In a typical commodity market the traders known as “commercials” are usually hedging their exposure to the physical commodity when they buy or sell futures contracts. For example, in the oil market the most important “commercials” include oil producers, who are naturally ‘long’ the physical commodity and often sell futures contracts to hedge this exposure, and manufacturers of oil-based products, who are effectively ‘short’ the physical commodity (by virtue of the fact that oil is one of their biggest costs) and often buy futures contracts to hedge this exposure. However, the gold market is different.

Some of the commercial traders operating in the gold market are traditional hedgers. Mining companies and jewellery manufacturers, for example. But given that the existing aboveground stock of gold dwarfs the annual supply of new gold and that the amount of gold that changes hands for store-of-value, investment and speculative purposes dwarfs the amount of gold bought/sold for more traditional commercial uses such as fashion jewellery and electronics, a reasonable and knowledgeable person would expect that traditional commercial traders would play a relatively small role in the gold market. A reasonable and knowledgeable person would be right.

In the gold market the dominant commercials are not traditional hedgers. They are also not speculators, in that they rarely take positions that rely on the gold price moving in a particular direction. They are spread traders, meaning that they make their profits by trading the differences in price between the physical and futures markets.

For example, if speculative buying of gold futures causes the futures price to rise relative to the spot price by a sufficient amount it will create an essentially risk-free arbitrage opportunity for a commercial to sell the futures and buy the physical, and if speculative selling of gold futures causes the futures price to fall relative to the spot price by a sufficient amount it will create an essentially risk-free arbitrage opportunity for a commercial to buy the futures and sell the physical. For another example, if gold buying by hoarders of physical gold causes the cash (physical) price to rise relative to the futures price by a sufficient amount it will create an essentially risk-free arbitrage opportunity for a commercial to sell the physical and buy the futures, and if the ‘dishoarding’ of physical gold causes the cash (physical) price to fall relative to the futures price by a sufficient amount it will create an essentially risk-free arbitrage opportunity for a commercial to buy the physical and sell the futures. In other words, commercial trading in the gold market is mostly about arbitrage.

The difference between commercial trading in the gold market and commercial trading in all other commodity markets is tied to gold’s long history as money. Strangely, many gold ‘experts’ assert that gold is different due to its dominant monetary and store-of-value roles, but then insist on applying a traditional commodity-style method of supply-demand analysis. Unsurprisingly, the result is a pile of hogwash.

The following charts relate to comments on the gold and silver markets that will be emailed to TSI subscribers later today.

Way back in early-2009 and again in mid-2012 I wrote in TSI commentaries that if the story unfolded as I expected then a lot of future economic commentary would begin with the word “despite”, and that in most cases the commentary would be a lot closer to the truth if “despite” were replaced with “because of”. For example, a comment along the lines of “despite the huge monetary stimulus the economy remains weak” would be closer to the truth if it read “because of the huge monetary stimulus the economy remains weak.”

My 2009 assessment remains applicable in that most commentators still don’t get it and still use “despite” when they should be using “because of”. They still don’t realise that pumping money into the economy falsifies prices (including the price of credit, the most important price of all) in ways that make the economy less, not more, efficient. The reality is that the more the central bank tries to stimulate the economy via ‘loose’ money, the more it will HINDER economic progress.

A sensible way to use the word “despite” is in reference to plans for future stimulus. For example, it could reasonably be said that DESPITE the lack of logical support for creating money out of nothing and the evidence that previous QE programs did not help, it’s a near certainty that the Fed will introduce a new monetisation program if the economy gets much weaker. It could also be said that the US economy’s only hope is that the remnants of capitalism are strong enough to generate sustained improvement DESPITE the price distortions caused by the Fed.

This post is a slightly-modified excerpt from a recent TSI commentary.

The Federal Reserve has monetised a few trillion dollars of bonds over the past seven years without creating much in the way of what most people call “inflation” (a rise in the general price level). How could this happen?

One popular explanation is that the Fed’s Quantitative Easing (QE) adds to bank reserves, but not the economy-wide money supply. According to this line of thinking, the ‘money’ created by the Fed to purchase bonds remains trapped in reserve accounts at the Fed. However, this explanation can be immediately eliminated, because as previously explained every dollar of QE adds one dollar to bank reserves at the Fed AND one dollar to demand deposits within the economy. The fact is that the economy-wide money supply is now a few trillion dollars larger thanks to the Fed’s QE.

A second explanation is that QE isn’t “inflationary” because it involves the exchange of one cash-like instrument for another. This explanation can also be immediately eliminated due to the fact that it mistakenly conflates two very different things — money and debt securities. If you don’t understand the difference, try buying something with a T-Bill. You should then understand. Also, more information on this particular issue can be found in my 9th May post at the TSI Blog.

As an aside, QE is not only NOT an exchange of one cash-like instrument for another, it involves increasing the amount of cash in the financial system and simultaneously decreasing the amount of financial assets that can be bought with cash. That is, it results in more cash ‘chasing’ fewer assets.

A third explanation is that the increase in the money supply stemming from the Fed’s QE has been offset, in terms of effect on the general price level, by a decrease in the velocity of money. This is yet another explanation that can be eliminated, because changes in “money velocity” never explain anything. The reason is that money velocity (V) is nothing more than a fudge factor that makes one side of the tautological and practically-useless equation of exchange (MV = PQ) equal to the other side. It exists in academia, but not in the real world. For more information on the irrelevance of money velocity, refer to my 10th June post at the TSI Blog.

Having eliminated three of the fatally-flawed explanations for why the Fed’s gargantuan QE hasn’t yet led to problematical “price inflation”, I’ll now provide two explanations that make some sense.

First, for decades prior to 2008 almost all of the US economy’s new money was created by commercial banks (commercial banks can loan new money into existence and they can also monetise securities). As a result, the first receivers of the new money tended to be within the ‘general public’ (home buyers/sellers, private businesses, etc.). However, since August-2008 almost 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 were bond speculators, and that the second, third, fourth and fifth receivers of the new money were probably bond speculators or stock speculators. In other words, rather than being trapped in reserve accounts at the Fed as some people have mistakenly asserted, it is likely that a lot of the new money has effectively been trapped within the financial markets. It will eventually leak out into the ‘real’ economy, but due to the way the money was created/injected there has been a much longer-than-usual delay between the money creation and the inevitable effects on everyday prices.

Second, it’s important to understand that even if it were possible to come up with a single number that reliably reflected the actual change in the economy-wide purchasing-power (PP) of money, this number would not tell us the “inflationary” effect of a change in the money supply. The reason is that to know the effect on money PP of a change in the money supply you have to know what would have happened to PP in the absence of the money-supply change.

For example, let’s assume for the sake of argument that there is a consumer price index (CPI) that reliably indicates the change in the general price level. In our hypothetical example, the CPI would have fallen by 10% over a certain period, but due to money-pumping by the central bank the CPI increases by 2%. In this case the “inflationary” effect of the central bank’s money-pumping is not a 2% increase in the CPI, it is a 12% increase in the CPI (the difference between what happened and what would have happened).

Taking into account the high private-sector debt levels that existed in 2008 and have persisted to this day, it is not hard to imagine that in the absence of the Fed’s money creation there would have been a sizable decline in the CPI rather than a moderate increase. The “inflation” caused by the Fed’s QE is the difference between the decline in the general price level that would have happened and the rise in the general price level that did happen.

In conclusion, there are two main contributors to the lacklustre performance of the “general price level” over the past few years. First, unlike in earlier cycles a lot of the money created during the current cycle was injected directly into the financial markets. Second, it’s likely that there would have been significant “price deflation” in the absence of the money-pumping.

One of the interesting aspects of the financial newsletter business is that an incorrect prediction of a market crash will probably drum-up a lot more new business than a correct prediction that there won’t be a crash. Hence, the never-ending popularity of crash-forecasting, despite the fact that such forecasts almost never pan out.

From the perspective of a newsletter writer or any other commentator on the financial markets, the best thing about forecasting a crash is the massively asymmetric reward-risk associated with it. If the market doesn’t crash this year, when it was supposed to according to your original forecast, then you can just say that the event has been delayed and will happen next year instead. You don’t have much to lose because people will soon forget the failed prediction and focus on the next prediction. And if it doesn’t happen next year, then just repeat the process because eventually the market will crash and your amazing prescience will be there for all to see. Furthermore, after you correctly predict a crash there will be thousands of people eager to find out your next big prediction and buy your newsletter/book. In other words, from the forecaster’s perspective the downside of making an incorrect crash forecast is trivial compared to the upside of making a correct crash forecast.

The point is that regardless of how many times you forecast a crash that never happens, you will only have to get lucky once and you will be set for life. From then on you can promote yourself, and be introduced in interviews, as the person who predicted the great crash of XXXX (insert year). From then on a large herd of ‘investors’ will hang on your every word and rush to buy your advice whenever your next big forecast hits the wires.

Having seen how the process works, I’m officially entering the crash forecasting business. My inaugural forecast is for the US stock market to crash during September-October of 2016.

My forecast isn’t a completely random guess, for four reasons. First, stock-market crashes have a habit of occurring in September-October. Second, the two most likely times for the stock market to crash are during the two months following a bull market peak and in the year after a bull market peak (that is, roughly a year into a new bear market). The 1929 and 1987 crashes are examples of the former, while the 1974 and 2008 crashes are examples of the latter. The current situation is that either 1) a bear market began a few months ago, in which case the opportunity to crash during the two months following the bull market peak was missed and the next opportunity will arrive during the second half of 2016, or 2) the bull market is intact, in which case a major peak is likely during the second half of next year. Third, market valuation is high enough to support an unusually-large price decline. Fourth, interest rates are likely to have an upward bias over the next 12 months.

A few months from now a lot of commentators on the financial markets will be forecasting a crash for September-October 2016. If/when the crash happens, remember that you read about it here first and be ready to pay a much higher price (higher than zero, that is) for my next big prediction.

Just once I’d like to read a negative critique of “Austrian” economics from someone who actually understands it, but up until now every piece of criticism I’ve come across has contained basic misunderstandings of what this school of economics is about. The latest example is a 6th November blog post by Martin Armstrong.

According to the beliefs expressed by Mr. Armstrong in the above-linked blog post, Austrian Economics informs us that “fiat” money causes the business cycle and that the business cycle began with the Industrial Revolution. Both of these beliefs are completely wrong. Austrian Economics does not say that the business cycle is caused by fiat money and it does not say that the business cycle began with the Industrial Revolution.

Austrian Economics informs us that the business cycle is caused by large increases in the supply of money that create the impression that there are more real savings in the economy than is actually the case. Over the past few centuries the dominant cause of these large money-supply increases in the most developed economies was “fractional reserve banking”, a practice that effectively began with goldsmiths issuing more receipts for gold than they had actual gold in their vaults. However, “Austrian Business Cycle Theory” does not revolve around the specific method via which the monetary inflation occurs. A king debasing the coinage or issuing large quantities of paper money could potentially have a similar effect to goldsmiths issuing unbacked receipts for gold or an economy being flooded with gold — in the days when gold was money — due to successful foreign conquest (e.g. Spain and the Conquistadors in the 1500s) or commercial banks lending new money into existence or modern central banks implementing QE.

As to the other of Mr. Armstrong’s aforementioned beliefs, anyone who has gone to the trouble of researching Austrian Economics would know that “Austrian” economists have analysed the monetary and economic developments that occurred throughout history. As a good economic theory should, Austrian Economics works in all circumstances. It works regardless of whether we are dealing with a large modern city, a small village, a man alone on an island, a free economy, a command economy, an economy that uses paper money, an economy that uses tangible money, a robust economy, an economy immersed in depression, and so on.

Towards the end of his post Mr. Armstrong makes two assertions that aren’t specifically related to Austrian Economics, but warrant clarification.

First, he writes:

“…tangible money must have a “use” other than money. Gold and silver were prized objects but had no utilitarian “use” value outside of jewelry. Gold was desirable but was not a vital commodity that served a purpose beyond its prized status like art. Therefore, numerous monetary systems have existed that were not gold based since the medium of exchange had to have a “use” value other than as money.”

The fact is that many things have been used as money throughout the ages, but the more advanced economies ended up gravitating towards gold and/or silver. One reason is that for an item to become money in a large and mostly-free economy it must have a use other than money, but the non-monetary demand for the item will ideally be very small — to the point of being trivial — relative to the monetary demand. Otherwise, changes in non-monetary demand could cause large and unpredictable swings in the purchasing-power of money. That’s why if markets were free to choose they would almost certainly not choose platinum as money, even though platinum has similar physical attributes to gold.

Second, he writes:

“Money is not a store of value; it is a medium of exchange. In that case, it is merely an agreed upon medium to supplant barter.”

This is mostly correct. However, if an item isn’t widely perceived to be a good store of value then in a free market it won’t generally be accepted as a medium of exchange and therefore won’t be money.

There are two general reasons for a trader with an intermediate-term or a long-term time horizon to sell a stock during a period of strength. The first encompasses the situations where the stock has reached the trader’s price target, or has become stretched to the upside in valuation terms, or has reached a price level at which the intermediate-term risk/reward is no longer favourable. When a stock is in such a position it offers what I call an “objective selling opportunity”. The second general reason is that even though a stock is not yet fully valued and is still well below the trader’s intermediate-term target, selling makes sense based on personal money-management considerations. I call this a “subjective selling opportunity”.

Many of the stocks I own and also many of the stocks I cover in the TSI newsletter are in the gold-mining sector. For these stocks, objective selling opportunities have been as scarce as hen’s teeth over the past 2.5 years. However, over this period there have, from my perspective, been many subjective selling opportunities. Most recently, the September-October rally created several such selling opportunities.

I can’t identify subjective selling opportunities for my readers as these opportunities are, by definition, determined by each individual’s financial position. However, what I can do is note when TSI stocks are becoming ‘overbought’ or nearing resistance that could limit the short-term upside. I can also (and do also) note when I’m taking some of my own money off the table.

Due to the nature of modern money, it would technically be possible to adjust the way the monetary system works such that governments directly print all the money they need. If this change were made then there would be no requirement for the government to ever again borrow money or collect taxes. This would have an obvious benefit, because it would result in the dismantling of the massive government apparatus that has evolved to not only collect taxes but to monitor almost all financial transactions in an effort to ensure that tax collection is maximised. In other words, it would potentially result in greater freedom without the need to cut back on the ‘nanny-state services’ that so many people have come to rely on. So, why isn’t such a change under serious consideration?

The answer is that it would expose the true nature of modern money for all to see, leading to a collapse in demand for the official money. Taxation, you see, isn’t just a method of forcibly diverting wealth to the government; it is also an indispensable way in which demand for the official money is maintained and modulated.

Think of it this way: If the government were to announce that in the future there would be no taxation and that it would simply print all the money it needed, there might initially be a great celebration; however, it probably wouldn’t take long for the average person to wonder why he/she should work hard to earn something that the government can create in unlimited amounts at no cost. People would become increasingly eager to exchange money for tangible items, causing prices to rise. The faster that prices rose due to the general decline in the desire to hold money, the faster the government would have to print new money to pay its expenses. With no taxation and no government borrowing, there would be no way for the government to stop an inflationary spiral once it was set in motion.

One of the best historical examples of how taxation creates demand for money is the use of “tally sticks” in England from the 1100s through to the 1600s. In this case, essentially worthless pieces of wood were converted into valuable money by the fact that these pieces of wood could be used to pay taxes. Moreover, once taxation had created demand for the sticks, the government was able to fund itself by issuing additional sticks. A summary of the tally stick story can be read HERE.

Money can currently be created out of nothing by commercial banks and central banks, but hardly anyone understands the process. Also, many economists and so-called experts on monetary matters who understand how commercial banks create money are either clueless about the mechanics of central-bank quantitative easing (they wrongly believe that QE adds to bank reserves but doesn’t add to the economy-wide supply of money) or labouring under the false belief that money and debt are the same. The ones who wrongly conflate money and debt tend to wrongly perceive QE as a non-inflationary swap of one “cash-like” asset for another.

The point is that under the current system there is great confusion, even in the minds of people who should know better, regarding how the monetary system works. The combination of taxation and the general lack of knowledge about how money comes into existence helps support the demand for money.

Simplify the process by having the government directly print all the money it needs and the demand for money would collapse. That, in essence, is why taxation must continue.

In a recent article Mike Shedlock (Mish) weighs in on the question of whether or not gold is money. Near the end of the article he concludes: “The only possible debate about whether or not gold is money pertains to the phrase “demanded mainly as a medium of exchange”.” That’s totally correct, which is why it is not correct to say that gold is money. However, earlier in the same article Mish seems to argue that gold has again become money thanks to the advent of BitGold. As discussed below, this makes no sense.

There are two major problems with the argument that the advent of BitGold means that gold is now (once again) money. The first and more important is that the BitGold system comprises only a miniscule fraction of the total gold supply, so in no way does it result in gold being “demanded mainly as a medium of exchange”.

The second problem is that the BitGold debit card does not involve using gold as money. When someone uses such a card to buy something, the merchant doesn’t receive gold in exchange for goods/services. What happens is that some of the gold in the cardholder’s account is sold to obtain “money”, which is then transferred to the merchant. In this respect, paying for something using a BitGold debit card is similar to paying for something by writing a cheque on a Money-Market Fund (MMF). When you pay using a MMF cheque (check, if you are American), the receiver of the cheque doesn’t end up with MMF units. What happens is that the MMF sells some of its assets to obtain the “money” needed to complete the transaction. That’s why MMFs should not be counted in the money supply. They are investments in securities, not money.

Moving on, it’s important to understand that money isn’t just ‘a’ medium of exchange. At any given time in any economy, many things will be occasionally used as media of exchange, that is, as currencies. Take Frequent Flyer Miles as an example. Frequent Flyer Miles are sometimes used as a medium of exchange. In fact, in most developed economies they are used more commonly than gold as a medium of exchange. However, nobody is seriously claiming that Frequent Flyer Miles are money. Cigarettes are another example. Cigarettes are used as mediums of exchange in some prisons, but cigarettes obviously aren’t economy-wide “money” and nobody (as far as we know) is seriously claiming otherwise. Clearly, then, sometimes being used as ‘a’ medium of exchange is not the same as being money.

Money is not simply A medium of exchange (a currency), it is THE medium of exchange used in the vast majority of economic transactions (a very commonly-used currency throughout the economy).

The final word goes to Ludwig von Mises, the greatest economist of the 20th Century. It was Mises who, from beyond the grave via his writings, convinced me many years ago that gold is no longer money*. Here is Mises from his book “The Theory of Money and Credit“:

“The balancing of production and consumption takes place in the market, where the different producers meet to exchange goods and services by bargaining together. The function of money is to facilitate the business of the market by acting as a common medium of exchange.”

And for those people who harp on about “store of value” as if it were the dominant characteristic of money:

“The simple statement, that money is a commodity whose economic function is to facilitate the interchange of goods and services, does not satisfy those writers who are interested rather in the accumulation of material than in the increase of knowledge. Many investigators imagine that insufficient attention is devoted to the remarkable part played by money in economic life if it is merely credited with the function of being a medium of exchange; they do not think that due regard has been paid to the significance of money until they have enumerated half a dozen further ‘functions’ — as if, in an economic order founded on the exchange of goods, there could be a more important function than that of the common medium of exchange.”

And here is Mises from his book “Human Action“:

“The theory of money was and is always the theory of indirect exchange and of the medium of exchange.”

 

[*Like many of the people who responded negatively to my "Gold Is Not Money" articles, once upon a time I also laboured under the misconception that gold was money.]

A recent Bloomberg article notes that household leverage in Australia is now almost twice the developed-market average. Specifically, the article states that Australia’s household debt as a proportion of gross domestic product has risen to a record 134 percent, the highest among 36 developed- and emerging-market nations analysed by Barclays. This compares to a developed-market average of about 74 percent.

The article contains the following chart, which suggests that the easy-money policy of the country’s central bank is driving the housing-finance binge.

This is not going to end well.