Monetary update for the dollar

Nov 30, 2017·Alasdair Macleod

A dispassionate look at the quantities and flows of fiat dollars tells us much about the current state of the US economy, and therefore prospects for the dollar itself.

This is a starting point for understanding the dynamics likely to affect the dollar’s purchasing power after the next credit-induced crisis, which are now beginning to clarify. That is the purpose of this article, which starts by updating the most recent developments in the quantity of fiat money (FMQ), the greatest of all monetary pictures.  [i]


Inflation of the fiat money quantity appears to be stalling, as the above graph attests. It has increased just under 3% over the last year to October, compared with 5.8% the previous year. It seems the monetary punch bowl, while not taken away, is lacking its post-crisis drive.

By far the largest component is deposits and savings held at the banks, which total $11,132bn, and have grown a vigorous 7.4% during the last year. The component that has a significantly lower balance is the US Treasury general account, which has reduced from $348.7bn to $160.4bn, knocking FMQ’s overall growth rate. The fact that it is this account that is holding back FMQ inflation tells us that FMQ inflation in public hands is still very much alive.

In recent months, there has been heated debate about whether the US economy is stalling or not, and that perhaps the widely anticipated increase in the Fed funds rate next month will be the last for some time. However, the continuing growth in depositors’ bank balances suggests consumer demand is reasonably robust and interest rate rises are not over.

We are of course skating over an important consideration, the ownership of these deposits. Long-standing experience tells us that when the banks first increase their loans to their customers after a credit crisis, they tend to favour the lower risk accounts. These are the big corporates capable of bringing not only interest income, but fees as well. Additional loans are drawn down through payments to their suppliers, who tend to be large and medium-sized businesses. Thus, deposits are created, and they filter down from the larger to smaller businesses over time. And as these businesses employ extra staff, their personal bank balances benefit as well.

This trickle-down effect conventionally disperses the ownership of bank balances from the large to the less large, and eventually the general public. But today, life is not so simple. The general public is up to its neck in credit card, auto, student and mortgage debt. The creation of bank deposits is therefore the result of consumer debt, more than business loans. This issue is explored further later in this article.

Business finance

It is also clear that we need to dig deeper to see what is going on with American businesses, and whether they collectively think trading conditions merit further investment. There is no doubt the Fed is keeping interest rates suppressed below the level indicated by time-preference, the condition required to justify increasing business investment.[ii] This can be measured by seeing what proportion of overall monetary expansion is being applied to business investment, and whether it is increasing or decreasing relative to the total, which is represented by the blue line in the following chart.


The blue line represents business loans as a percentage of broad money (M2). An increasing percentage represents periods, when in aggregate, businesses are investing in production. A decline represents periods when businesses decide returns on business investment are less than the cost of financing. Instead, they pay down their loans, or alternatively the banks decide to call them in. Before 1980, investment downturns were driven by both these reasons, while after 1980, central bank interest rate policy increasingly became the overriding factor. The correlation between interest rates and the expansion and contraction of business loans, while readily apparent, should be regarded in this light.

There are other factors to consider. Since the last financial crisis, a substantial portion of business debt taken out has been for share buy-backs, so even less investment has been applied to production than the chart implies. Before the last financial crisis, FMQ had been growing at a reasonably constant annual average of 5.9% (the dashed line in the first chart), after which the quantity of fiat money increased with unprecedented rapidity. The chart shows that lending to businesses as a percentage of money supply has been anaemic at best compared with lending to other categories since the crisis, even though it has increased in absolute terms.

Whichever way you cut it, this chart shows the US’s supply-side is now stalling (circled), particularly following the quarter-point increases in the Fed funds rate from December 2015 onwards (also circled). And with only 15.5% of M2 applied to business loans, the other 74.5% is applied to consumer credit and purely financial activities.

This finding is consistent with business surveys that indicate a mixed picture for US production, and supports concerns in the investment community that the economy faces a low-growth future, with a significant risk of a downturn.

The lacklustre performance of this, the supply side of the US economy, is in contrast with the pick-up in productive activity elsewhere in the world. Driven by China’s voracious appetite for commodities, the outlook for all commodity exporters is improving. Europe is being linked into the Chinese economy through two-way trade, driving the euro up on improving economic prospects. Japan similarly benefits from the expansion of regional trade with China and all the East Asian nations. The only exception to this positive outlook is for the US and therefore its currency, the dollar.

Credit flows have reversed

The decline of US domestic business lending as a proportion of the total is the consequence of decades of monetary and economic meddling with free markets. When money was sound, or relatively so, the bulk of non-financial lending was to commercial businesses, and it was their demands for funds that drove interest rates, in the context of monetary policy. This is no longer so. Consumer credit became an increasingly important economic factor, particularly after 1980. Excluding mortgage debt, it is currently 27.5% of M2, compared with business loans at 15.5%. While business loans are interest-rate sensitive, consumer credit is very much less so, being comprised of credit cards, motor vehicle and student loans.

Mortgages are a far larger and additional element of consumer credit, and the majority of them in America are fixed rate, with only 10% being variable.[iii] As we have seen, the small increases in interest rates have already stalled business loan growth, but it will need further interest rate increases to moderate the expansion of consumer debt. So, if the Fed is forced to raise rates further from here, there will be a disproportionally negative effect on businesses.

The effect of bank credit growth switching to consumers has been to reverse credit flows from their original direction. Instead of credit flowing from the financial sector to finance business expansion, which in turn leads to increased consumption, business is now bypassed and consumption is financed directly. Instead, deposit balances are accumulating in the bank accounts of financial entities as a consequence of debt origination taken up directly by the consumer.

In terms of credit flows, a consumption-driven economy is therefore very different from a production-driven economy. Consequently, production of goods fails to keep pace with demand. This surplus demand is satisfied by imports, which sooner or later leads to a general price adjustment through a decline in the currency.

Not enough attention is paid to these flows and the consequences of reversing the natural order of monetary events. They are an important contributor to the trade deficit, which has little or nothing to do with the current administration’s obsession with supposedly unfair trade practices by foreign manufacturers. Inevitably, the expansion of credit in favour of the consumer while neglecting the supply side creates net selling of the dollar, requiring inward investment or government intervention to counteract its decline.

There are other reasons why the dollar is set to decline anyway. Foreign ownership is already at saturation point, and further portfolio flows into foreign hands appear to be stalling. Additionally, China is pursuing a policy of discouraging use of the dollar for her own trade. The world is therefore awash with dollars that fewer people need or want.

This brings us back to the importance of the fiat money quantity. While the dollar was rising in terms of its purchasing power against both commodities and other currencies, it did not matter that the FMQ was increasing above its long-term trend rate. Those conditions have now changed, and the outlook for the dollar in terms of commodities and other currencies is for it to weaken. And when the next credit crisis comes along, instead of there being a scramble for dollar liquidity, after the initial hiatus we can expect a public desire to hold alternatives to bank deposits. Therefore, the next credit crisis should threaten the dollar with a significant fall in its purchasing power in the years following.

A falling purchasing power for the dollar is obviously beneficial for the gold price. How beneficial can be visualised from the next chart, which shows gold priced in dollars adjusted for the increase in FMQ since the price was first fixed at $35.

Adjusted for the increase in FMQ, the gold price today is in the same territory as it was when the gold pool failed in the late 1960s, and at the turn of the century when gold sank to $260. It is clear from this chart that the gold price is unlikely to go lower and has substantial upside, now that the dollar is poised for further weakness.

There is more on the dollar-gold relationship towards the end of this article.

The impact of cryptocurrencies

The context of our analysis so far has been restricted to the well-established credit cycle. This consists of a period of credit expansion, facilitated by central banks suppressing interest rates, leading to price inflation, and thereby forcing central banks to raise interest rates until credit stops expanding. Inevitably, when bank credit stops expanding, businesses get into difficulty, the economic climate sours, and bank credit begins to implode. The correlation between changes in bank credit applied to business loans and interest rates managed by the central banks is evident in the second chart in this article.

It should be clear that the current period of credit expansion, being unprecedented in its magnitude, will be followed by a credit crisis potentially worse than the last. Furthermore, as posited above, the rapid expansion of base money, which is the traditional central bank response to a credit crisis, will coincide with a surfeit of deposited dollars in the banking system accumulated since the last crisis. Accordingly, instead of a deflationary event being triggered, the next crisis will increase these deposits even further, and is likely to trigger an inflationary event, once the dust settles. Depositors, who are not finance companies, will almost certainly attempt to reduce their swollen bank accounts, in favour of precious metals, and perhaps tangible assets such as art, land and buildings as well.

We now must consider the impact of a new element, cryptocurrencies. Assuming that central banks do not prohibit commercial banks from processing payments to facilitate cryptocurrency settlements, it is likely the cryptocurrency bubble will not only survive the next credit-induced economic crisis, but be fuelled by it. This being the case, increasing public participation becomes an additional destabilising factor for fiat currencies themselves.

Before the next credit crisis, there could be increasing speculation in cryptocurrencies, providing windfall profits for growing numbers of the general public all round the world. This will have two affects. Fiat money will be diverted from other uses into settling cryptocurrency transactions. This will require additional expansion of bank credit, if not for this direct purpose, to satisfy continuing economic activities that benefit indirectly from the bubble’s wealth creation. And secondly, the decline in preference for fiat money in favour of holding cryptocurrencies is could trigger a wider decline in the purchasing power of state-issued money.

It is perhaps time to consolidate our thoughts so far, and summarise the danger to the dollar. Unlike the last credit-induced crisis, which triggered a flight into the dollar, the dynamics building for the next crisis are wholly different, even though it will happen for the same underlying reasons. This time, the world is flooded with dollars, both in the form of investment money and bank deposits.

The Fed’s solution to a credit-induced crisis is always to inject more money into the system. But there is already too much money in circulation, illustrated by the above-trend increase in FMQ since August 2008. Foreign ownership of dollars in portfolios also increased from $9.641 trillion in 2009 to $17.139 trillion in 2016 (according to TIC data from the US Treasury), the unwinding of which will undoubtedly put pressure on the dollar’s exchange rate, in addition to other negative trade-related factors. Furthermore, fiat currency in the banks and at the Fed is now $6.4 trillion above its long-term sustainable growth rate.

There is therefore, already a recipe for a substantial fall in the dollar, adversely affecting all other fiat currencies linked to it. This problem is compounded by the lack of headroom to raise interest rates without aggravating the overall debt situation. The addition of cryptocurrencies as an alternative to holding fiat cash, if the cryptocurrency bubble is still extant at the time of the next credit crisis, can be expected to offer the public an alternative to holding fiat currencies deposits in the banks. This is all bad news for the dollar.

The implications for gold

Some commentators have taken the view that cryptocurrencies are the new gold, sound money compared with unbacked fiat currencies. I have written elsewhere why cryptocurrencies are not money, but if they are going to undermine anything, it is not gold, but fiat currencies.

In the short-term, along with the more credible alternatives, bitcoin has had an incredible run, hitting $11,400 this week. There is perhaps too much bullishness in the price for the short-term, and while it has the potential to go much higher, a period of consolidation would be healthy. If that doesn’t happen, the price could blow off, doing serious damage to cryptocurrencies’ credibility in the longer term. It would also encourage governments to kill the phenomenon.

A far better outcome for cryptocurrencies would be some consolidation, making the potential threat to financial stability appear to diminish. That would encourage intervening governments to back off. It would give breathing space for futures and other regulated and listed investments to be planned and implemented, opening up cryptocurrencies to investing institutions. And then in the fullness of time, there is likely to be a wider participation from the public.

If some order and acceptability is restored, cryptocurrencies seem certain to eventually undermine fiat currencies, and in turn push up the price of gold. On our third chart of gold deflated by FMQ, a return to the $35 set in 1934 in today’s adjusted money is the equivalent of a gold price of $11,000 per ounce. This figure is only relevant in the sense it gives an indication of how suppressed gold relative to an expanding dollar has become over the last 83 years. If the dollar is undermined by a combination of speculation in cryptocurrencies and the Fed’s response to the next credit crisis, the magnitude of the shift in prices we should initially expect is in this ball-park. In this sense, the dramatic rise in cryptocurrencies so far could be just a foretaste of a similar rise in the gold price.

[iii] See

[ii] Time preference in this context is the discounted future value of the components that comprise production. If this value is deemed greater than the monetary cost of financing it, a businessman will profit by borrowing to invest. This is the theory behind monetary stimulation of production.

[i] FMQ, simply expressed, is the sum of true, or Austrian money supply, and money not in public circulation, being held on the balance sheet of the central bank.


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