Wealth, Then Credit, Then Money - Not the Other Way Around

Why We Are in More Trouble Than Many People Think...

Average annual wage in 1965 was $4658.72
Average cost of a house in 1965 was $20,700
Cost of Harvard tuition in 1973 was $3000

sources:
(www.ssa.gov/OACT/COLA/AWI.html)
(www.census.gov/const/uspricemon.pdf)
(www.provost.harvard.edu/institutional_re...)

The process of credit creation is straightforward from a top-level perspective:

1 - Banks create the bank money (deposits) to purchase financial assets (bonds)...
2 - Based on the wealth of the borrower (income and assets)
3 - Money serves to "clear" exchanges between depositors at different banks who use "bank money" (deposits) as a substitute for reserves.

Let's take a look at the errors that come from missing these fundamental facts, with an eye to keeping our investment powder dry.

Error 1a - We can put the cart before the horse - in fact we don't even need the horse, the cart will pull itself.

We can print "money" which gives rise to "credit" which then becomes "wealth".

There is no attempt at rational explanation how this is to occur. While many articles for the public are written, no prominent economist can explain this in front of their peers, because none of them are willing to say they believe in free lunches. Zimbabwe is apparently wealthy because they've more "money".

Error 1b - Banks are credit intermediaries and that is their main function.

Under fractional reserve banking, banks are credit creators. Banks remove value from the money (expanding the money supply and diluting the yields of savers), earn a spread for doing so (bank interest earned), while workers and entrepreneurs put the value in.

Error 2a - The people in government will solve the crisis.

Keep in mind the market decided to fire a number of these people in the corrections of 1992, 1998, 2001, and 2007, but the government stepped in ...

Error 2b - The government can recover the economy.

The government is a fraction of the size of the economy. Can the tail wag the dog or does, even if it takes time, the dog wag the tail?

Error 2c - Deficits are the problem.

Not true, spending is the problem. No matter how it's financed, spending consumes resources the market would put to other uses ... after all, what's the point of government unless to coerce people into financing things at a price to which they wouldn't ordinarily agree? We could rescind the remaining bailouts and support bank deposits (the effective money supply) and let the market decide how to divvy those deposits up! (goodbye bad managers ...)

Error 3 - The government can create something from nothing.

Since the government is only a transfer agent, it really cannot 'add' anything it doesn't take away from someone else. And since the exchanges are forced on people, it is always taking more than adding. No politician is able to explain how a loss to everyone becomes a 'gain' for society. They just willy-nilly say it is (as if by decree, the laws of nature can be rescinded). If everyone has to pay the Jones family for goofing off, that is not going to 'stimulate' the economy. Really it just drains everyone of productive capacity, including the Jones family.

Error 4 - Reserves lead to lending.

The rhetoric has become so amazingly backwards, even normally 'free market' economists are now yelling about the 'giant level of reserves' which must 'lead to excess lending'. However, reserves have never been a constraint on lending.

Think about it. If you are a bank, you know at what price you can borrow any amount of reserves you need. The relevant questions for the future are: What yield will I receive if I create the bank credit for this loan? What are the present and likely future costs of reserves should circumstances require me to provide reserves and how does that influence my decision to expand lending?

Now a bank isn't going to loan if they feel they are not going to make money, and they will be especially careful if they've precious little capital to lose, and even more careful if they are just scraping by in cash flow terms. And borrowers aren't going to borrow if they feel the results are going to hurt them. While things can change, reserves simply make no difference in this part of the situation.

Error 5 - Money flows tell something.

Money doesn't 'flow' anywhere. It is in someone's possession at all times. When a person buys a stock, two people agree on a price and money moves from one person's account to the other and the stock ownershiop goes the other way. At no time is there a 'flow'. Do we talk of 'stocks flowing into the money market'? Do we talk of cars or houses 'flowing into the loan market'? Imagine listening to the ticker commentary and hearing "there's a lot of aluminum on the sidelines ready to zoom into the bank deposit market!" ... it just makes no sense.

"Money on the sidelines" is just the same error. Money is always 'on the sidelines' because money is in someone's possession! It is not true that everyone can run their cash balances down. Everyone can try. Person A can spend quickly and person B can sell quickly and then spend quickly. Lots of exchanges occur, but in the end, the same amount of money exists and prices are higher.

Error 6 - Slack in the economy is fixed by more money if the authorities increase money by deficit government spending and the Fed prints the difference.

Imagine that we find that a new giant US Casino is a loser and cannot recoup the money put into it. In an effort to help the Casino, the government starts giving away money. How does this help? The Casino is a loser and only can temporarily be supported by an illusion of 'excess funds' which soon disappears.

This effect occurs whether or not overall prices rise or fall. The 'inflation / deflation' debate is about what to do with cash, but since it is aggregative, it has less to say about the fact that some prices are abnormally high and others are abnormally low because of government intervention. This of course makes profit and loss calculations in error and precious capital is wasted (imagine your revenues and expenses being off by 30% but you didn't know in which markets ... how can businesses calculate profit and loss under those situations?). That this basic fact is out of reach of so many commentators is a sad testament to the level of analysis.

Error 7 - We can solve our correction by stimulating 'velocity'.

First off, the concept of 'velocity' being an independent cause of anything makes little sense. It's like saying the 'tires push the car' and when the car doesn't move we need 'more tires'. Yeah? What about the engine? After putting on twenty more tires we're still sitting in the desert dying of thirst.

Bottom line, velocity is not the cause of anything, it is a result of things ... trades! The idea that if people make 7 exchanges a year rather than one exchange a year, and when exchanges fall, there's too little 'money' .... directly follows from this fallacy. Wealth drives exchanges, and in a fractional reserve banking economy, credit and money follow.

The problems have come from banks and entities that believe borrowing short and lending long is the norm, and that all this yield curve leverage is for 'free'. Well, there's a risk side to that, and it's nonsense the Fed makes poor people pay for disastrous money market management by large entities and banks, but that's the breaks. Imagine if the gains in productivity went to workers as prices fall by 70-80% over the last 20 years rather than rising 100%. We'd have people with 2x their income in real terms rather than going backwards.

Error 8 - Prices steady equals all-okay.

If prices should be going down by 10% (productivity increasing), holding prices steady is a disastrous policy as it channels funds into 'financial assets' that have no business whatsoever receiving new funds. If that's the policy, why not channel funds into the hands of the common worker? This is a democracy, right?

Incredibly, ALL these fallacies are on display today. In my view, recoveries just aren't going to be real until the government lets the market fire bad managers.

Enough of that. WHAT TO DO:

First off realize that the little guy is going to be toasted. So far it's been a near political free-for-all. A rational policy is to get everything you can as quickly as possible into the most solid assets you can and to engage in business 'off the radar' ... meaning a currently legal business where the exchanges aren't directly government controlled (and thus potentially hurt) but still are providing an essential good.

Keep in mind, the government may cut off a lot of support (in inflation adjusted terms) to many individuals as times get tougher. That means a whole lot of people are going to get hit, and that includes a lot of government employees at some point as well.

Since the Feds are facing disaster on both sides of the inflation / deflation debate, consider splitting the bets in a timely manner, as the Fed is more likely to oscillate policy. When everyone is talking inflation, hold more cash. When everyone is talking deflation, buy up cheaper assets.

Keep in mind, the current administration is bent on raising taxes, which cause about 3x the destruction dollar-for-dollar. In other words, $1 in taxes causes $3 in economic shrinkage. It could even go worse if we're kicked when we're down.

Be aware that our country is now borderline or (perhaps over the line) fascist. This can take a very dark turn as history shows. If you've the means, have an exit plan for your assets and family... just in case. The wealthy already do.

Hopefully this article is some balance to the happy smoke coming out these days. I wouldn't bet hard on the recovery and we will not recover in real terms unless there is enough savings to fund a recovery, which probably doesn't exist. We need to make changes in government more than ever.

Good luck in your investments and personal goals.

Disclosure: Jim holds a position in Gold ETFs.

Comments

[Dave Wrixon:]

For God's sake somebody put this guy in charge of the FED.

Excellent introduction to basic Economics. Most of it absolutely fundamental but apparently not obvious.

You are not, however, going to be popular if you start ruining a perfectly good debate by introducing incontrovertible facts.

Oct 20 05:42 AM

[chap08:]

"we will not recover in real terms unless there is enough savings to fund a recovery"

Please justify that statement Jim. You are commiting the same "cart before the horse" errors that you accuse others of. Why are these savings so important to recovery? We don't need more domestic saving to fund investment if that's what you're thinking. We have had "boom" years recently accompanied by record low savings rates. Meanwhile we have seen record amounts mal-invested in things like housing and Treasuries. The massive funds we have invested recently, have come from foreign governments and your hated fractional reserve banking. As you recognize, there is currently no shortage of bank reserves; and foreign governments will carry on propping up dollar assets. Also, how many historical instances can you point to where recovery has been driven by increased savings and how has that happened?

You have much to agree and disagree with, but I can strongly agree with one of your conclusions:

"Since the Feds are facing disaster on both sides of the inflation / deflation debate, consider splitting the bets in a timely manner, as the Fed is more likely to oscillate policy. When everyone is talking inflation, hold more cash. When everyone is talking deflation, buy up cheaper assets."

Spot on.

Oct 20 07:44 AM

[The Geoffster:]

"Be aware that our country is now borderline or (perhaps over the line) fascist."
Well said. As Lenin observed:
"Fascism is capitalism in decay."

Oct 20 04:05 PM