Gold Cannot Be Inflationary, But the Dollar Sure Can 54 comments
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As a follow-up to my article yesterday, I want to talk a little more about the relationship between gold, the dollar, and inflation. In response to my post, one reader wrote:
Holding physical gold [that has no intrinsic usefulness to most people], may not be effective. In a true financial crisis who will be able to buy it from you and why would they want it?
Several other readers suggested that gold is not a good "hedge" against inflation.
I have referenced a chart from the St. Louis Fed in several articles this week that shows just how much currency is being printed right now. Every time I look at it, I chuckle and shake my head. The line in 2008 is nearly vertical!
Look, if you try to make things complicated, you'll succeed. But there's no reason to do that. Here are a few key things to remember:
1. If you increase the supply of dollars, you had better increase demand for those dollars at the same rate -- or an even greater rate -- or those dollars are going to lose value. Period. Granted, there has been some increased demand for dollars in recent months, but can you honestly tell me that demand is sufficient to outpace the number of dollars being printed? Furthermore, do you honestly see sustained or increasing demand for those dollars? If so, why? We're a debtor nation that manufactures almost nothing. We're a colossal pack of spoiled brats who think we deserve to work 30 hours a week for $85,000 a year.
I'll try this again: if you see sustained or increased demand for dollars, I'd like to know why.
2. If you are unable to increase the the supply of gold in any sort of meaningful way (which you can't), and you are making an argument that the price if gold is going to fall, you had better also make a strong argument that demand for gold is going to fall. I say this, because you cannot predicate any argument for the price-destruction of gold using supply as a premise. In other words, supply of gold can't be increased, so if the price is about to fall, you better convince me it's going to result from reduced demand -- because it sure as hell isn't going to come from an oversupply.
If you can't meaningfully create gold, it cannot be inflationary. I know you're all getting very tired of hearing me say this, but the only definition of inflation is an increase in the money supply.
Didn't I say something about avoiding complication earlier in this article? I think I did. Okay. Here's the simple part. Are you ready?
The supply of dollars is increasing. Prices and rates are going to rise unless the Fed can miraculously find a way to bring all those dollars back in, very quickly. But how could they possibly achieve that? Are they going to borrow more? Are they going to print more money? The problem is so obviously and viciously unsolvable that I'm not quite sure how anyone thinks the dollar can survive.
Meanwhile, the supply of gold in the economy is not increasing. If anything, it's being hoarded, which translates to increased scarcity. Does somebody want to tell me how the government (or anyone else) plans to print more gold? How do you do that? Do you look up "alchemist" in the yellow pages?
Okay, I'm getting to the good part now. The supply of dollars is increasing. So the dollar is losing value. The supply of gold is, at best, stable, but probably shrinking.
And here's all you have to think about: would you bet that demand for dollars is going to outpace its production? And would you bet that demand for gold is going to fall in the face of a stable or declining supply? Don't think about it too long...
Now if I could just get the whole "timing" thing figured out.
Disclosures: Paco is short U.S. Treasuries through the Proshares Ultra Short 20+ Treasuries ETF (ticker: TBT). He is long physical gold, and the Proshares Ultra long gold ETF (ticker: UGL).
Copyright 2009, Paco Ahlgren. All Rights Reserved.
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This article has 54 comments:
But the battleship is starting to turn, in response to growing realization of systemic risk. One or two more shocking pieces of news should complete the process.
Small diamond 1ct I bought my girlfriend on our trip to Israel, costed 4,500$ that was a good deal from my friend there who showed me this stone with certificate, by Rapoport Diamond Report cost in retail 12,000$.
I think the category of investors who buy real fine gold and coins, are small naive investors who can not afford to buy minimum of 100oz. on COMEX for the fair price.
The bid/ask for 100oz. is only 10 cents, the bid/ask from Commerzbank that deals in gold and even have it's own gold refinery for gold coins and bars is about 10-15%. You can see it here:
https://commerzbank.de/de/haup...
So what sophisticated investor is going to be in the market with 10-15% bid/ask spread? NO ONE.
To make money, I mean real money not 10,000$, the only way is to trade gold futures both buying and selling.At this price of gold buy and hold will not work longer term as gold is luxury asset same as vintage Bordeaux wines or diamond necklage from Graff for 1,000,000$ that have in it stones and precious metal in market price for it of 100,000$ maximum.
You can't make $$$ when you buy gold for 950$ then if you want to sell your coin or gold bars back to a dealer he will pay you 750$.
Enjoy gold as a luxury, as a beautiful thing but if you want to invest in gold, real gold not ETF that is all paper gold, then buy 100oz and you will see how easy it is to buy it and how gold is available if you have US$ to buy it and how gold can go down in price same like any other asset from Pink Sheets stock to Cotton through EUR and even bread with milk.
Mark Medayski
The biggest debtor nation in the history of the world, is increasing the supply of the major reserve currency to such an extent, that I see the danger of future inflation arising from currency debasement.
Overproduction from a diminishing manufacturing base is not going to push living costs up by shortages in meeting demand.
High demand is not in my opinion going to inflate prices either.
If "value added goods" are not creating wealth, what value is backing the fiat?
I see the currencies in all developed economies being debased on a daily basis. In my view inflation due to currency debasement is not even on many peoples radar.
Am I seeing the Boogy Man, or what?
Historically, there was a period of great gold inflation back when gold was used as currency, when the New World was discovered, and the Spanish (primarily) looted the gold stocks of the Incas and Aztecs and dumped them onto the European markets. There was no new gold in the world then, just a big jump in the amount being traded in the European markets.
For nations to dump/spend their gold reserves would have a similar effect.
Gold is *not* money. Money is anything that is universally used as a medium in economic transfers of goods and services. Try taking your bullion, gold coins, or other forms of gold to the grocery or gas station and putting them to use. Gold is simply a commodity, that for historical, commercial, and emotional reasons, has value. Since the amount being traded does not fluctuate very much, it tends to hold its value during times of inflation, but suffers (just like any other commodity) during times of deflation.
Deflation is what we still have, despite the Fed's printing money at high speed. Eventually (we hope), the Fed's attempt at inflation will induce inflation to offset the deflation -- however, it might appear as a localized effect only, with the US dollar crumbling while deflation roars on in the global markets, killing us with commodity and import inflation.
Then (and probably only then) will gold resume its upward movement, although it will be eclipsed by the upward movement in other commodities that are controlled by cartels that are willing to reduce production to push prices higher. When gold resumes its upward move, it will be following oil once more.
Try turning this around and assume a gold-based economy:
If "value added goods" are not creating wealth, what value is backing the gold?
So long as we have The Incredible Shrinking Global Economy, value is going to keep shrinking, along with demand, and ANY form of currency is going to find itself in greater numbers than needed, with the velocity of money taking a nose-dive.
The central bankers are desperately trying to goose the velocity of money my printing too much of it, as deflation is a cancer that will ultimately destroy global markets and encourage trade barriers to be erected to protect shrinking domestic markets, just as occurred in the 1930's.
So far, their efforts are failing. Worry more about how to get demand going again, in the face of soaring unemployment and a rapidly diminishing functional economy. Shifting the currency to gold isn't going to fix that.
Then why has the dollar been strengthening in the latest time? Interest rates are zero, which gives really no incentive whatsoever to hold dollars. Apparently, we again see a flight to safety. Prospects are also lousy for the dollar, due to the stimulation packages due out, increasing the deficits in the balance of payments, increasing the risk of inflation. All of this should really bring the dollar down, instead we see the reverse. Supposedly we face another period of stress in the financial system, with redemptions, etc. This could of course also benefit gold.
Another thing that has to be added to the picture, is the velocity of money. As long as it stays down, all the increase in money supply might have no effect at all.
Thirdly, it's as easy for the Fed to decrease the money supply, as it is to increase it.
You have it exactly backwards, Paco. Demand for dollars is strong, and the total supply (monetary base total money supply PLUS the multiplier effect) is actually shrinking. The M2 measure has increased to 10% y-o-y, but the velocity of money is plunging. Do you understand the point? As leverage is coming down, it REDUCES the supply of money. Your gold bet is plain wrong in my opinion (and, by the way, the supply does increase). On the bond side, I don't expect that bond yields will change substantially one way or the other, but the likelihood in my opinion is that they will stay surprisingly low for quite some time. Have you checked Japanese bond yields over the last decade? That you would use TBT instead of TLT is risky as well. Why make the bet leveraged on a daily basis when you can just be short it unleveraged and not worried about getting whipped around by volatility? Likewise on using UGL instead of GLD. You should at least disclose the inherent risk in that strategy if indeed you are aware of it.
Golds value is backed by the labour expended in it's production.
It's store of value comes from the amount of labour this represents, and yes I do support the classical economists theories of wealth creation.
As fiat has a broken relationship to gold, it's value in a modern fractionalized money system only works if goods are produced and traded. This is clearly breaking down.
NB I'm not a gold bug, but I am long and large in bullion.
A fine Southern statesman much smarter than any of us had something to say about this. To support his argument against Hamilton’s desire for a central bank, Thomas Jefferson made this prophecy:
“If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of their property until their children will wake up homeless on the continent their fathers conquered.” (From the "Federal Reserve," by H.S. Kennan, pg. 247)
As I've been saying for years, now that we have that evil entity, all that's left for us to do is figure out how long it will be before it either swallows us all or implodes, thereby blasting green confetti around the whole world.
Another good article, PA. Thank you!
> is going to keep shrinking, along with demand, and ANY form of currency
> is going to find itself in greater numbers than needed, with the
> velocity of money taking a nose-dive.
OK - let's go back maybe a century. (when federal reserve note velocity = zero) I seem to recall that a cow-puncher could get a $20.00 gold piece (1 oz) for a weeks work. A Ford cost $500. (25 oz.) [feel free to correct my generous assumptions] At today's economy $750/week may be around the norm (for those working folks). (a $25000 auto costs ~30oz) Gold as compared to work has not lost value, therefore gold compared to goods purchased should maintain it's free market value as a form of wealth. When dollars are worthless, there must be a strong barter formula. Precious metals fills the bill there. When one wishes to liquidate assets, he will not want worthless paper. He will want to use what the market is using. The market understands precious metals. It's not a matter of money, it's how the free uninhibited market will perform.
Why don't you just call me stupid and get it over with? :-)
The velocity of money will return, suddenly and ferociously. De-leveraging will stop when the velocity of money increases, and people perceive prices to be rising again. They won't, of course, actually be rising.
Finally, Treasuries are going to collapse, and rates are going to rise at the same time prices are exploding. I've written many articles detailing my position in the last two weeks, and I strongly suggest you read them.
Finally, to the other reader who suggest money is as easy to take out of the economy as it is to put it, my question is how? By selling Treasuries? See the previous paragraph.
The party is over.
On Jan 19 08:40 AM Alan Brochstein wrote:
> Your position is the exact opposite side of the trade I would recommend
> taking. You take a single piece of evidence (the chart you and so
> many others like to cite) and extrapolate IN A VACUUM. I can't believe
> you don't see a demand for dollars. Have you seen short rates?
> That is the best indicator there is in terms of a desire for liquidity
> (cash). A proper analytical framework would justify not a "doubling"
> of the monetary base (oh my), but rather the role of the monetary
> base in the entire economy. The amount of wealth that is being wiped
> out domestically is multiples of the entire level of the monetary
> base.
>
> You have it exactly backwards, Paco. Demand for dollars is strong,
> and the total supply (monetary base total money supply PLUS the multiplier
> effect) is actually shrinking. The M2 measure has increased to 10%
> y-o-y, but the velocity of money is plunging. Do you understand
> the point? As leverage is coming down, it REDUCES the supply of
> money. Your gold bet is plain wrong in my opinion (and, by the way,
> the supply does increase). On the bond side, I don't expect that
> bond yields will change substantially one way or the other, but the
> likelihood in my opinion is that they will stay surprisingly low
> for quite some time. Have you checked Japanese bond yields over
> the last decade? That you would use TBT instead of TLT is risky
> as well. Why make the bet leveraged on a daily basis when you can
> just be short it unleveraged and not worried about getting whipped
> around by volatility? Likewise on using UGL instead of GLD. You
> should at least disclose the inherent risk in that strategy if indeed
> you are aware of it.
If I were a investment advisor I would have gold in my clients portfolio just as a insurance policy. When the majority of investment firms come to grips with these facts, that alone could give golds price further gains.
Well guess what?...
...neither do treasuries anymore.
Just pointing out the obvious here.
On Jan 19 07:05 AM ROLEX18K wrote:
> I love my gold Rolex, I love my girlfriends gold Chopard, I love
> gold jewelry she has, I love to give as a gift 5-10 grams gold bars
> that I buy from Commerzbank in Frankfurt to my business friends but
> same I like platinum, emeralds. diamonds, rubys, saphirs that are
> even more expensive than gold.
> Small diamond 1ct I bought my girlfriend on our trip to Israel, costed
> 4,500$ that was a good deal from my friend there who showed me this
> stone with certificate, by Rapoport Diamond Report cost in retail
> 12,000$.
> I think the category of investors who buy real fine gold and coins,
> are small naive investors who can not afford to buy minimum of 100oz.
> on COMEX for the fair price.
> The bid/ask for 100oz. is only 10 cents, the bid/ask from Commerzbank
> that deals in gold and even have it's own gold refinery for gold
> coins and bars is about 10-15%. You can see it here:
>
> https://commerzbank.de/de/haup...
>
>
>
> So what sophisticated investor is going to be in the market with
> 10-15% bid/ask spread? NO ONE.
> To make money, I mean real money not 10,000$, the only way is to
> trade gold futures both buying and selling.At this price of gold
> buy and hold will not work longer term as gold is luxury asset same
> as vintage Bordeaux wines or diamond necklage from Graff for 1,000,000$
> that have in it stones and precious metal in market price for it
> of 100,000$ maximum.
> You can't make $$$ when you buy gold for 950$ then if you want to
> sell your coin or gold bars back to a dealer he will pay you 750$.
>
> Enjoy gold as a luxury, as a beautiful thing but if you want to invest
> in gold, real gold not ETF that is all paper gold, then buy 100oz
> and you will see how easy it is to buy it and how gold is available
> if you have US$ to buy it and how gold can go down in price same
> like any other asset from Pink Sheets stock to Cotton through EUR
> and even bread with milk.
>
>
> Mark Medayski
On Jan 19 08:09 AM constantnormal wrote:
> The way that the government "produces" more gold is to sell the reserves
> locked up (hoarded) at Ft Knox. This would work for any government,
> taking their gold reserves and liquidating them to provide cash.
> As our foreign lenders inevitably decide to reduce or cut off Uncle
> Sam's access to credit, this may be a way in which we raise cash.
>
>
> Historically, there was a period of great gold inflation back when
> gold was used as currency, when the New World was discovered, and
> the Spanish (primarily) looted the gold stocks of the Incas and Aztecs
> and dumped them onto the European markets. There was no new gold
> in the world then, just a big jump in the amount being traded in
> the European markets.
>
> For nations to dump/spend their gold reserves would have a similar
> effect.
>
> Gold is *not* money. Money is anything that is universally used as
> a medium in economic transfers of goods and services. Try taking
> your bullion, gold coins, or other forms of gold to the grocery or
> gas station and putting them to use. Gold is simply a commodity,
> that for historical, commercial, and emotional reasons, has value.
> Since the amount being traded does not fluctuate very much, it tends
> to hold its value during times of inflation, but suffers (just like
> any other commodity) during times of deflation.
>
> Deflation is what we still have, despite the Fed's printing money
> at high speed. Eventually (we hope), the Fed's attempt at inflation
> will induce inflation to offset the deflation -- however, it might
> appear as a localized effect only, with the US dollar crumbling while
> deflation roars on in the global markets, killing us with commodity
> and import inflation.
>
> Then (and probably only then) will gold resume its upward movement,
> although it will be eclipsed by the upward movement in other commodities
> that are controlled by cartels that are willing to reduce production
> to push prices higher. When gold resumes its upward move, it will
> be following oil once more.
On Jan 19 10:46 AM auto44 wrote:
> I CAN STORE GOLD EASILY. I CAN'T STORE OIL VERY WELL.
They have all reiterated the same things with the same Disclosures, TBT, UGL and Physical Gold.
So, I will reiterate the same questions: What percent of your Portfolio is in the mentioned assets? What percentage do you recommend that your readers hold?
AND, do you have Stop Loss points just in case your scenario does not unfold. IE buy UGL at $29, sell if it goes to new lows, sell if you lose 20%, 30%, 50%?
Your Articles are fairly succinct in stating your position.
But you seem to believe that your stance is the Only one that has any validity. They are your opinions. Others have differing opinions.
never mind predictions based on reading tea leaves, and hoping gold prices rise "like a coiled spring", because past performance shows that the trend for gold has been to rise in 8 out of 10 years.
What you have to see is that since the March 17th 2008 spike it has trended down in $US. 1020-843 today
In Sterling it has trended higher 505-574 today.
A global economy cannot be studied in isolation, by looking at only how it affects one country.
Gold is not an item that is for speculation, far too volatile in my opinion.
It should only be invested in for security of ones savings.
On Jan 19 11:37 AM DiggerUK wrote:
> @secmaven,
>
> never mind predictions based on reading tea leaves, and hoping gold
> prices rise "like a coiled spring", because past performance shows
> that the trend for gold has been to rise in 8 out of 10 years. <br/>
>
> What you have to see is that since the March 17th 2008 spike it has
> trended down in $US. 1020-843 today
> In Sterling it has trended higher 505-574 today.
>
> A global economy cannot be studied in isolation, by looking at only
> how it affects one country.
>
> Gold is not an item that is for speculation, far too volatile in
> my opinion.
> It should only be invested in for security of ones savings.
I should point out I am long and large in bullion.
If so, that would explain why gold is not already skyrocketing like the chart in this article. It won't be until the real estate market recovers and the stock market is in a new bull market, and passes the difference between the dollars lost in the meltdown and the new money printed, that gold will start to skyrocket. [But then, couldn't the government begin to contract the money supply to keep gold at a steady level? I doubt they would contract the money supply - they need inflation to 'pay' for the money governments have borrowed - but it is within the realm of possibility.]
Not only do I agree with you that other people "have differing opinions," I'm counting on it. In the truest Popperian sense, my objective is to present the knowledge I have accumulated to intense scrutiny, with the greatest possible risk of falsification. It looks like SeekingAlpha is just the place to get it, too.
Investors should do their own research in order to balance their portfolios; I am no longer a portfolio manager, nor am I comfortable giving anyone recommendations.
On Jan 19 11:02 AM paultaut wrote:
> Mr. Ahlgren: You have written a lot of Articles, haven't you?
>
>
> They have all reiterated the same things with the same Disclosures,
> TBT, UGL and Physical Gold.
>
> So, I will reiterate the same questions: What percent of your Portfolio
> is in the mentioned assets? What percentage do you recommend that
> your readers hold?
>
> AND, do you have Stop Loss points just in case your scenario does
> not unfold. IE buy UGL at $29, sell if it goes to new lows, sell
> if you lose 20%, 30%, 50%?
>
> Your Articles are fairly succinct in stating your position.
> But you seem to believe that your stance is the Only one that has
> any validity. They are your opinions. Others have differing opinions.
>
>
>
>
On Jan 19 12:06 PM bowman711 wrote:
> I don't know how many dollars of wealth have been lost - have vanished
> - in the meltdown of real estate and the decline in the stock markets,
> but I am sure that it is far more than the 'dollars' printed by governments
> to counter this loss of wealth and to try to get the economy moving
> again. It would seem that if $10-trillion of wealtlh has been lost,
> and the government prints $5-trillion in new dollars that the net
> effect would still be deflationary, not inflationary; just half as
> deflationary compared to if no new money was printed.
>
> If so, that would explain why gold is not already skyrocketing like
> the chart in this article. It won't be until the real estate market
> recovers and the stock market is in a new bull market, and passes
> the difference between the dollars lost in the meltdown and the new
> money printed, that gold will start to skyrocket. [But then, couldn't
> the government begin to contract the money supply to keep gold at
> a steady level? I doubt they would contract the money supply - they
> need inflation to 'pay' for the money governments have borrowed -
> but it is within the realm of possibility.]
The new dollars that are now being "created" out of thin air by the Fed and Treasury are not real either but merely entries in computer memories.
Such is the world of fiat "money".
First, if we start with MV = PQ, it looks like your reasoning is that, insofar as this equation applies to gold, M is going to increase and Q will stay roughly the same, so P should increase also. As others may have pointed out, this seems to ignore the role of V. I realize that V should increase as interest rates go down, but this obviously isn't happening in the current environment (at least yet) and if lending continues to tighten then it may not happen at all.
Second, it seems like there is at least a case for the demand for gold going down (both industrial and discretionary demand seem likely to be hurt by the economic slowdown) and for the supply of gold that's actually in circulation going up (if individuals, institutions or governments start selling it to raise actual money). Gold as an investment works as long as lots of other people think it's a good investment; for historical and other reasons, people think of gold this way more than many other resources the supply of which is difficult to increase quickly, but it's still pretty arbitrary.
So I wouldn't be shocked to see gold go up in the next couple years (and I'd happily trade in it if things set up right), but I think the argument for a price increase has to come with a big dollop of psychology to support the demans side and can't be framed only in economic terms.
If I have 100 shares of stock i bought at $50/share ($5,000), and the stock drops to $30/share, ($3,000), there is $2,000 that has gone noplace; it is no more. You say it is still 'somewhere?' Where? From what I have seen, the government isn't printing money anywhere near fast enough to compensate for the 'dollars' lost just in real estate and the stock market, not to mention retail stores closing, auto company losses, etc.
If, as you say, the money is someplace, it would have to be that for every dollar stockholders and real estate owners have lost, there is someone else who has 'gotten' those dollars and is getting fabulously wealthy. I don't see any evidence of that happening. Some people may be getting wealthy shorting stock, but not nearly as many as who've gotten poorer as their portfolio has gone down in value.
you are dead right
all those clowns short$ long gold just don't get it,incredible
deflation,deleveraging... is a debt crisis ,debt is deflationary,so $ up gold and commodities down
and you are right taking a leverage bet(without telling your readers about the leverage trap) is just plain stupid and dangerous,those etf are trend vehicles,if you are not pretty sure about the move ,as the author states in his article,it is just giving money to the market
On Jan 19 08:40 AM Alan Brochstein wrote:
> Your position is the exact opposite side of the trade I would recommend
> taking. You take a single piece of evidence (the chart you and so
> many others like to cite) and extrapolate IN A VACUUM. I can't believe
> you don't see a demand for dollars. Have you seen short rates?
> That is the best indicator there is in terms of a desire for liquidity
> (cash). A proper analytical framework would justify not a "doubling"
> of the monetary base (oh my), but rather the role of the monetary
> base in the entire economy. The amount of wealth that is being wiped
> out domestically is multiples of the entire level of the monetary
> base.
>
> You have it exactly backwards, Paco. Demand for dollars is strong,
> and the total supply (monetary base total money supply PLUS the multiplier
> effect) is actually shrinking. The M2 measure has increased to 10%
> y-o-y, but the velocity of money is plunging. Do you understand
> the point? As leverage is coming down, it REDUCES the supply of
> money. Your gold bet is plain wrong in my opinion (and, by the way,
> the supply does increase). On the bond side, I don't expect that
> bond yields will change substantially one way or the other, but the
> likelihood in my opinion is that they will stay surprisingly low
> for quite some time. Have you checked Japanese bond yields over
> the last decade? That you would use TBT instead of TLT is risky
> as well. Why make the bet leveraged on a daily basis when you can
> just be short it unleveraged and not worried about getting whipped
> around by volatility? Likewise on using UGL instead of GLD. You
> should at least disclose the inherent risk in that strategy if indeed
> you are aware of it.
Wonderful article. I find much to agree with in your analysis.
While I've recently added substantially to my PM investments, including both physical and mining shares, there's one thing that's keeping me from jumping in with both feet, and it has to do with the questions you asked here:
"The supply of dollars is increasing. Prices and rates are going to rise unless the Fed can miraculously find a way to bring all those dollars back in, very quickly. But how could they possibly achieve that? Are they going to borrow more? Are they going to print more money? The problem is so obviously and viciously unsolvable that I'm not quite sure how anyone thinks the dollar can survive."
The Fed recently announced that they're looking at issuing their own debt. Many analysts speculated as to why. I'm not sure it's even legal for them to do it at the moment, but of course Congress can change that in the matter of a few days, and will if the Bernanke says it's necessary.
I'm thinking that the reason they'll want to issue debt is precisely to avoid the raging, or even hyper, inflation scenario. If the market were to accept and buy Fed debt, (and this is by no means a given), this would be a way for them to pull vast sums of dollars out of the economy very quickly, even while their balance sheet contains crap that, were they to sell it, wouldn't otherwise do the trick.
Whether they would or could act quickly enough to offset a credit expansion that could be expanding at light speed, given the monetary base your graph depicts, once banks DO start lending again, is another question.
Try to remember that I define inflation and deflation as an Austrian -- the expansion or destruction of the money supply. We are not in a deflationary period, but an inflationary one. The collapse of prices is from de-leveraging, not deflation.
When people start to perceive that asset prices are increasing again, the velocity of money will speed up, and it's going to come hard and fast. The Fed is not going to be able to control rising prices.
Add to this the Treasury tinderbox, and it doesn't bode well for the future of the dollar or the global economy.
On Jan 19 03:15 PM gjvoor1 wrote:
> Deflation is front and center, all asset prices are falling, yet
> gold is hanging by its fingernails because of fear. Gold will follow
> all other assets and fall as well. The demand for dollars comes
> from the amount of debt within the system denominated in dollars.
> As a country we have a higher debt to asset ratio than a year ago
> and thus dollars are in greater demand to pay those debts. We also
> have greatly decreased the velocity of money in the system due to
> deleveraging, fear, etc... Many people confuse the monetary base
> with the money supply. A huge increase in bank reserves does not
> add to inflation if those funds can not be loaned out into the economy
> (thus adding to the money supply). Right now these banks are measured
> based on survival. They are just praying they are building up enough
> in reserves for the additional commercial writedowns that are around
> the corner. Stagnate money supply or a stagnate monetary base does
> not lead to inflation even if they are increasing (it has to be spent
> and start turning over in the economy). Remember a simplistic measure
> of GDP equals money supply X velocity. Right now the velocity decrease
> has overwhelmed the money supply increase. I have no doubt that
> the fed will eventually win the deflation war. This is a long war
> though and will need to be measured by following M1 (and who own
> M1) and not just M2 or M3 estimates, which are really stores of value
> just like stocks, bonds, houses, etc. With less value in all these
> assets on a combined basis there is less fuel to create money supply
> and thus inflation. Nice post, but deflation is not leaving yet.
> There will be a time for your trade though. p.s. say hi to your
> Dad - I heard he left EP
Let's put it this way: if the Zimbabwe central bank started issuing debt, would you buy it simply based on the fact that it wasn't issued by the Zimbabwe treasury? Of course you wouldn't.
If the U.S. credit rating collapses, it won't matter.
On Jan 19 04:13 PM JohnAl wrote:
> Mr. Ahlgren,
>
> Wonderful article. I find much to agree with in your analysis.<br/>
>
> While I've recently added substantially to my PM investments, including
> both physical and mining shares, there's one thing that's keeping
> me from jumping in with both feet, and it has to do with the questions
> you asked here:
>
> "The supply of dollars is increasing. Prices and rates are going
> to rise unless the Fed can miraculously find a way to bring all those
> dollars back in, very quickly. But how could they possibly achieve
> that? Are they going to borrow more? Are they going to print more
> money? The problem is so obviously and viciously unsolvable that
> I'm not quite sure how anyone thinks the dollar can survive."
>
> The Fed recently announced that they're looking at issuing their
> own debt. Many analysts speculated as to why. I'm not sure it's
> even legal for them to do it at the moment, but of course Congress
> can change that in the matter of a few days, and will if the Bernanke
> says it's necessary.
>
> I'm thinking that the reason they'll want to issue debt is precisely
> to avoid the raging, or even hyper, inflation scenario. If the
> market were to accept and buy Fed debt, (and this is by no means
> a given), this would be a way for them to pull vast sums of dollars
> out of the economy very quickly, even while their balance sheet contains
> crap that, were they to sell it, wouldn't otherwise do the trick.
>
>
> Whether they would or could act quickly enough to offset a credit
> expansion that could be expanding at light speed, given the monetary
> base your graph depicts, once banks DO start lending again, is another
> question.
On Jan 19 04:15 PM Paco Ahlgren (Bona Fide) wrote:
> When people start to perceive that asset prices are increasing again,
> the velocity of money will speed up, and it's going to come hard
> and fast. The Fed is not going to be able to control rising prices.
Being Austrian in your approach is great, but for me your definition of money supply is to narrow for our monetary and banking system. Read my blog if you get a chance for my current stance. Great stuff to debate about. Thanks for the article. If you read my blog, it is just a private blog for family and a couple friends (although I put it on my reply for you and the world). Nice to see you throw your hat in the Seeking Alpha ring. You are right that the turn will be hard and fast, but you are really early (I think).
On Jan 19 04:15 PM Paco Ahlgren (Bona Fide) wrote:
> G III, I presume? :-)
>
> Try to remember that I define inflation and deflation as an Austrian
> -- the expansion or destruction of the money supply. We are not in
> a deflationary period, but an inflationary one. The collapse of prices
> is from de-leveraging, not deflation.
>
> When people start to perceive that asset prices are increasing again,
> the velocity of money will speed up, and it's going to come hard
> and fast. The Fed is not going to be able to control rising prices.
>
>
> Add to this the Treasury tinderbox, and it doesn't bode well for
> the future of the dollar or the global economy.
>
>
On Jan 19 03:04 PM henarl wrote:
> Auto44: The "dollars" that were and are being lost to deleveraging
> are not "somewhere" because they were never really there to begin
> with. They were created out of thin air by fractional reserve banking,
> 40 to 1 leveraging by investment bankers, CDSs created far in excess
> of underlying values, exagerated real estate prices and other financial
> scams.
> The new dollars that are now being "created" out of thin air by the
> Fed and Treasury are not real either but merely entries in computer
> memories.
> Such is the world of fiat "money".
On Jan 19 03:52 PM bowman711 wrote:
> Auto44, I am not sure how you are thinking when you say 'WHERE DID
> THOSE DOLLARS GO? THEY ARE STILL SOMEWHERE. THE PRINTING PRESSES
> ARE ADDING TO THAT.'
>
> If I have 100 shares of stock i bought at $50/share ($5,000), and
> the stock drops to $30/share, ($3,000), there is $2,000 that has
> gone noplace; it is no more. You say it is still 'somewhere?' Where?
> From what I have seen, the government isn't printing money anywhere
> near fast enough to compensate for the 'dollars' lost just in real
> estate and the stock market, not to mention retail stores closing,
> auto company losses, etc.
>
> If, as you say, the money is someplace, it would have to be that
> for every dollar stockholders and real estate owners have lost, there
> is someone else who has 'gotten' those dollars and is getting fabulously
> wealthy. I don't see any evidence of that happening. Some people
> may be getting wealthy shorting stock, but not nearly as many as
> who've gotten poorer as their portfolio has gone down in value.
1. Can they do it fast enough to avoid hyperinflation?
2. Can they do it at the correct time and at the correct pace to avoid hyperinflation?
3. At what point, after a long, nasty and destructive recession, will the political will emerge to take actions to slow the economy? Between now and Obama's reelection campaign? Between which Congressional races?
4. Assuming they want the ability to mop up dollars quickly, they will want to make their debt attractive. Where will the money stream "income" come from to pay the interest on the notes? Printing press? Bank fees? Direct taxation? Will the debt be guaranteed by the US taxpayer? If it is, how does this avoid the familiar old problem of debt overburden on the US taxpayer?
On Jan 19 04:13 PM JohnAl wrote:
> The Fed recently announced that they're looking at issuing their
> own debt...
>
> I'm thinking that the reason they'll want to issue debt is precisely
> to avoid the raging, or even hyper, inflation scenario. If the
> market were to accept and buy Fed debt, (and this is by no means
> a given), this would be a way for them to pull vast sums of dollars
> out of the economy very quickly, even while their balance sheet contains
> crap that, were they to sell it, wouldn't otherwise do the trick.
>
>
> Whether they would or could act quickly enough to offset a credit
> expansion that could be expanding at light speed, given the monetary
> base your graph depicts, once banks DO start lending again, is another
> question.
Commercial bank loans create money in this same way. People leverage or 'get in debt' when banks create new loan-money for them. When the people repay their loan principal the money is destroyed. Creating loans increases the money supply, repaying loans decreases it. So widespread 'deleveraging' means repaying loans, which means the money supply is shrinking as that repaid loan money ceases to exist.
Commentors have pointed out that the amount of money being destroyed by everybody trying to get out of debt is a lot bigger than the amount of new money Ben and Hank are throwing into the system to try to replace it, which will slow money supply deflation but won't stop it. Prices don't have to drop in lockstep with declining money supply. If the market is crappy keep your assets off the market; i.e. don't try to sell your house, boat, whatever. The 'velocity of assets' offered for sale can also decline to shore up prices. This is OPEC's modus operandi.
The repaid loan money doesn't 'go' anywhere because it's lifecycle is: creation as a loan; destruction when the money, the loan principal, is repaid. During its life the money went out in the economy and did work, inducing all kinds of economic activity out of people in exchange for (temporary) ownership of the money. The more times this money changes hands in a given period of time, the greater its 'velocity', and the greater the total amount of economic activity was induced by the money's circulation.
I pay Joey $20 to mow my lawn, he immediately goes and spends $5 on candy, the grocer puts in an order for more candy, the distributor puts in an order and decides to hire a couple more staff to meet the candy stocking demand, etc. Joey's only getting started spending his money and it has already done a lot of economic work.
Now the Fed wants to issue debt like commercial banks do it, which just means the Fed wants to create and lend money directly to commercial banks and other businesses. Unlike commercial banks, the Fed is not constrained by legislated capitalization and solvency requirements so the Fed can create and lend unlimited amounts of money. This power would come in handy lending money to long term or risky enterprises like financing an auto industry turnaround or financing large scale infrastructure rebuilding by states and cities, or financing the commercial banks who are going to finance these initiatives.
Fed and Treasury work together so there would be no problem sucking money out of the economy if threatened with hyperinflation. Treasury could take money out of the economy by raising taxes, either targeted or general, and using the money to buy back its bonds from the Fed.
There will be a new 'countercyclical rule' that bank asset:capital ratios will be increased to slow inflation and decreased to prevent deflation, so even in a fractional reserve banking system the 'fraction' can be rapidly changed to effectively permit or prevent the creation of new loans.
I think we are going through a 'generational' event and the present generation of economic participants will be much more cautious about debt, so even if banks have lots of money-creating capacity borrowers may be unwilling to take on new debt. I don't think hyperinflation is going to be a problem.
Assuming a ProShares Ultra ETF (+200% market exposure) has a net asset value (NAV) of $100, it needs $200 of exposure to generate a doubling of it's benchmark index's return the next day. If the market rallies by 10%, the NAV of the ETF would increase by 20% (double the index return of 10%) to $120. To double the next day's return, the ETF now needs $240 worth of exposure. This would be represented by $120 of NAV and $120 worth of leverage. Effectively, the ETF needs to increase the dollar value of its leverage by $20 to keep its leverage ratio constant ($1 of leverage for each $1 of NAV). The opposite occurs during a market decline when Ultra ProShares need to reduce leverage to maintain 200% daily exposure. In effect, Ultra ProShares increase market exposure as the market rallies (buying high) and decrease exposure as the market declines (selling low).
During deflationary times, as the cost of items fall, the relative value of money increases and for this reason gold, as a currency, does well. At the same time those who have money become rich while those without continue to struggle. A bank clerk who keeps his job will employ a gardener, while the one who loses his job becomes the gardener.
A self-sufficient hunter/farmer/fisherma... has no need of currency of any kind – provided he is completely satisfied with his life style and feels no need to provide for his old age.
However should he want a little coffee, sugar or a Plasma TV to lighten his life, the simplest way is to first exchange (sell) his excess of barley or fish for money and of course cash money can be saved for old age, not so easy with fish or game.
What currency should he select? Normally he would have little choice and will gladly accept the perfectly adequate currency of the country in which he lives.
However let us suppose that he lives close to the border of two countries at war with each other. Uncertain who will win he would probably accept both currencies until it gradually became clear which way the tide of war was flowing. With the currency of the loser highly likely to become worthless his preference would gradually move to that of the likely victor. What would the Shekel be worth if Hamas defeated Israel?
This course of action will protect his spending power for immediate needs but would almost certainly bring home to him the inadequacy of his provision for old age. The war just won might not be the last war fought, another country, with yet a different currency could well be the victor next time around. The need for an international currency becomes immediately apparent and gold is the only one he knows of, he can obtain it fairly easily and it has been around since at least the days of the Pharaohs.
In today’s complex world, war is not the only threat to the value of a country’s currency, the printing press is every bit as dangerous to financial security. A loyal citizen may well feel uneasy about questioning the ability of his leaders to maintain indefinitely the safety of its citizens or the value of the currency and is normally happiest investing in the Stock Market or, patriotically, in Government Securities and recent history tells us this is usually the most profitable course to take. However history didn’t begin recently and who can foresee the future?
In normal times investing in gold is rather like not going to the races, you won’t multiply your stake money but it will still be there for the future, even if you live as long into the future as Julius Caesar is in the past. A contemporary benefit is that we are not living in normal times and buying gold has a high chance of being as profitable as a winning day at the races.
"In effect, Ultra ProShares increase market exposure as the market rallies (buying high) and decrease exposure as the market declines (selling low)."
Please forgive my ignorance here, but if Ultra Proshares managers were doing this, none of their funds would show gains, right? And that simply isn't the case.
I'm not saying you're wrong, and I'm still looking into it (because I don't want to be holding a "time bomb"), but before I took this position, I looked deeply into it, and from everything I can see, the ETFs pretty much work the way they say they're going to..
Yes, after fees, you lose a little return. But even if TBT only mimics 1.85 times its underlying long-term treasuries, I'm still getting a lot more return on my position than I would with a 1X ETF, and since I can't short Treasuries directly, those are my only choices.
I did try to short ETFs that mimic long long-Treasuries, but several brokers told me they can't get the shares. If you know of a broker who can get those ETFs for shorting, I would certainly love to know which one it is.
Finally, I could short futures, but that's way too much leverage (and risk), and then you have to deal with rolling over contracts as well.
TBT seems like a solid, relatively easy way to get some good exposure to short long-term Treasuries. The swaps are re-set every day... and these are super-leveraged CDFs... these are just plain-vanilla fixed-for-floating contracts that are backed up by huge cash positions.
If I'm wrong about the relative safety of TBT, I'd like to see some more evidence, because I'm not absolutely married to this position -- and I mean that. Dogmatism is the worst thing for a portfolio. But to me it looks like a good strategy for capitalizing on the coming collapse in long-term Treasuries.
On Jan 19 10:44 PM wulfmeister wrote:
> Paco - A comment on TBT and other short leveraged ETF's. In a research
> report entitled "DIG"ging Deeper into the Effects of Compounding
> on Leveraged and Leveraged Inverse ETF's," published Jan 13, 2009
> by Morgan Stanley: "On average we found that... ETFs captured 90-110%
> of their expected daily return 48% of the time and captured 70-130%
> of their expected return 77% of the time...." " Even if leveraged
> and leveraged inverse ETFs capture 100% of their targeted daily return,
> they are unlikely to match a point-to-point doubling of their underlying
> benchmarks as a result of the effects of compounding." So let's
> say you buy TBT when the index is at 100. On day two the index is
> down 10%. due to the doubling effect, TBT is down 20% and you are
> down to 80. On day three, the index is up 10% so TBT is up 20%.
> But since your capital base is now 80, then 80X1.20=96. A tidy -4%
> loss. Note that even thought the daily doubling was perfect each
> of the two days (down 20% when the index was down 10% and up 20%
> when the index was up 10%). Simply stated, the larger the base value,
> the greater each day's percentage change has on the notional value
> of each security." Also... "In order to provide +200% of an index's
> daily return, Utlra ProShares need to increase exposure when the
> market rallies and decrease exposure when the market declines."<br/>
>
> Assuming a ProShares Ultra ETF (+200% market exposure) has a net
> asset value (seekingalpha.com/symbo...) of $100, it needs
> $200 of exposure to generate a doubling of it's benchmark index's
> return the next day. If the market rallies by 10%, the NAV of the
> ETF would increase by 20% (double the index return of 10%) to $120.
> To double the next day's return, the ETF now needs $240 worth of
> exposure. This would be represented by $120 of NAV and $120 worth
> of leverage. Effectively, the ETF needs to increase the dollar value
> of its leverage by $20 to keep its leverage ratio constant ($1 of
> leverage for each $1 of NAV). The opposite occurs during a market
> decline when Ultra ProShares need to reduce leverage to maintain
> 200% daily exposure. In effect, Ultra ProShares increase market
> exposure as the market rallies (buying high) and decrease exposure
> as the market declines (selling low).
"The repaid loan money doesn't 'go' anywhere because it's lifecycle is: creation as a loan; destruction when the money, the loan principal, is repaid." - derryl
This is correct. As long as the dollar amount of new loans exceeds the dollar amount of retired loans, the circulating supply of money is increasing. When repayments exceed new loans, the circulating supply deminishes.
Now as an exercise in stretching one's thought process on this topic, what happens when someone defaults on the loan and the collateral can't be liquidated for enough dollars to repay the entire principal? How does that impact the circulating supply of money?
Example:
derryl borrows $1,000,000 to build a house (derryl has expensive tastes). Hires a builder who purchases lumber, shingles, granite countertops, gold plated commodes, stainless kitchen appliances, all the best stuff, and builds the house, keeping some of the $1,000,000 as profit. derryl has no money left over from the loan, it's all spent into circulation. The money supply increases by $1,000,000 due to the loan.
Two years later, real estate has crashed. derryl's house is only 'worth' $500,000. derryl's option arm rate loan resets and he can't make the loan payments any more, so he mails the keys in to the bank and moves in with his parents.
The bank forecloses (legal formality) and sells the house for $500,000 and writes off $500,000 as a loss. In theory this reduces the money supply by $500,000. But the original loan increased the money supply by twice that amount.
How does that 'extra' $500,000 ever get removed from circulation? It all got spent building the house, or kept by the builder as profit and became part of the money supply at large.
Is that inflationary? How about if the loan losses amount to trillions of dollars in aggregate?
No. Unless the bank printed the money to give to Derryl, the money supply has not increased. The bank's loss offsets any "gains" from the money that was spent.
Are you saying that investment losses increase the money supply? If you are, would it be safe to say that investment gains decrease the money supply?
Again, I'm not saying leverage isn't dangerous, because it can be. But leverage is not the same thing as increasing the money supply.
On Jan 20 12:18 PM Smarty_Pants wrote:
> outstanding post derryl.
>
> "The repaid loan money doesn't 'go' anywhere because it's lifecycle
> is: creation as a loan; destruction when the money, the loan principal,
> is repaid." - derryl
>
> This is correct. As long as the dollar amount of new loans exceeds
> the dollar amount of retired loans, the circulating supply of money
> is increasing. When repayments exceed new loans, the circulating
> supply deminishes.
>
> Now as an exercise in stretching one's thought process on this topic,
> what happens when someone defaults on the loan and the collateral
> can't be liquidated for enough dollars to repay the entire principal?
> How does that impact the circulating supply of money?
>
> Example:
>
> derryl borrows $1,000,000 to build a house (derryl has expensive
> tastes). Hires a builder who purchases lumber, shingles, granite
> countertops, gold plated commodes, stainless kitchen appliances,
> all the best stuff, and builds the house, keeping some of the $1,000,000
> as profit. derryl has no money left over from the loan, it's all
> spent into circulation. The money supply increases by $1,000,000
> due to the loan.
>
> Two years later, real estate has crashed. derryl's house is only
> 'worth' $500,000. derryl's option arm rate loan resets and he can't
> make the loan payments any more, so he mails the keys in to the bank
> and moves in with his parents.
>
> The bank forecloses (legal formality) and sells the house for $500,000
> and writes off $500,000 as a loss. In theory this reduces the money
> supply by $500,000. But the original loan increased the money supply
> by twice that amount.
>
> How does that 'extra' $500,000 ever get removed from circulation?
> It all got spent building the house, or kept by the builder as profit
> and became part of the money supply at large.
>
> Is that inflationary? How about if the loan losses amount to trillions
> of dollars in aggregate?
When 5k was given to your broker in exchange for stocks, that money was then in turn transferred to the company who's stock you purchased minus fees that went into your brokers pocket (who invariably spent it on any number of things - so the fee money is still in the system at a grocery store for instance). Now the remaining money that went to the company who sold you their company paper was used for salary, asset purchases, supplies, investments, loan payments etc. So now that money may be spread throughout the system still, but is not "lost" whether it is in the hands of whoever sold the asset or it's in a savings account of an employee. Even with asset prices plunging, the last person who sold the asset to you still has that same cash money (or has since transferred it somewhere else in the system). Just because the asset you purchased from me for 5k, is now marked to market at 3k, does not mean that the 2k was lost and never to be recovered. I still have the extra 2k you paid me for that asset unless I already spent it (which would still keep it in the system). The loss is yours, the gain is mine. It is not "lost" unless the fed destroys it without replacing it. Am I looking at this wrong? I just don't see the money being lost but rather just not available right now since cash seems to be king and everyone needs dollars to pay down their own debts.
On Jan 19 03:52 PM bowman711 wrote:
> Auto44, I am not sure how you are thinking when you say 'WHERE DID
> THOSE DOLLARS GO? THEY ARE STILL SOMEWHERE. THE PRINTING PRESSES
> ARE ADDING TO THAT.'
>
> If I have 100 shares of stock i bought at $50/share ($5,000), and
> the stock drops to $30/share, ($3,000), there is $2,000 that has
> gone noplace; it is no more. You say it is still 'somewhere?' Where?
> From what I have seen, the government isn't printing money anywhere
> near fast enough to compensate for the 'dollars' lost just in real
> estate and the stock market, not to mention retail stores closing,
> auto company losses, etc.
>
> If, as you say, the money is someplace, it would have to be that
> for every dollar stockholders and real estate owners have lost, there
> is someone else who has 'gotten' those dollars and is getting fabulously
> wealthy. I don't see any evidence of that happening. Some people
> may be getting wealthy shorting stock, but not nearly as many as
> who've gotten poorer as their portfolio has gone down in value.
You are incorrect. The bank does create money to loan to derryl. This is the nature of fractional reserve banking.
Even the FED does not dispute that banks create money:
www.federalreserveeduc...
See page 57 ("For the economy and banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to “create”money.")
Also Wikipedia:
"Fractional-reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all deposits immediately upon demand. This practice is universal in modern banking"
Your original article leads me to believe that you are familiar with the Austrian School of thought and give it some weight in your thinking.
I would suggest that you read through Rothbard's "The Mystery of Banking" for a more complete description of how fractional reserve loans create money from an IOU (as derryl pointed out in his original post). The mechanics of bank balance sheets makes the point clearly.
You can download Rothbard's text here:
mises.org/mysteryofban...
The book has several examples which show that the bank actually does create money, starting from a very simple balance sheet and adding complexity up to and including fractional reserve loans.
My original question was intended simply to make people think beyond the creation / destruction of loan money by normal means. It presupposes that the reader understands how fractional reserve loans add (temporarily) to the circulating money supply as derryl noted.
I chose an example everyone can understand (a house), though the same prinicple applies regardless of the use of the loan. If a loan defaults and there is insufficient collateral to repay the balance, then the effect on the money supply is beyond what most people consider when they try to connect all the dots, but it happens just the same.
My understanding of the process leads me to say that such a default would have one of two possible impacts, depending on the state of the bank's balance sheet.
1) The bank is well capitalized and the loss on the loan is small compared to the bank's net capital position: In this case, the bank will record a loss against its capital equal to the loss on the loan. This will effectively transfer capital from the bank's shareholders to the recipients of the loan which is, strictly speaking, not inflationary because the bank capital was already part of the circulating money supply. Instead of belonging to the bank, it now belongs to those who received the loan funds.
2) The bank's capital position is smaller than the loan loss (ie. the bank becomes insolvent): In this case, the created money cannot be fully offset by a loss in the bank capital and the money supply is permanently increased by the underage.
Given that Case 2) seems to be quite widespread these days (ie. many banks are technically insolvent and only operating because of TARP bailout funds), it would seem to me that every foreclosed house with an upside down mortgage would be in fact be adding to the money supply.
Even the TARP money is simply 'extra' money added to a bank's capital structure to replace the "lost" loan amount. So now that loan money has been spent into circulation, and is also sitting in the bank's reserves, with a matching bank IOU (preferred shares) to the FED.
It is my belief that failed fractional reserve loans that make the issuing bank insolvent permanently increase the circulating money supply. If there is a flaw in my reasoning, I'd be interested in discovering where my thought process fails.
I even wrote about the multiplier effect in my article today...
On Jan 20 03:00 PM Smarty_Pants wrote:
> "No. Unless the bank printed the money to give to Derryl, the money
> supply has not increased." - Paco Ahlgren
>
> You are incorrect. The bank does create money to loan to derryl.
> This is the nature of fractional reserve banking.
>
> Even the FED does not dispute that banks create money:
>
> www.federalreserveeduc...
>
>
> See page 57 ("For the economy and banking system as a whole, the
> practice of keeping only a fraction of deposits on hand has an important
> cumulative effect. Referred to as the fractional reserve system,
> it permits the banking system to “create”money.")
>
> Also Wikipedia:
>
> "Fractional-reserve banking is the banking practice in which banks
> keep only a fraction of their deposits in reserve (as cash and other
> highly liquid assets) and lend out the remainder, while maintaining
> the simultaneous obligation to redeem all deposits immediately upon
> demand. This practice is universal in modern banking"
>
> Your original article leads me to believe that you are familiar with
> the Austrian School of thought and give it some weight in your thinking.
>
>
> I would suggest that you read through Rothbard's "The Mystery of
> Banking" for a more complete description of how fractional reserve
> loans create money from an IOU (as derryl pointed out in his original
> post). The mechanics of bank balance sheets makes the point clearly.
>
>
> You can download Rothbard's text here:
>
> mises.org/mysteryofban...
>
> The book has several examples which show that the bank actually does
> create money, starting from a very simple balance sheet and adding
> complexity up to and including fractional reserve loans.
>
> My original question was intended simply to make people think beyond
> the creation / destruction of loan money by normal means. It presupposes
> that the reader understands how fractional reserve loans add (temporarily)
> to the circulating money supply as derryl noted.
>
> I chose an example everyone can understand (a house), though the
> same prinicple applies regardless of the use of the loan. If a loan
> defaults and there is insufficient collateral to repay the balance,
> then the effect on the money supply is beyond what most people consider
> when they try to connect all the dots, but it happens just the same.
>
>
> My understanding of the process leads me to say that such a default
> would have one of two possible impacts, depending on the state of
> the bank's balance sheet.
>
> 1) The bank is well capitalized and the loss on the loan is small
> compared to the bank's net capital position: In this case, the bank
> will record a loss against its capital equal to the loss on the loan.
> This will effectively transfer capital from the bank's shareholders
> to the recipients of the loan which is, strictly speaking, not inflationary
> because the bank capital was already part of the circulating money
> supply. Instead of belonging to the bank, it now belongs to those
> who received the loan funds.
>
> 2) The bank's capital position is smaller than the loan loss (ie.
> the bank becomes insolvent): In this case, the created money cannot
> be fully offset by a loss in the bank capital and the money supply
> is permanently increased by the underage.
>
>
> Given that Case 2) seems to be quite widespread these days (ie. many
> banks are technically insolvent and only operating because of TARP
> bailout funds), it would seem to me that every foreclosed house with
> an upside down mortgage would be in fact be adding to the money supply.
>
>
> Even the TARP money is simply 'extra' money added to a bank's capital
> structure to replace the "lost" loan amount. So now that loan money
> has been spent into circulation, and is also sitting in the bank's
> reserves, with a matching bank IOU (preferred shares) to the FED.
>
>
> It is my belief that failed fractional reserve loans that make the
> issuing bank insolvent permanently increase the circulating money
> supply. If there is a flaw in my reasoning, I'd be interested in
> discovering where my thought process fails.
Is that inflationary? How about if the loan losses amount to trillions of dollars in aggregate? " Smarty
Yes, it normally would lead to price inflation according to MV = PY or P = MV/Y. The inflation was created when the original $1,000,000 loan was made (M = M + $1,000,000). However, as you pointed out, if the net of new FRB loans - repayment of old FRB loans is negative, then M might decrease anyway (M = M - FRB loan repayments).
Yet once again for the benefit of the other folks, the fractional reserve model:
1. Create principal from nothing. This is inflation. The purchasing power of it is stolen from all dollar holders for the sake of the banks, borrowers and governments who tax the phony economic growth.
2. Lend the principal out for interest with IOUs as collateral.
3. As the loans are repaid the principal goes back to nothing. The bank pockets the interest.
4. In the event of default, the money is not destroyed. In addition, new money might be created by new FRB loans to purchase the defaulted collateral.
However, according to MV = PY, or P = MV/Y, the velocity of money (V) as well as aggregate output (Y) also determines the price level (P). Even if M increases, the price level need not rise immediately if people choose to save the new money instead of spending it. As a consequence, even a helicopter drop of new money might end up in saving accounts until such time as public sentiment changes.
This is not so.
When the bank forecloses, they get title to the property which was pledged as collateral. The loan balance is still due. The loan money is still in the hands of the public that worked on the house. The bank then auctions off the property to get the loan money back and pay off the loan. Paying off the loan "collects" money from circulation and "eliminates" it by paying off the loan (as detailed in derryl's post).
If the auction brings more money than the loan amount due, the bank pays off the loan ('destroying' that money) and the remainder reverts to the home owner (ignoring expenses, and the like). The money supply is then back at the level it held prior to the original bank loan.
If the foreclosed loan balance is $1,000,000 and the house only brings $500,000 at auction, only $500,000 of the orginal loan is eliminated. The remaining $500,000 is still circulating.
If the bank's capital structure (ie. assets minus liabilities) is larger than $500,000 then the bank will record a loss against their capital (ie. their assets go down by $500,000). You can consider this the same as having the bank just "give away" $500,000 of their own money into circulation. What the bank lost, the home builders gained.
If, however, the bank's assets minus liabilities is less than $500,000, then they can't record the entire amount as a loss because they would go bankrupt. There is no way to "get rid" of that extra loan amount.
On Jan 19 10:01 AM Paco Ahlgren (Bona Fide) wrote:
> In the years I've been debating finance, economics, and even politics,
> I have never quite gotten used to the idea that some people believe
> condescension is a substitute for a cogent argument. Does the cynicism
> make you feel more "right?"
>
> Why don't you just call me stupid and get it over with? :-)
>
> The velocity of money will return, suddenly and ferociously. De-leveraging
> will stop when the velocity of money increases, and people perceive
> prices to be rising again. They won't, of course, actually be rising.
>
>
> Finally, Treasuries are going to collapse, and rates are going to
> rise at the same time prices are exploding. I've written many articles
> detailing my position in the last two weeks, and I strongly suggest
> you read them.
>
> Finally, to the other reader who suggest money is as easy to take
> out of the economy as it is to put it, my question is how? By selling
> Treasuries? See the previous paragraph.
>
> The party is over.