either mixed or slightly bullish), history tells me that it could still be at least 12 months before a strong upward trend gets underway. For example, gold’s fundamentals were as bullish as they ever get in early-2001, but the bull market didn’t really get going until 2002.

However, it’s certainly possible that the sentiment shift will happen faster this time around, because the current situation is so far into unprecedented territory that the historical precedents can’t even be seen from here. The mal-investment fostered by central banks over the past several years is simply mindboggling.

For example, the fact that trillions of dollars of government bonds now trade at negative yields reflects mal-investment on a gigantic scale. It means that a huge quantity of wealth has been diverted towards bond speculation and government.

For another example, US corporations have spent hundreds of billions of dollars buying back their own shares instead of investing in business growth. This is a consequence of the perverted incentives created by the Fed.

So, I’m not betting on a rapid change of fortune for gold-related investments, but I can’t rule it out.

Over the most recent Christmas and New Year holiday period, one of the places I visited (with wife and 15-year-old son) was Siem Reap in Cambodia. The town of Siem Reap is best known for, and is a popular tourist destination largely because of, its close proximity to the ruins of Angkor, the capital of Cambodia during the Khmer Empire (9th to 15th Century). Angkor contains the — in some cases largely intact or restored — remnants of some huge temples, including Angkor Wat. However, if (like me) you quickly get bored with temple viewing, Siem Reap is still worth visiting. The town is so vibrant and friendly, with so many interesting eating/drinking places, shops and markets, that I actually wouldn’t mind living there. But the purpose of this post isn’t to discuss the things to see and do in Siem Reap, it’s to discuss some economics-related observations I made while visiting that part of the world.

On arriving at the Siem Reap airport and spending about one hour making our way through the chaotic immigration section I was finally at the document-checking counter, where I had all five digits on both hands scanned for prints. After completing the tedious finger-scanning process I offered to provide a urine sample, but apparently it wasn’t necessary. I thought about giving it to them anyway, but then thought better of it.

What a totally counterproductive exercise in a place that is heavily reliant on tourism! Fortunately, it turned out that the airport was the only bad experience we had in Siem Reap. Not coincidentally, the airport is one of the few parts of the town that is totally controlled by the government. The government, by the way, claims to be democratically elected, but in reality Cambodia is a one-party state headed by a former member of the Khmer Rouge.

The main reason to bring up the airport experience isn’t to complain about the ridiculous security measures and the general inefficiency of the place, it’s because this is where I made the novice mistake of exchanging some US dollars for the local currency, known as the Riel. I didn’t convert much money, thinking that the airport exchange rate would be unattractive, but I shouldn’t have converted any. The reason is that everyone in Siem Reap prefers to deal in US dollars. To put it more accurately, they prefer US dollars to the Riel when receiving payment, although they are happy to give you change in Riel. So, in Siem Reap and perhaps all of Cambodia there are two monies: the money generally perceived to be good (the US$) and the money generally perceived to be not so good (the Riel). This leads me to Gresham’s Law. Cambodia is a good example of why the popular understanding of Gresham’s Law, although it might seem reasonable at first or even second glance, often doesn’t apply in practice.

The popular adaptation of Gresham’s Law is: bad money drives out good. This concept seems to make sense, because people will naturally prefer to hoard the good money and part with the bad money when buying things. However, it generally doesn’t work that way in practice because people will naturally prefer to receive the good money when selling things, so for a trade to take place it will often be necessary for the buyer to offer the good money.

That’s the popular understanding of Gresham’s Law, but the actual principle is: “When a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation.” That is, Gresham’s Law really only applies in the specific case where there are two equally acceptable types of money and the government fixes the exchange rate between the two. The classic example — and the most relevant example for hundreds of years prior to the last century — is where gold and silver are the most common media of exchange in an economy and the government fixes the gold/silver ratio too high or too low. Actually, even if the ratio is initially set at roughly the right level, changes in the supply of and the demand for the two metals over time will eventually result in one becoming over-valued relative to the other at the official exchange rate. This will lead to the relatively expensive (that is, over-valued) commodity being used progressively more in trade and the relatively cheap (that is, under-valued) commodity being progressively removed from circulation.

In Siem Reap the two types of money aren’t equally acceptable, and although there is an official exchange rate it seemed that people were generally able to trade at whatever rate they deemed appropriate. Consequently, the “bad money” is not driving out the “good money”. On the contrary, the “good money” is thriving as a medium of exchange.

My final Cambodia note is about corruption. Most people believe that all corruption is bad, but in terms of effect on the economy there is both good and bad corruption.

Good corruption is when a government regulation, that for no sensible reason makes it much more difficult for businesses to provide the service that their customers want, can be cheaply ‘got around’ by slipping some money into the pocket of a government rep. In other words, good corruption greases the wheels of commerce. It shouldn’t be required, but in the real world the government puts many unnecessary obstacles in the way of voluntary exchange. An example of good corruption is covered in Jeffrey Tucker’s article about former Washington D.C. mayor Marion Barry.

Bad corruption is when representatives of the government greatly increase the cost of doing business for the purpose of enriching themselves. It is Mafia-style extortion that puts additional obstacles in the way of voluntary exchange.

In Cambodia I saw examples of bad corruption that I suspect are just the tip of the iceberg. In particular, although the town of Siem Reap is a little chaotic (in a good way), it seems that a government licence is required for almost everything. Even setting up a stall selling fried grasshoppers by the side of the road well outside the main town requires a licence. This is not necessarily a big deal by itself, but I found out about cases where the requirement to get a licence made the cost of going into business prohibitive due to the amount of money that has to be paid ‘under the table’ in addition to the official licence fee. For example, I was told that to become a travel agent you must get a licence and to get the licence you must first pass an exam, but that regardless of how well you do in the exam you will not be given a passing grade unless you pay a relatively large bribe to the government-appointed examiner. This is bad corruption. Good corruption would entail slipping a small sum of money to someone to avoid the silly requirement of having to sit the exam.

In conclusion, Siem Reap is a part of the world where good and bad money openly compete, which is the way it should be. It is a great place to visit and perhaps even to live for a while, but I get the impression that it wouldn’t be a great place to set up a business.