Two Kinds of Money; Two Kinds of Tears. As an investor you need to understand the two types of money, so you can avoid the two kinds of tears.
There are two kinds of money: exchange (or thing) money and debt money.
All financial wealth breaks down into two categories: property and debt.
Adam and Eve did not have money. But the creation of new people created the need for money; a need to store value and take that value to another place or into the future to exchange it with others. As the social world expanded, it gave birth to money. Money could be any portable and durable object-beads, shells, salt, shiny rocks such as gold, even paper. Debt also served as money, an obligation to pay could be transferred and transported.
Governments quickly took over the control of both kinds of money. With control of the legal system and control of the money supply they could control the economy.
Thing Money. Exchange money comes from simple trading. I trade you a chicken for some fish. But when people got tired of carrying around fish and chickens to exchange them for something else later they substituted commodities that were easy to carry and that smelled better. Sea shells, salt, gold are some of the early exchange monies. Wood would work as an exchange money, as would paper, and even paper with some king's picture on it. Paper money works fine as an exchange money, and unlike gold the amount can be adjusted as the economy grows or declines.
In the beginning, governments could not easily increase the supply of thing money. Miners dug up gold and the world had either too much gold and inflation, as in the Spanish Colonial Empire, or not enough gold in an expanding economy and we had deflation. To solve this problem, and others, governments switched to paper money. Paper money has existed at least since the time of Kubla Khan. We all know the problem with paper money - governments have found it too easy to pay their debts by printing more paper money. Much easier even than adding base metals such as lead to the gold currency.
Debt Money. Once people discovered debt, debt money was not far behind. We all use debt money. Our savings account, our money market fund, our savings bonds. These feel like money to us, yet they are also debt. The value of debt money depends on: the rate of interest, the ability of the borrower to pay the interest and principal, and the wealth, if any, that secures the debt (for example, a house mortgage).
Debt money has a more recent, complex and secretive history than thing money. Governments borrow money, commonly by selling bonds. Since governments can print more paper money or increase taxes to pay their bonds investors tend to like government bonds. Still, investors have often gotten burned as governments sometimes borrow too much and drive up interest rates, default, revalue the currency, or print too much thing money. In other words, lenders do not always get paid full value.
Governments have discovered another amazing aspect of debt money; by increasing the amount of private debt money, governments apparently can stimulate economic activity without inflation. This is the secret elixir that politicians have searched for centuries, an apparently endless fountain of wealth. I say apparent, because the problem of abusing debt money is that, to paraphrase John Maynard Keynes, "in the long run, we are all dead… broke."
In the capitalist world borrowing serves a crucial function in expanding economies. Savings are gathered up and loaned to merchants and industrialists, who if their enterprises succeed, pay back those loans with handsome interest. (Similarly, limited liability entities and stock serves as a way to gather up savings, although in the form of property, rather than debt.)
Time and interest distinguish debt from property; and similarly, time and interest distinguish debt money from paper money. Debt must be repaid - by a time certain and with interest. This means that investments that use debt must succeed, and must return a profit great enough to pay the debt - on time and with interest. Failure to do so results in the death of the company. The debt also dies, dropping in value and even becoming worthless. We may think of debt money as living money, money that grows in value by a time certain or dies. Paper money on the other hand can sit on the shelf forever; it never goes out of existence as long as the issuer exists. Its value, like the value of all objects, depends on supply and demand, and inflation and deflation.
Governments can stimulate economies by lowering interest rates and otherwise encouraging private borrowing. When companies can borrow easily and cheaply then weak companies can stay alive. Other brave souls can borrow cheaply and start up new enterprises. Individuals can borrow and buy more than what their incomes would allow. This greater economic activity results in more jobs, and increasing asset values. As the economy expands the debt money supply - that is, the amount of private loan transactions, increases. An ever riskier complex chain of Peter owing Paul comes into being, one that depends on every cog meshing together, and on asset values increasing so that old debt can be paid off. The slightest slip - a tenant that can't pay the rent, a small company that misses it loan payment, and the chain may unravel.
People are wealthier, businesses are wealthier, investors are rock heroes - and it all gets better and better until…
Oops, someone misses that game-changing payment.
Quickly, real estate entities cannot collect the rents they need to pay their loan. Companies with high stock valuation suffer falling sales that do not cover loan payments. And when the borrowers seek out loans to refinance old loans or to buy new assets, they find that new lending has disappeared.
Debt money supply collapses, as loans turn into worthless obligations. The collapse of debt money supply accelerates as asset values plummet. This is deflation, depression. As borrowers scramble to pay loans they sell assets and paper money becomes scarce. Bank runs (or in modern times money market runs) occur.
Governments step in, determined to increase the money supply. They provide cash and short term loans to banks to prevent bank runs. This may solve the liquidity crisis, but it does not solve the insolvent borrower problem.
Governments then try to stimulate the creation of new private debt. They lower overnight interest rates. This works for a few business cycles, but in the end interest rates can only go to zero. The governments can also try guaranteeing bad debt, and replacing it with their own obligations, by for example, bailing out companies or banks. This does not increase economic activity but it prevents unemployment from spreading.
In modern times governments fight against the wave of deflation with a new trick - buying their own bonds. When governments run a deficit they can issue bonds and then buy their own bonds by printing electronic money - a technique that increases the thing money supply (and risks inflation) with the intent of increasing private debt money supply (and preventing deflation).
This process allows for the following benefits. First, by borrowing money the government can run a deficit and spend more than it collects, and thereby provide some economic stimulus through building highways, paying pensions, providing student loans, and employing government workers. When the government buys its own debt it can run an even deeper deficit.
Second, by buying its own debt and other debt such as mortgage bonds the Fed can increase the ability of banks to loan money, since they replace lower quality debt with higher quality debt or with thing money.
Third, it can stimulate private lending by driving down bond interest rates and related long term interest rates through purchases of its own debt.
The Fed hopes to increase economic activity through increased private borrowing - that is, it hopes to increase the debt money supply.
However, this only works if the banks make more loans or somehow encourage others to do so. When the banks mainly loan the money that they get from the government back to the government, they collect interest (a taxpayer subsidy) and remain in business. This helps the banks, but no one else.
Will this clever scheme work and how will it end? Some argue that the Fed can make adjustments in time. This assumes that the Fed will have sufficient options available. It might also appear to work if the forces of inflation and deflation remain in balance. This delicate and unsustainable balance is what people mistake for a "normal economy". A normal economy, where investment is limited to real savings is a distant dream; returning to it would require pain beyond what most voters and politicians would accept.
We have some risks. If the banks finally make more loans it creates at least two risks: 1) inflation, from increased debt money supply; and 2) asset bubbles from "too-cheap" financing. If the Fed stops QE, or even reverses it, long term interest rates will probably rise. This creates other risks: 1) greater cost to the government in the form of higher interest payments; 2) recession caused by higher interest rates; and 3) stagflation, caused by excess money supply combined high interest rates at the same time. Because the US Dollar is the world's currency, other parts of the world are deeply affected by these same risks, and in particular, by a withdrawal of easy debt money.
Thus, the Fed cannot easily end its efforts to lower interest rates; it will not be able to easily exit QE.
What about all the exchange money being created by the Fed buying debt? This would offset any deflationary pressures if it ever gets out of the banking system. This is another reason why it is hard to predict whether deflation or inflation will dominate in the future. We might see companies unable to borrow at rates low enough to prevent bankruptcy, and while this would be deflationary, the escape of thing money from the Fed's massive buying might increase inflationary pressures at the same time. Rising interest rates will also tank the asset bubbles that have formed from cheap debt. Such events will also be deflationary. In short, stagflation and deflation/depression are both possible.
While hyperinflation is also possible, in my opinion hyperinflation could only happen if Congress got direct control over the paper money supply, an unlikely event, although possible. We have seen how in Japan that the elected government can exert great pressure on the central bank.
Trouble seems very, very likely from QE and the government's continued deficits. Unfortunately, we cannot predict whether it will come in the form of stagflation or depression/deflation. We will have deflation if decreases in debt money supply (through higher interest rates and bursting asset bubbles) outweigh the increase in paper money supply; and inflation if we have the reverse. Thus, stagflation or depression seems increasingly likely, with hyperinflation an unlikely possibility. Since other countries, such as Japan and China, may have even greater problems, the world financial system remains very fragile.
What to do? You might wish to save in ways, at least some of which might provide a measure of protection in either a stagflation or depression environment. TIPs, short term treasuries, some precious metals, and low-leverage positive-cash flow real estate are possibilities. Stocks and long-term bonds seem less interesting to me. Thank you. Bill
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for educational purposes only, and I have no advice as to what you should do (other than think about the article). I do not suggest that you buy, sell or hold any investment. Please make your own judgments in conjunction with those professionals you trust.