Many would agree that strong monetary expansions often lead to weak paper currencies, but the evidence is mixed. The reason may be because money supply is usually treated as a generic concept, from base money, notes and coin, gold and other commodity monies.
To really understand modern financial systems, we must acknowledge that they are based on many competing types of money - ie ‘liquidity’ - most of which are privately created.
Take the repo and shadow banking markets, otherwise known as wholesale lending, which increasingly drive the world economy. These are heavily concentrated in different private monies. The ‘value’ of these private monies can fluctuate significantly. To understand capital and credit flows, we need to focus on the changing qualities of these different monies.
In our work, we split out central bank liquidity from private sector liquidity. As central banks increase the supply of a currency, it inevitably leads to devaluation. However, private sector money can have the opposite effect.
Herein lies the simple truth that printing money devalues currencies.
On the other hand, increasing private sector liquidity likely signals stronger economic growth, expanding credit and rising industrial profitability. This represents demand and should strengthen a currency unit: As the US Fed tightens or when the US corporate sector creates cash, the US dollar should rally
Gold is the antithesis of paper money. Therefore, strength in paper money means weak gold prices, and weak paper monies correspond to strong gold prices
The message is that world central bank liquidity is relatively tight and private sector liquidity is falling rapidly. This index has halved from 80 to barely 40 in less than 20 months.
We envision further falls in US liquidity as US corporations continue to see downward margin pressures and shadow banks struggle to grow their loans. In addition, central banks, led by the ECB and PBoC, will likely have to expand liquidity to support fragile economies.
Taken together, it’s likely that the net balance between central bank and private sector liquidity will move away from an excess of ‘good’ money that hurts gold towards an abundance of ‘bad’ money that favours it.
Based on past liquidity trends, it suggests that gold at US$2000/oz is possible by mid-2017. Could the dollar’s best days be behind us?