Follow the Money
March 22, 2007
by Graham Makohoniuk, CMA CFA
Editor's note:What follows is part of an email exchange between Graham Makohoniuk and Charles Zentay on the subject of money, inflation and deflation. Graham wrote this in response to Charles's excellent recent essay, "The Good, the Bad and the Ugly" which was originally published here at bullnotbull.com. It is an extremely clear and concise analysis of money, credit, inflation and deflation. Since both Charles and I thought a larger audience would also benefit from the information, we made arrangments with Grahm to republish it here. Thank you, Graham.
So without further ado:
This is my view of the universe of money. It may seem simplistic, but I don't know what you know, or what meanings you would assign to certain terms. I will build this view in basic terms step by step, and please forgive me if you find it at too basic a level.
Let's assume a country "Omniland" where there are exactly 100 widgets and nothing else. Let's also assume that there are 100 "spendios", which is their currency. Each widget is priced at 1 spendio (S$1.00).
Now if somehow an additional S$50.00 are put into Omniland, then there would be a total of S$150.00, but still only 100 widgets. So every widget is now priced at S$1.50. I would call this inflation. The price of each widget has risen, because there are more spendios but the same number of widgets. By extension, inflation in the USA would occur if the money supply (including credit) grows without a corresponding increase in productive capacity - be it manufacturing or services.
For now, forget about the 50 spendios being put into Omniland and suppose instead that somehow S$25 is taken out of the economy. There is now S$75 in total circulating in the economy, and 100 widgets. So each widget is now priced at S$0.75. I would call this deflation. In the USA, this would come about as a result of a credit contraction - the total amount of borrowing shrinks. THIS IS BAD because, like the widgets, every asset would be re-priced lower. The "value" may not have changed, but there are fewer dollars to spread over the same number of assets.
But back to the original inflationary scenario: If the additional 50 spendios were used to create another 50 widgets, then there would be no inflation or deflation because the increased money supply would have been used for productive purposes and not consumption or financial engineering. In the same way, if credit expansion is used in the USA to build additional manufacturing capacity or expand services offered, then there are few or little inflationary effects.
The effects of inflation are unequal among the population. The first person or entity to get the extra spendios would get to buy a widget at the old price, with the new "lesser worth" spendio. In other words, they would get a kick from the inflation. Whereas, by the time the extra spendios had all been used, it would now cost S$1.50 spendios to buy a widget. Whoever bought the widgets with the new extra spendios at a price of S$1.00 would have made a 50% profit.
In the USA, the financial institutions are the first beneficiaries of inflation because that is where the money enters the system. Based on this premise, it should be no surprise that the investment banks have created their own hedge funds and that leveraged hedge funds are proliferating - because they are both the first level of entry for additional unearned "money". And their spending outlets are so-called financial assets.
2. Increasing the supply of money and credit.
The FED expands the money supply through the use of credit. It has a number of vehicles to do this:
2.1. Setting the price of money, or the interest rate. This is used on the demand side (i.e. influencing borrowers and potential borrowers). The theory is that if the interest rate is lowered, more projects become attractive and more money is borrowed. This is effective if there is still borrowing capacity in companies and PEOPLE. On the other hand, raising the interest should lessen the demand for credit. Since credit is used for consumption and for increasing productive capacity in both goods and services, the rate of growth of the economy should slow.
2.2. Adjust the margin level for major investment entities such as investment banks and hedge funds. This affects the demand side for money in that these institutions can IMMEDIATELY borrow more. This again shows that they have joined that elite first circle for new money coming into the economy. The FED no longer has to be obvious and play with margin requirements at the retail level for individuals. They can manipulate it at the wholesale level, which is much easier. This has been happening much more over the last 2 years, which suggests to me that the borrowing capacity of individuals is running out.
2.3. Adjust the amount of credit available. This is used on the supply side (i.e. giving more money to lenders that can be on-lent to the borrowers). It assumes that there are still companies and people that will want to borrow money. This can be accomplished in 2 ways (There may be more but I'm not sure so I will keep it simple)
2.3.1. Lower or raise the reserve requirements that banks have to hold against deposits. It IMMEDIATELY makes additional money available to lend (in the case of lowering reserve requirements). So, if someone wants to borrow money, they can. If there is enough new money in this way, it may even lower interest rates for whatever sector of the economy is being targeted by the lending
2.3.2. Through Open Market Operations (OMO). This is where the FED engages in Repo operations. In effect they lend money to the banks at low interest rates because the loan is of short duration, and secured by assets. These assets can only be (I believe) government securities or T-bills. But, the bank continues to get the interest from them - so it is a win-win situation. What this does is make cheap money available to be lent out. Or, in the event that a Repo isn't rolled over for another (1 - 60 day) term, it reduces the amount of cheap money available to be lent out. This amount is now at the highest level it has ever been. Further, if you look back at the last 9 FED decisions, the stock market has started to rise 2 business days before the decision and peaked at 1 day following the decision. This has happened no matter what the expected decision is. I am going to go look for data on the Repo levels and see what happens 3, 2, and 1 weeks before the FED decision to see if there might be a case for collusion. (But that's another topic).
2.4. The FED uses suasion. It telegraphs a POSSIBLE FUTURE ACTION that it might take, and the markets respond IMMEDIATELY as if that had in fact happened. Bernanke has even mentioned this in a speech as a technique that the FED can use to make things work:
"There is some evidence that central bank communications can help to shape public expectations of future policy actions and that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset."
Source: Monetary Policy Alternatives at the Zero Bound
An example of how well this works (possibly in conjunction with the banks and investment houses "priming" the stock market) is the latest FED decision. All they did was change a few words to lead people to believe that they MIGHT lower interest rates in the future. All this in the face of admitting that housing continues to die and yet inflationary pressures are increasing. And what happened? The market jumped believing that no matter how bad things get, the FED would bail everyone out. How do I know this?
We are told that changes in the FED rate takes 12 - 24 months to impact the economy. The drop in interest rates hasn't happened yet, so we may be 2 years from an impact. The market, we are told, discounts 6 months into the future. The benefits from any interest rate decrease are so far in the future that there should not be any impact yet. The risk of things not working out in the best scenario is high - yet the market acts as if it is an IMMEDIATE GIVEN.
3. My contention is that if the money supply (including credit) is increased without a corresponding increase in production (goods and services) that this creates inflation. The reason that we are not seeing inflation in the official statistics is twofold:
3.1. The CPI and PPI measures have been modified. Going back to the pre-Clinton era shows that inflation is actually running at 6%. The "Shadow Statistics" http://www.shadowstats.com/cgi-bin/sgs? web-site claims that inflation is closer to 10% when removing all the adjustments that official agencies make to the numbers. (You said the same thing in your e-mail so we are on the same page).
3.2. A material portion of the goods consumed in the USA come from outside the country (say China) where the currency is pegged to the US$ and the standard of living is so much lower that the price in US$ terms either stays the same or falls.
Since most services are provided locally, there should be inflation in this area. The official statistics show that services inflation is running higher than that for goods. This is moderated somewhat, although to a lesser extent than goods, by the availability of certain services from other countries, that can be "imported". An example is the call centers in India. Another example is software development that has been moved offshore.
4. So where is all the extra growth in money supply going? By necessity, it has to go somewhere, and this has been into assets. That is why we have seen the stock market bubble, followed by the real estate bubble (domestic), followed by the real estate bubble (commercial - look at the prices being paid for REITs), followed by the bubble in private equity and LBOs, and so forth. This can continue so long as the money supply keeps growing faster than GDP and the emerging world economies continue to supply cheap and cheaper goods and services. As well, because of the way asset prices work, if the price of an asset rises by 10% by someone spending $1 million on one unit of that asset, then everyone who holds that asset sees the same 10% increase even though they did not have to sell to see that increase in value. They can also now borrow more money against that asset. The only catch is that it will now take more money to get the next 10% increase because of the new price for the asset. In this way, it takes more and more money to keep the price increases at the same level. There is a limit to growth on debt.
5. Why are inflation measures made to seem less than they would have been in the past?
The US government (among others) has made direct and indirect promises about future benefits to the population. These include social security, pensions, medical benefits, among others. The cost of these promises is estimated at US$50 trillion, which has to come from taxes. With an aging population and shrinking work force, this could create considerable social upheaval. One solution, to avoid this pain, is to inflate the value of benefits away. However, this will only work if productivity grows, i.e. wages and benefits don't keep pace with that inflation. So, it is in the government's best interest to reduce the value of the benefits through inflation while keeping the general population ignorant of what is happening. Otherwise, people would demand higher wages in anticipation of the next inflation (just like in the '70s or in Brazil), which would create a vicious cycle of accelerating inflation. So, inflation is good for reducing the impact of liabilities. If I, as a rational person, truly believed that inflation was going to accelerate (i.e. people become aware of its actual level and impact), I would borrow as much money as possible and put it into assets such as real estate or gold - "Real" assets that do not lose value under inflation. This would put me in the first tier of money supply, like the banks, because I would be borrowing money that I could pay back with inflated dollars - while the asset would go up in: "price." Because of the rampant inflation, wages would rise in nominal terms - probably rapidly in order to anticipate future inflation, and the debt would become a smaller portion of my earnings with each passing year - while the asset kept pace with inflation.
6. Where does deflation come into the picture?
I think of deflation as a contraction in the money supply. In the case of the US economy, this means a credit contraction since most "money" has been borrowed. So, a contraction in available credit would be the same as the S$25.00 that were taken out of the Omniland economy in the very first point in this long explanation. The same thing would happen in the USA. The price of assets would contract along with the credit. The price of stocks, commodities, real estate, art, collectors' wine and so forth would fall.
What might cause deflation?
Either there is no more money left to lend, or no one wants to borrow it.
6.1. No more money left to lend. The banks can only lend based on their book value, or amount of equity they have. If a loan goes bad, this reduces the amount of equity and the amount of loans they can make - even if the FED does Repos with them, and reduces the deposit reserves. Even if someone out there wants to borrow money, they are not allowed to lend it because of regulatory limits. This is why the impact of the mortgage market meltdown is important. It is reducing the amount of credit available because of loans that have gone bad. The fact that lending standards have been tightened means that it is difficult to replace those loans.
6.2. No one wants to borrow it. At some point, no one can or wants to borrow any more money. On the consumer side, debt levels as a percentage of income are quite high. That is why more and more money use has shifted to the hedge funds. New margin rules (lower requirements) are coming into effect at the beginning of April.
7. Both of 6.1 and 6.2 happened in Japan. First, with all their self-dealing and loans to related parties, when loans began going bad the Japanese banks were hit hard. They were unable to lend any more money due to the impact of the bad loans on their equity. This created a vicious circle (the same way it had been a virtuous cycle on the way up) where an end to credit growth led to a contraction in credit, which reduced asset values, which led to more loans going bad, which hurt the banks - well you see where this is going.
The government created liquidity like they were trying to bring the Sahara to life. But due to the falling asset values, no one wanted to borrow because there was nowhere they wanted to spend the money. So credit kept contracting for 18 years.
8. Deflation is very, very bad if you own assets or are in debt.Inflation is very, very good if you own assets that have been funded by debt. But, the Austrian school of economic thought says that inflation eventually leads to a credit contraction because, sooner or later, there is no more lending capacity or no more borrowing capacity left (simplistically).
9. So, the FED can print as many dollars as it wants. The only way they can get into the economy is through someone borrowing the money and spending it. There is a limit to the amount of debt that can be taken on, and once the balloon springs a leak, it doesn't matter how much air the FED blows into it - the end is inevitable. Either there will be a credit contraction or the USD will become worthless. It does not matter if you own assets worth $1 million if that won't even pay for a cup of coffee.
In the 1920's, inflation was so great in Germany, that the printing presses could not keep up with the need to print money. At the end, all of the Reichmarks in existence were not enough to pay for a single newspaper.
1. If a rational person believes that inflation will continue in such a way that it either increase wages or asset values, then that person should borrow as much as they can at a fixed rate for as long a time horizon as possible (at least to when they anticipate the inflation would end) and buy assets.
2. If inflation continues accelerating, it can only end in two ways:
2.1. The first is that all liabilities are settled in the old currency (great if you have debt) and a new currency is issued. Imagine having a salary of $100 million per year, with a house worth that much, but the debt on it being only about $400,000 because that was the price paid in 2005. Then the government creates the USBuck and lops 3 or 4 zeros off the currency and every one exchanges their $1 billion in savings for USB1,000. Then the process starts all over again. Clearly, this is not in the best interests of the banks who would see their loans paid back in extremely devalued currency. This scenario happens more rapidly as people demand wages that are anticipating inflation, which is why their servant, the FED, does not want anyone to perceive that inflation is happening at the rate it is.
2.2. The second is that there is a credit contraction and a recession which will continue until the inflation process can start again. The government does not want this because it would increase the value of their future promises. Also, everyone who owned assets would be "poorer" in price terms, and recessions are no fun for anyone. If a rational person believes that the credit contraction is imminent, they should have no debt, hold no locally priced assets and stay liquid.
3. In the end, theory states that the use of fiat currencies (printed money supply that can be expanded at will) can only end in recession/ depression and credit contraction. Even if a new currency is created, the whole process starts again.
There probably is a lot more that could be said, and many points that could be argued. I hope that this helps clear up my earlier e-mail, and show the assumptions and thought processes behind what I say. I welcome your critique and insights since, like you, I am trying to make sense of this whole mess.