Many goldbugs
like gold as a hedge against Federal Reserve policies and high inflation.
Paul van Eeden, president of Cranberry Capital,
says he does not fear high inflation due to Fed policies. Van Eeden is a different kind of goldbug
and in this interview with The Gold
Report, he explains how his
proprietary monetary measure, "The Actual Money Supply," is the
reason why.
The Gold
Report: Paul, your
speech at the Hard Assets Conference in San Francisco was titled
"Rational Expectations." You spoke about monitoring the real rate
of monetary inflation based on the total money supply.
You take
into account everything in your indicator that acts as money, creating a money aggregate that links the value of gold and the
dollar. You conclude that quantitative easing (QE) is not resulting in
hyperinflation and is not acting as a driver for the continuing rise in the
gold price. What then is pushing gold to $1,700/ounce (oz)?
Paul van Eeden: Expectations and fear. It's
very hard to know what gold is worth in dollars if you don't also know what
the dollar is doing. When we analyze the gold price in U.S. dollars, we're
analyzing two things simultaneously—gold and dollars. You cannot do one
without the other. The problem with analyzing the dollar is that the market
doesn't have a good measure by which to recognize the effects of quantitative
easing.
Since
approximately the 1950s, economists have used monetary aggregates called M1,
M2 and M3 (no longer being published) to describe the U.S. money supply. But
M1, M2 and M3 are fatally flawed as monetary aggregates for very simple
reasons. M1 only counts cash and demand deposits such as checking accounts.
M1 assumes that any money that you have, say, in a savings account isn't
money. Well, that's a bit absurd.
TGR: What
comprises M2?
PvE: M2 does
include deposit accounts, such as savings accounts, but only up to $100,000.
That implies that if you had $1 million in a savings account, $900,000 of it
doesn't exist. That's equally absurd.
"If
gold is money, we should be able to look at gold and compare gold as one form
of money against dollars, another form of money."
M3
describes money as all of these—cash, plus demand deposits plus time
deposits, but to an unlimited size. One may think then that M3 is the right
monetary indicator. But the problem with both M2 and M3 is that they also
include money market mutual funds, a fund consisting of short-term money
market instruments.
That's
double-counting money because if I buy a money market mutual fund, the money
I use to pay for that mutual fund is used by the mutual fund to buy a money
market instrument from a corporation. The corporation takes the money it
received from the sale of the instrument and deposits it into its bank
account, where it is counted in the money supply. I cannot then count the
money market mutual fund certificate as money, as it would be counting the
same money twice.
TGR: So there
is no accurate indicator.
PvE: M2 and M3
double-count money; M1 and M2 don't count all the money. All are imperfect
measurements. That is why I created a monetary aggregate called "The
Actual Money Supply," which is on my website at www.paulvaneeden.com.
TGR: How is
your measurement more accurate?
PvE: It counts
notes and coins, plus all bank deposit accounts, whether they're time
deposits or demand deposits. This is equal to all the money that circulates
in the economy and can be used for commerce—nothing more and nothing
less.
TGR: How does
that separate out gold from the dollar in value terms?
PvE: I'm a goldbug. I believe gold is a store of wealth and gold is
money. If gold is money, we should be able to look at gold and compare gold
as one form of money against dollars, another form of money.
Changes in
the relative value of gold and dollars will be dictated by their relative
inflation rates. If I create more dollars, I decrease the value of all the
dollars. If I create more gold, I decrease the value of all the gold.
TGR: The
relationship is determined by both quantitative easing and mining?
PvE: Correct.
Essentially most of the gold that has been mined is above ground in the form
of bars and coins and jewelry. We can calculate how much that is. That's the
gold supply. That supply increases every year by an amount equal to mine
production less an amount used up during industrial fabrication. That's
gold's inflation rate.
"If
the Federal Reserve starts to see an increase in price inflation or a rapid
increase in loan creation—monetary inflation—it can sell assets
back into the market."
We can
also look at the money supply and see how it increases every year. That's the
dollar's inflation rate. The value of gold vis-a-vis via the dollar will be dictated by these relative
inflation rates.
I have
data on both gold and the U.S. dollar going back to 1900 and thus can compare
the two. By doing that, I can calculate how the value of gold changes
relative to the U.S. dollar and what gold is theoretically worth in terms of
dollars.
Keep in
mind that the market price is not the same as the value. In the market, price
is seldom equal to value. Price often both exceeds and is below value. But it
will always oscillate around value.
For
example, in 1980, gold was trading much higher than value. By 1995, the gold
price had sufficiently declined and U.S. dollar inflation had sufficiently
increased to bring the gold price back to value, vis-a-vis the dollar. By 1999, gold was substantially
undervalued. By 2007, it was again reasonably valued. But in
2012, it is again substantially overvalued.
Gold price
and U.S. dollar inflation (blue) 1970–present
TGR: The value
of gold is not $1,700/oz?
PvE: No. The
value of gold is about $900/oz. Expectations of monetary inflation are
keeping gold prices high.
In 2008,
after the financial crisis, the Federal Reserve Bank announced the first
round of quantitative easing. The gold price started to rally because there
was an expectation, with the Fed openly engaging in quantitative easing, that
we would see massive U.S. dollar inflation. But that didn't happen.
"Whether
annual mine production goes up or down, it makes no difference to the price
of gold."
When the
Fed engages in quantitative easing, it does so by buying assets in the open
market, such as Treasury notes or bonds. When the Fed buys a government bond
in the open market it creates the money to pay for it out of thin air. The
payment is credited against a commercial bank's account at the Federal
Reserve Bank and is not available for commerce in the economy. It's part of the monetary base, but not the money supply,
as the money supply only counts money that can be used for commerce.
Thus, the
money that the Fed creates is not in circulation. It's not part of the money
supply because it cannot be spent. The commercial bank in whose name it is
credited cannot withdraw it. The only thing it can do is to create new loans
against that reserve asset. But the bank can only create new loans equal to
the demand for such new loans.
Right now,
as a result of QE1 and QE2, there is an enormous amount of excess reserves on
account at the Federal Reserve on behalf of these commercial banks. These
excess reserves in theory could be used to create new loans. The reality is
that new loan creation by commercial banks have proceeded at a very normal
pace, and not at all at a rate that should cause fear of hyperinflation.
TGR: Is it that
there isn't a demand or that the banks don't see creditworthy people to loan
to?
PvE: It doesn't
matter; the result is the same. The point is that the marketplace is not
creating those loans.
Money that
is counted in the money supply is created when consumers and corporations
borrow money from commercial banks. When a loan is created by a commercial
bank, the banking system creates that money out of thin air just as the
Federal Reserve created its money out of thin air.
When a
loan is repaid, that money is destroyed. The natural increase of the money
supply is the balance between loan creation and loan repayment from consumers
and corporations to commercial banks. Their ability to create those loans is
dependent, to some extent, on their reserve assets in the monetary base that
they have on account at the Federal Reserve. Right now, those reserve assets
are much, much larger than what is necessary to account for existing loans of
banks. So banks have enormous capacity to create loans, but capacity to
create is not the same as having created. We are not seeing runaway inflation
in the market. The U.S. money supply is increasing at an annual rate of
around 7%, which is high, but not high enough to cause the type of hysteria
that the gold price is exhibiting.
TGR: The
expectation that banks will eventually loan up to their lending capacity is
what is causing the fears of hyperinflation and the gold price to go up.
PvE: That is
correct.
TGR: When will
banks start lending?
PvE: They are
lending, which is why the U.S. money supply is increasing. But they are not
lending at a torrid pace—the U.S. money supply is increasing only very
slightly faster than the average annual rate since 1900, and slower than it
was in the period from 2000 to 2009 before quantitative easing started. It is
highly improbable that we will see the kind of monetary inflation the market
is afraid of—the fear is misplaced.
The
Federal Reserve alone controls the level of money in the monetary base. If
the Federal Reserve starts to see an increase in price inflation or a rapid
increase in loan creation—monetary inflation—it can sell assets
back into the market. When those assets are sold back into the market the
money that the Federal Reserve receives for the asset is destroyed. It
evaporates.
Just as
the Federal Reserve created money, it can destroy money. The Fed can
absolutely prevent runaway inflation by selling assets back into the market,
therefore constricting the ability of commercial banks to make loans.
TGR: If the
Fed-created money isn't loaned out, will the inflationary expectation in the
market eventually disappear? Will the price of gold go to $800–900/oz?
PvE: That's a
possibility. The gold price rallied in response to QE1 and QE2 and when QE2
ended, the gold price started falling.
Prior to
the announcement of QE3, the gold price rallied again in anticipation, but
since QE3 has been announced, the gold price has been falling.
When the
Federal Reserve announced QE1, there was a massive increase in the monetary
base. When it announced QE2, there was another substantial increase in the
monetary base, but much less than with QE1. But there hasn't been an increase
in the monetary base since the QE3 announcement. The Fed is
"sterilizing" QE3 by offsetting sales of assets at the same time it
is purchasing assets.
TGR: So the key
is how the Fed implements quantitative easing?
PvE: Correct.
The question is whether the gold market is rational in expecting
hyperinflation or massive runaway inflation. That expectation is not being
supported by the money supply, or by price inflation, or any other data. The
only place the expectation is being manifest is in the prices of gold and
silver.
TGR: If you
look at the supply and demand expectations for gold versus the inflated
valuation for gold, do you see more gold producers bringing gold out of the
ground? If so, is that going to have an effect on the price?
PvE: If the
gold price is high relative to production costs then yes, it does bring
marginal mines into production, which increases the supply of gold.
Incidentally, the increase in production from marginal mines then causes
production costs to increase as well.
Does that
have an impact on the price of gold? No. The reason is very simple.
Approximately 1,000–2,000 tons of gold is traded each day. Annual
production of gold is roughly 2,000 tons. If annual gold production increases
by 5%, which is a lot, it's 100 tons. We trade that in a couple of hours.
Whether
annual mine production goes up or down, it makes no difference to the price
of gold. The gold that's trading globally is not just the gold that's being
mined; it's all the gold that's ever been mined, that's sitting above ground
in vaults and in storage. That's where the price is set. Not on the margin of
incremental production.
TGR: As you're
looking at the gold companies that are out there, are you seeing that we have
some good prospects or are you seeing that the producers aren't able to
replace what they're using and the juniors aren't able to get the funding to
find new sources?
PvE: I agree
with your last statement. Producers are not able to replace their reserves.
New exploration is not keeping up with reserve depletion and the juniors are
not getting the funding to do the exploration.
The reason
juniors aren't getting funding is because the market has become quite risk
averse. Junior exploration companies are among the most risky investments you
can imagine. When risk aversion increases in the market, the ability of
juniors to fund exploration evaporates.
It's also
true that the miners, particularly gold and copper, are having a tough time
replacing reserves. Is that something that's going to cause a calamity in the
next 12 or 24 months? No. But, it is a reason why, over the long term,
investing in mineral exploration is an interesting business. Without mineral
exploration, there can be no mining industry and without a mining industry,
our society does not function.
TGR: The last
time we spoke to you,
you said that you were very scared and that it was a healthy thing for
investors to be scared because it keeps them from making mistakes. Are you
still scared?
PvE: I'm
definitely concerned that the market is going to look worse in 2013 than it
looked in 2012. I think risk aversion is not yet ready to be replaced by risk
appetite. The big concern I have for next year is further deterioration of
the Chinese economy. In particular, a tipping point is being reached in China
where its banking system can no longer sustain the bad loans it has created.
If
economic growth in China takes a really big hit at the same time the
financial problems in Europe have not yet been resolved, I see more risk
aversion creeping into the market. That's not good for junior exploration
companies.
What makes
me optimistic is that I think the worst is behind us in the United States. I
think that slowly but surely the U.S. economy is going to get better and
better. With time the improvement in the U.S. economy will bring risk
appetite back into the market, but I don't see that happening in 2013. We'll
have to see this time next year what the prognosis is for 2014.
TGR: In 2008,
you told your investors to sell everything. Is that still your position?
PvE: The end of
2007 and the beginning of 2008 was the top of the market for most metals and
certainly for mineral exploration stocks. That was the time to sell
everything. Now we're very close to the bottom of the market. It could be a
long and drawn-out bottom but, nonetheless, I think that we're close to a
bottom.
This makes
it a very good time to be accumulating mineral exploration assets or junior
exploration companies. It assumes an investor has the patience and financial
ability to wait for the next bull market and stay with the trades. Remember
that junior exploration companies don't generate revenue. If the bear market
is protracted, these companies will need several rounds of financings in
order to stay alive.
TGR: You also
invest in silver, base metals and energy. Are some of these sectors doing
better than others?
PvE: Copper,
like gold, is very expensive. So is silver. The other base metals, such as
aluminum, zinc, lead and nickel, are much more reasonably priced. Oil is also
very reasonably priced at $85/barrel. I see less systemic risk in those
sectors than I see in gold, silver or copper.
TGR: What
specific companies do you like in those sectors?
PvE: I have
recently acquired additional shares of both Miranda Gold
Corp. (MAD:TSX.V) and Evrim Resources Corp. (EVM:TSX.V). I'm on
the board of both of those companies and so I am not at all independent, or
impartial.
I also
recently acquired shares of a company called Millrock
Resources Inc. (MRO:TSX.V). And I
continue to scour the market for more opportunities. I intend to be a buyer
of mineral exploration companies for the foreseeable future.
TGR: Why do you
like those three?
PvE: All three
of those companies share one element that is critically important. All have
competent, experienced management and they have management that I trust:
trust that they're not going to squander the money that we give them and
trust that they will use their best efforts to create shareholder value. It
is my confidence in management teams that causes me to invest in mineral
exploration. Mineral exploration is a business about ideas. It's not about
assets. And when you're dealing with ideas, the asset that you're de facto
buying is people—it's management.
TGR: You say
that you're doing this for the long term. How long do you think that you'll
have to wait?
PvE: Who knows?
5, 10 years? Maybe we get lucky sooner. Maybe we don't.
TGR: Thanks for
your insights.
Paul van Eeden is
president of Cranberry Capital Inc., a private Canadian holding company. He
began his career in the financial and resources sector in 1996 as a
stockbroker with Rick Rule's Global Resources Investments Ltd. He has
actively financed mineral exploration companies and analyzed markets ever
since. Van Eeden is well known for his work on the
interrelationship between the gold price, inflation and the currency markets.
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DISCLOSURE:
1) JT Long of The Gold Report conducted this interview. She personally
and/or her family own shares of the following companies mentioned in this
interview: None.
2) The following companies mentioned in the interview are sponsors of The
Gold Report: Millrock Resources Inc. Streetwise
Reports does not accept stock in exchange for services. Interviews are edited
for clarity.
3) Paul van Eeden: I personally own shares of the
following companies mentioned in this interview: Miranda Gold Corp., Evrim Resources Corp. and Millrock
Resources Inc. I am a director of the following companies mentioned in this
interview and receive remuneration as a director from these companies:
Miranda Gold Corp. and Evrim Resources Corp. I was
not paid by Streetwise Reports for participating in this interview.
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