Benson's Economic &
Money Created "Out
of Thin Air"
July 30, 2004
We hope this brief essay
stimulates your thoughts with respect to how money is created
- a secret all investors should know.
Money is created in two ways:
First, money creation comes from borrowing it and spending it.
(Money is literally borrowed and spent into existence.) Second,
it can simply be printed up "out of thin air" by a
central bank. The U.S. economy and other modern economies have
central banks and fiat currencies. Central banks have two major
powers. They can 1) "peg" the nominal level of short-term
interest rates, and 2) purchase assets such as government debt,
with newly printed money. When the central bank pegs short-term
interest rates at a low level, it greatly encourages corporate
and individual borrowing and spending. .
For the past decade, most money has been created through private
sector borrowing and spending. However, the day is fast approaching
when the private sector's new borrowing will not create enough
new money to keep servicing the already massive level of old
debt. Central banks will need to step up their efforts to "print
money out of thin air." Central bank printing of new money
is accomplished by purchasing government debt or other assets.
Measure of Money: M3
Billions of Dollars)
Clearly, there has been substantial
money growth since 2000. Moreover, neither the crash of the NASDAQ
stock market, or the last recession, has slowed down money growth.
The fact that the Fed cut interest rates 13 times since 2000
- reducing them to a 46 year low - has a lot to do with the massive
amount of borrowing that has taken place in the United States.
Borrowing in the U.S.
Billions of Dollars)
The amount of net borrowing
in the United States is quite impressive, particularly when you
consider the old economic model when borrowing was limited to
simply recycling savings. In 2003, the savings rate was 2 percent
of GDP, while net credit market borrowing was well in excess
of 20 percent of GDP. There has been a whole lot of borrowing
and spending of new money going on!
Certain asset classes, such as financial assets and housing,
have benefited the most by this credit and money creation. For
instance, because the mortgage market has been willing to finance
any and all mortgages, the credit creation process has allowed
both new mortgage debt and the ability to pay for higher housing
prices. These higher housing prices have, in turn, allowed for
the funding of larger mortgages. Money creation in the private
sector tends to concentrate in certain asset classes that facilitate
the creation of new credit. This new credit lends itself to new
spending, leaving behind new money as the residual, and a growing
mountain of debt.
To say that this process has been left to run wild is an understatement.
Indeed, it's time to think "Bubble" in stocks, bonds
and housing. A rational investor understanding the credit creation
process would have played the resulting upward momentum in asset
prices for all they were worth!
However, the world is changing. The central banks are already
printing vast quantities of new money, making 2004 a "watershed"
year. In the general price level, due to the creation of new
money borrowed into existence, inflation is starting to leak
If one examines individual incomes and corporate cash flows,
you will realize the U.S. economic system can not service the
mountain of private debt that has already been created at higher
nominal interest rates. This watershed year could turn into a
cliff side waterfall unless money growth keeps increasing to
encourage the growth in personal and corporate incomes. Inflation
is needed to push up cash flows to service old debt.
Without inflation, there remains a massive risk of deflation.
If old debt is paid down, or forgiven in bankruptcy, money that
has been previously created will vanish from whence it came.
If the money and debt goes, asset prices will crumble. Many intellectual
writers have logically concluded that rising interest rates will
cause a "deflationary debt collapse" as interest rates
rise. Certainly, a rise in interest rates to more normal levels
will be painful and will cause some financial distress. Moreover,
a rise in interest rates tends to slow the private money creation
process. So, some questions remain unanswered. Where will enough
money come from to keep the U.S. economy liquid and solvent?
Where will the massive amounts of new money come from to service
the debt mountain?
Let's not forget that central banks can create new money with
a few strokes at a computer keyboard to purchase whatever assets
they wish. The Federal Reserve can create any volume of money
it needs to keep the economy servicing both old and new debts.
It seems virtually certain that the Fed, and other friendly central
banks, will print as much new money as they need to because "inflation
tomorrow is better than a collapse of the financial system today."
U.S. Treasury is running a $450 Billion deficit and a 5 percent
trade deficit, central banks have actually begun the "Great
Money Printing." In the past 12 months, global central banks
have created about $800 Billion worth of new money (as measured
by the increase in world central bank reserves). This is what
the Federal Reserve Governor, Ben S. Bernanke, lovingly calls
Foreigners already hold almost
40 percent of marketable U.S. Treasury debt. The Asian central
banks have increased their holdings of U.S. assets to about $1
Trillion. In the relay race of money creation, 2004 is the year
when the baton of money creation has already been handed from
the private sector to the world's central banks!
Wide open money spigots in the private economy have a habit of
financing "asset price bubbles." Since the prices of
bubble assets (stocks, bonds and housing) are not included in
the price indexes that measure inflation, the inflationary consequences
of new money growth can be ignored. As central banks inject money
growth directly into their respective economies by buying assets
such as United States treasury bonds with Helicopter Money, it
is impossible to totally conceal the fact that there is more
money chasing the same number of goods. Inflation happens!
The massive trade and budget deficits in our country have acted
as an "excuse" for friendly foreign central banks to
do much of the needed money printing that would normally be done
by the Federal Reserve. Our trade deficit gives companies in
foreign countries dollars in exchange for their exports. Our
treasury deficit gives foreigners the opportunity to buy our
U.S. treasury debt with the dollars. Any foreign central bank
can then swap their local currency with companies holding dollars
and buy U.S. treasury debt! It's all so simple! New money has
been created, just not in our country!
For instance, the Central Bank of China is creating new money
by buying U.S. treasuries with our trade deficit. This has helped
to drive up their domestic inflation rate to 5 percent a year!
Until just recently, even the Japanese have been suffering from
mild deflation and may not have the economic capacity to buy
unlimited quantities of our treasuries. Japan is already flooding
their economy with fresh Yen out of thin air, as they finance
their own government deficit. Japan is currently running a 7-8
percent fiscal deficit and their savings rate has been dropping.
Japan's national debt is 140% of GDP and is rising rapidly. The
Japanese bond market faces a serious risk of price collapse as
their interest rates start to rise. Therefore, Japan can not
be counted on to finance both their government deficit and our
deficit for much longer.
Very soon it will be incumbent on our Federal Reserve to crank
up the domestic U.S. printing press. It is one thing when your
neighbor's central bank floods their country with newly printed
money buying U.S. Treasury debt. It is quite another when the
Federal Reserve floods America with Helicopter Money
by buying massive amounts of U.S. Treasuries.
As inflation comes, interest rates will be forced up. Rising
interest rates certainly hurt the owners of old low-coupon bonds.
Moreover, rising interest rates have never been the stock market's
friend. Rising interest rates are the declared enemy of housing
prices. Indeed, rising inflation in the general price level is
the enemy of all those wonderful bubble markets. Rising inflation and
falling asset prices will turn the world of investing upside
July 30, 2004
Finance Group, LLC
2505 S. Ocean Boulevard
- Suite 212
Palm Beach, Florida 33480