The main reason that monetary inflation (creating new money out of nothing) is an economic problem isn’t the effect it has on the economy-wide purchasing power of money. The general decline in money purchasing-power is very much a secondary negative. The primary negative revolves around the fact that new money does not get evenly spread throughout the economy. Instead, it gets injected at specific points, causing some people (the early recipients of the new money) to benefit at the expense of others and causing some prices to rise relative to others. One consequence is an undeserved transfer of wealth to the early recipients of the new money and another consequence is the falsification of price signals. I’ve discussed both of these consequences in detail in the past, but I have never homed-in on the question: Who gets the new money first?

The answer to the above question will depend on whether the new money is created by the private banks or the central bank, and in the case where the private banks are doing the bulk of the money-pumping it will vary from one cycle to the next. A comprehensive answer to the question would therefore require a lot more words than I want to use in this blog post, so rather than trying to cover all the possibilities I am narrowing-down the question to: Who gets the new money first when the Fed implements QE (Quantitative Easing)?

By the way, if you think that the Fed’s QE adds to bank reserves and doesn’t add to the total quantity of money available to be spent within the economy then you do not understand the mechanics of the QE process. An explanation of how the Fed’s QE creates money can be found HERE.

Since about 60% of the assets monetised in the Fed’s various QE programs were US government debt securities it could superficially appear that the government was the first receiver of most of the new money created by the Fed, but this was not actually the case. The government benefited from the Fed’s QE programs to the extent that these programs lowered the cost of debt*, but it’s unlikely that QE resulted in the government borrowing more than it would otherwise have borrowed. In other words, the amount of money borrowed by the government probably wouldn’t have been materially less if QE had never happened. It’s therefore more correct to view the government as an indirect beneficiary of the Fed’s QE rather than as an early receiver of the new money.

It helps to answer the question “who got the new money first in the Fed’s QE programs?” by re-wording it thusly: As a result of the Fed’s QE, who initially found themselves with a lot more money than would otherwise have been the case?

The answer is the group called “bond speculators”. This group comprises institutions and individuals, including banks, hedge funds and mutual funds, who invest in and trade large dollar-amounts of debt securities.

To explain, the government issued about $2.5T of debt that was purchased by the Fed with newly-created dollars. If not for the Fed, the issuing of this debt would have necessitated the transfer of $2.5T of money from “bond speculators” to the government. It is therefore fair to say that the Fed’s monetisation of Treasury debt left “bond speculators” with $2.5T of extra money. This money was naturally ‘invested’ in other financial assets, giving the prices of those assets a boost.

Under its QE programs the Fed also monetised (purchased with newly-created dollars) about $1.7T of mortgage-backed securities (MBSs). In this case the fact that “bond speculators” ended up with a lot of extra money is obvious, since the Fed replaced existing MBSs owned by “bond speculators” with cash created out of nothing.

In total, “bond speculators” found themselves with about 4.2 trillion additional dollars** courtesy of the Fed’s QE programs. The average productive salary-earner found himself with a negative real return on savings and negative real earnings growth courtesy of the same programs. And yet, Bernanke and Yellen appear to genuinely believe that the Fed’s actions were righteous.

    *The Fed’s debt monetisation not only lowered the interest rate on all new debt issued by the government, for the $2.5T of Treasury securities bought by the Fed the interest rate was effectively reduced to zero. This is because interest paid on government debt held by the Fed gets returned to the government.

    **Just to be clear, the Fed’s QE didn’t directly create $4.2T of additional wealth for “bond speculators”, since the Fed replaced bonds with money. Bond speculators initially had more money and less assets as the result of Fed asset monetisation, but the new money was a proverbial ‘hot potato’ and was quickly used to bid-up the prices of other bonds and financial assets.

The usual suspects made a big deal out of evidence that the banks involved in the London “gold fix” had used the ‘fixing’ process to clip unwarranted profits. As I explained last week, this evidence did not in any way support the claims that a grand price suppression scheme had been successfully conducted over a great many years, but unsurprisingly that’s exactly how it was presented in some quarters. Anyhow, the purpose of this post isn’t to rehash the reasons that manipulation related to the London “gold fix” could only have resulted in brief price distortions and definitely could not have been used to shift the directions of multi-month trends. Rather, the purpose is to marvel at the inconsistency of those who loudly and relentlessly complain that the gold market is dominated by the manipulative actions of a banking cartel.

The latest example of the inconsistency is the collective cheering by the aforementioned complainers of last week’s introduction of a twice-daily ‘gold fixing’ process in China. The “Yuan gold fix” will be implemented by a group of 18 banks (16 Chinese banks and 2 international banks) and will be subject to exactly the same conflicts of interest and abilities to clip unwarranted profits as the traditional London ‘gold fix’.

So, are we supposed to believe that manipulation of the gold price by Chinese banks would be perfectly fine, or are we supposed to believe that the average Chinese bank, which, by the way, has non-performing loans (NPLs) of greater than 20% but claims to have NPLs of less than 2%, is a paragon of virtue? It would be impossible for a rational and knowledgeable person to hold either of these beliefs, but those who regularly complain about gold-market manipulation by banks and also cheered the implementation of the “Yuan gold fix” must hold one of them.

At this time last year there was a lot of talk in the financial press about the huge US$ short position that was associated with the dollar-denominated debts racked up over many years in emerging-market countries. This debt-related short position supposedly guaranteed additional large gains for the Dollar Index over the ensuing 12 months. But now, with the Dollar Index having drifted sideways for 12 months and having had a downward bias for the past 5 months it is difficult to find any mention of the problematic US$ short position. Did the problem magically disappear? Did the problem never exist in the first place?

Fans of the US$ short position argument needn’t fret, because the argument will certainly make a comeback if the Dollar Index eventually breaks above the top of its drawn-out horizontal trading range. It will make a comeback regardless of whether or not it is valid, because it will have a ring of plausibility as long as the Dollar Index is rising.

I’m not saying that the argument for a stronger US$ driven by the foreign-debt-related US$ short position is invalid. I’m not saying it yet, anyway. The point I’m trying to make above is that if the argument was correct a year ago then it is just as correct today (since debt levels haven’t fallen) and should therefore be just as popular today. It is nowhere near as popular, though, because most fundamentals-based analysis is concocted to match the price action.

I actually view the “global US$ short position” as more of an effect than a cause of exchange-rate trends. Major currency-market trends are caused by differences in stock-market performance, real interest rates and monetary inflation rates. When these factors conspire to create a downward trend in the US dollar’s foreign exchange value it becomes increasingly attractive for people outside the US to borrow dollars. And when these factors subsequently conspire to create an upward trend in the US dollar’s foreign exchange value, debt repayment becomes more costly for anyone with US$-denominated debt outside the US.

So, if the Dollar Index resumes its upward trend later this year then anyone outside the US with hefty US$-denominated debt will have a problem, but the deteriorating collective financial position of these foreign US$ borrowers won’t be the cause of the dollar’s strength. It will just be a popular justification for the strength.

In general, fundamentals-based analysis will look correct and achieve popularity if it matches the price action, even if it is complete nonsense. A related point is that if fundamentals-based analysis is contrary to the recent price action then hardly anyone will believe it, irrespective of the supporting facts and logic.

It was reported last week that Deutsche Bank has settled lawsuits over allegations it manipulated gold and silver prices via the “London Fix“. This is not really news, in that experienced traders would already be aware that banks and other large-scale operators regularly attempt to shift prices one way or the other in most financial markets to benefit their own bottom-lines. I just wanted to point out that this “news” does not, in any way, shape or form, constitute evidence that there has been a successful long-term price suppression scheme in the gold and silver markets.

As far as I can tell, the banks that were involved in setting the twice-daily levels for the London gold and silver fixes had two ways of using or manipulating the ‘fix’ to generate profits. The first is that the participants in the fixing process were privy, for two very brief periods (10-15 minutes, on average) each day, to non-public supply-demand information, making it possible for them to obtain a very brief advantage in their own trading. For example, if the volume of gold being bid for was significantly greater than the volume being offered near the start of a particular day’s fixing process, a participant would know that the price was likely to rise over the ensuing few minutes and could enter a long position with the aim of exiting at around the time the ‘fix’ was announced.

The other way of using or manipulating the ‘fix’ to generate profits is more sinister, as it essentially involves the ‘fix’ participants stealing from their clients. I’m referring to the fact that although the ‘fix’ is primarily a market price, in that it is designed to reflect the bids and offers in the market at a point in time, the participating banks would have the ability to nudge the price in one direction or the other. Situations could arise where a participating bank could improve its bottom line at the expense of a client by influencing the ‘fix’ in a way that, for example, prevented an option held by the client from expiring in the money or allowing the bank to purchase gold from the client at a marginally lower price.

I don’t know that the participants in the London ‘fixing’ process sometimes used the process to increase their own profits at their clients’ expense, but I wouldn’t be the least bit surprised if they did. There was certainly a huge conflict of interest inherent in the way the ‘fix’ was conducted.

Anyhow, it’s important to understand that price distortions resulting from the ‘fix’ would have existed only briefly (for less the 20 minutes in all likelihood) and could not have affected the price trends of interest to anyone other than intra-day traders. In particular, there is simply no way that a multi-month price trend could have been shifted from bullish to bearish or bearish to bullish by manipulating the London gold or silver fix.