Thursday, May 11, 2006

Gold at $700 an Ounce - What Inflation?

This message reached my inbox today from Downside DC, a grass roots effort to hold Congress accountable to the laws they create.

"Gold reached $700 an ounce on Tuesday.
The media, being economically ignorant, mentions oil, Iran, and sunspots as possible causes.
We're just kidding about the sunspots. But it is important to note that no one in the media knows to mention an increasing money supply as the most likely cause of soaring gold prices.
However, the Federal Reserve, at least, must be concerned about an increase in the money supply because . . .
  • They raised the interest rates at which banks borrow from the Fed yesterday
  • They've stopped reporting M3, the best indicator of monetary inflation

We're not trained economists ourselves (though we did sleep at a Holiday Inn Express last night), so what follows is merely our layman's understanding. And if we're wrong, someone will surely correct us, and we'll let you know. But, as we understand it, there are two ways the Fed creates new money . . .

Method #1:
Banks borrow from the Fed using outstanding loans as collateral. The Fed issues an order to the Treasury, new money is printed, and loaned to the banks. The banks then loan out this new money to their customers. These new loans, in turn, can be used as collateral to borrow yet more money from the Fed. When the Fed thinks the money creation caused by this pyramiding of debt is moving too fast, they tend to raise their interest rate to the banks. This gives the banks less incentive to borrow from the Fed, which slows the bank portion of the inflationary spiral. This is what happened yesterday.

Method #2:
The Fed buys government bonds, and the Treasury prints new money to give to the Fed to finance these purchases. So this new currency stays at the Treasury, the Fed gets the bonds as so-called collateral to "back" the new currency, and the Treasury uses the new currency to pay the government's bills. (Yes, our currency is "backed" by debt, and not by real assets like gold.)
Eventually all of this new currency works its way through the entire economy bidding up prices for food and gas and everything else. Including the price of gold, which is the best hedge against inflation, because it is very scarce and has instrinsic value. So . . .

Gold hits $700, the Fed raises interest rates, and stops reporting M3. What does it all mean? It probably means the money supply is soaring and the Fed wants to slow the portion of it that goes through the private sector (the banks), but maintain the portion that is helping fund the government.

Why does the Fed want to maintain the monetary inflation that funds government? Simple . . .
Congress has two ways to fund its deficits. Borrow money or print it. Increased borrowing equals increased demand for money. Increased demand for money drives up the interest rate Congress pays to borrow. This increases the debt still further. The Treasury fights this by printing new money, using inflationary Method #2. But this lowers the value of the dollar. Big lenders, like China, respond by increasing interest rates to compensate for inflation. Either way, the government's interest expense is bound to soar as long as deficits continue to mount.
The Fed is trying to hide this for as long as possible by not reporting M3. Problem is, the gold price gives them away.

The price of gold does not lie. But it is a late indicator.

And you can bet that gold is also being bid up right now because investors no longer have M3 to give them advance warning of monetary inflation. They're hedging. And all of this is very destabilizing.

The best way to stop this viscious cycle is to return to sound money -- dollars backed by gold reserves so that new dollars can only be created as fast as the gold supply increases, which is always very, very slow. Barring that, we can gain some increased stability by making the Fed report M3 again. This could be very important to your economic well-being, which is why we keep harping on it. Congressman Ron Paul has a bill that will do this, and we need to keep hammering on Congress to pass this bill. Hit them again! You can do so here.

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