Why Gold Is Set To Soar: Money Supply, Fractional Reserve Banking, A Global Recession

By: Mr. DeepValue

 

- The creation of global money supply will lead to an aggregate reduction in the value of global currencies relative to gold in the long-term.

- The rise of the fractional reserve banking system as a model for the majority of established central banks will continue to exacerbate the money supply problem.

- Gold's value to global currencies will continue to appreciate with global monetary stimulus measures on the rise.

- The relative values of global currencies are driven by macroeconomic principles such as money supply, and this discussion deserves more attention.

 
This article takes a very broad but in-depth look at some of the major macroeconomic issues the global financial system is currently facing. We will discuss specific key elements of the global economy which are often under-reported in mainstream media. We hope this article will prompt a more in-depth discussion of these important issues. The primary focal points are: (1) the creation of global money supply; (2) the rise of fractional reserve banking; (3) the relative position of gold and other measures of value; and (4) the link between global money supply creation and the relative value of global currencies.
 
I agree that long-term investment should be the primary "pillar" of a well-executed investment strategy, however I also think holding gold in a portfolio is a very prudent strategy. I have over 15% of my portfolio in gold right now (via ETFs and mining companies) and am considering adding to the position for the reasons discussed in this article.
 
The Creation of Global Money Supply
 
The Fed's own self-proclaimed purpose is to provide liquidity in times of financial disasters. To put that in plain English, if the financial system or banking system is at risk of either a run on the banks, or a run on the stock market, the Fed is there to step in and create money supply ("print money") or prop the stock market up by buying securities (the first is known as "adding liquidity" and the second is known as "quantitative easing").

It is true that from a pure macro-economic perspective, the exorbitant amount of "money printing" or money supply creation that has been undertaken by the world's central banks via negative interest rates, quantitative easing, bond repurchases, outright money printing, and other stimulus measures will lead to the aggregate depreciation of currency in general, and holding gold constant, the price of gold relative to currency should increase over time, regardless of how the stock market performs.
 
The Fractional Reserve Banking System
 
Most people don't know how money is actually made. The amount of actual physical currency floating around in the world is relatively constant, and money does not actually get printed by massive printing presses and dropped out of helicopters.
 
I encourage all who are interested in this topic to review the literature on the fractional reserve banking system and the creation of "money" (actually debt) by banks. Central banks increase money supply through the fractional reserve banking system - the requirement for banks to only hold some fraction (traditionally 1/9) of cash reserves on its books at any given time. The result is banks are able to lend money they don't have, meaning banks are given the authority to lend (create money) at a rate of approximately 9x the cash they have on hand at any given time.
 
The multiplier effect of government purchases of bonds from the large U.S. banks forms a "trickle down" effect where a bank lends 9x its capital reserves (money received from the government via receiving cash for government bonds), and the consumer who borrowed the money goes and take the money (debt) to buy something else, which results in money being deposited by the business who sold the goods to the consumer into another bank, and that bank lends out 9x more based on the cash reserves provided by the deposit, and so on. The end result is that the total amount of money supply floating around in the economy is significantly higher than the actual amount of physical currency in existence.

An example using a more conservative ratio of 1/5 would result in a multiplier effect of approximately 400%. That is, for every $100 deposited into bank coffers, banks are able to lend out $500 to consumers, creating an additional $400 in money that did not previously exist. 
 

The fractional reserve banking system relies on the basic principle that only a fraction of the money lent out by banks needs to be on hand at a given time, as the chance that a high percentage of depositors will all ask for their deposits at the same time is very low. Holding only a fraction of all deposits on hand at any given time has been proven to pose risks such as "runs" on the banking sector, which was experienced during the Great Depression. The removal of the gold standard and the subsequent rise of paper money as a substitute has allowed the Fed to go beyond its mandate of providing liquidity in serious financial depressions to providing liquidity to boost growth, growing the money supply at a much faster rate than the output of goods in the economy. We will discuss why this has not led to massive inflation later.
 
The Relative Value of Gold and Other Measures of Value
 
Gold is not a productive asset. It is not a farm that produces a yield or a business that produces cash flows from selling goods.
 
Gold is, however, an item of value which is able to be easily traded and is scarce. The big difference between gold and paper currency is that there is a relatively fixed amount of gold in the world relative to paper money which can be created out of thin air (note: the amount of gold mined each year as a percentage of the total amount existing is very small, and for the purposes of discussion, let's hold it fixed. Compared to the amount of money supply that is created each year, the growth rate of gold production is negligible).

Gold, silver, precious metals, collectibles, or anything that is deemed to have value and is somewhat scarce, will (according to macroeconomic fundamentals) increase in value relative to currency in times of money supply creation.
 
The rise and drop in the price of gold is thus linked more directly to money supply, and less to a "financial disaster" or "crash" although both scenarios are likely to result in additional money supply, so in an indirect way, the logic holds.
 
The mainstream media often talks far too much about "doomsday" scenarios, and less about the fundamentals behind gold. Headlines such as "the world is about to end" garner far more attention than "increased money supply will lead to an increase in the price of gold."
 
The Link Between Global Money Supply Creation and The Relative Value of Global Currencies
 
Another often unreported fact is that the rise of the U.S. dollar relative to world currencies is directly linked to the increased money supply of other large economic areas (such as the EU and Japan) who are increasing money supply at a faster rate than other economic zones such as the U.S.
 
Money from the EU and Japan, among other areas, is flowing into the U.S. at a rapid rate, reflective of low (or negative) growth rates in these economic regions. Thus, the rise in the U.S. dollar is a function of global (non-U.S. money supply), and is not a result of the U.S. dollar simply being the "king of all currencies." Headlines such as "the U.S. dollar is the kind of currencies" should read something more akin to "capital outflows from the rest of the world due to money supply creation is leading to an artificial rise in the U.S. dollar", although a headline such as this likely wouldn't make it to print.
 
It should be noted that any temporary rises in the value of foreign currencies after an announcement of increased money supply creation, such as the recent announcement by the ECB, are a reaction of the market to perceived "stability" arising from these monetary stimulus measures, however the long-run principles of supply and demand will eventually lead to further depreciation in such currencies based on macroeconomic principles. That said, if the money supply of other regions of the world increase at a faster pace than the Eurozone, for example, fundamental macroeconomic principles such as supply and demand would actually lead to a higher euro relative to a basket of world currencies.
Conclusión
 
The EU and Japan are currently two of the biggest culprits adding to the increased global money supply, and further speculation of increased "stimulus" (actually, debt creation) is the one of the only things driving the current global growth rate. In real terms, taking money supply creation out of the picture, we are already in a global financial crisis.

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