Where does all the money go?
A lesson in non-linear thinking:
how money printing can lead to liquidity contraction
Robert Wutscher
The Shadow Economist
Jan 27, 2010
The general view is that the Fed can
always print more than enough money to avert any deflation. Some
pundits, in trying to explain away the collapse in certain asset
prices that would generally always have been associated with
inflation such as real estate, have gone as far as to start splitting
definitions. We now have price deflation for certain asset classes
and price inflation for others. Funny how such definitions are
only derived after the fact.
With the following short article including
many others I hope to illuminate that there may be workings going
on behind the fabric of our everyday perceptions and preconceived
modes of quick thinking. These articles are designed to be counter-intuitive
and may lead to shock against the emotional protection afforded
by associating with commonly held consensus views or conspiracy
theories.
How to incarnate Dollars
What would you say if I told you that
even if the Fed literally printed trillions of US paper Dollars
it would not be adding to the money supply AT ALL?!
Before you choke on the above question,
let me try to explain:
Imagine a bank run. People run on banks
because they believe that they can get their cash out first because
there is less physical cash than deposits in the banking system.
But couldn't the Fed just print all the necessary Dollars, thereby
converting all deposit balances into paper Dollars? I would say
"incarnating" all those digital Dollar spirits!
Do you not see that there are no more
US Dollars in the system than before? All that has happened is
that deposit balances at banks have been converted into paper
dollars in peoples' hands. Both of equal weight in terms of purchasing
power at any "current" point in time. Of course the
banks are being squeezed as they are showing the same amount
of loans with less deposits on their books, but that's another
story. (1)
Once the point is reached where people
are no longer willing to borrow and lend,
there is only one way for the Fed to cause inflation through
the printing of paper Dollars. That way is to find and give paper
Dollars to someone who has NO debt. And this must be given to
him or her who does not use it (for whatever purchases desired)
to pay someone else who does have debt. This would of course
be absurd unless perhaps one were able to invent some sort of
economic system of apartheid.
Giving to someone who has debt could
result in that person using it to repay debt, instead of using
it to bid up prices on a limited supply of goods. Money supply
is reduced because every time someone uses money to repay debt,
he is effectively drawing a deposit from somewhere in the system
and using it to cancel out a debt from which a deposit was originally
created.
So even if the government is the first
beneficiary of new money, it does not help if its employees or
service providers are heavily indebted, at least not until enough
private debts have been repaid up to the point where people are
again willing to start borrowing and lending again. Only
after such a point will debt erosion through a policy
of inflation be possible as inflationists love to argue. Before
that point, the growth in public debt only serves to contract
the leverage in the private sector.
On the other hand, creating more digital
Dollars does not solve the problem either IF they are used to
cancel debts. Here the process of money contraction can be even
faster in the realm of Dollar spirits and credit ghosts.
A reader kindly provided me with this
quote from John Exter (a former New York Fed vice president)
which I think epitomises what I have tried to explain above:
"There are two Achilles Heels
to our fractional reserve banking system; One is, you can't force
people to borrow money. Two is, you can't force people to spend
money. In these are the potential nemesis of the system."
The Fed's dilemma: how do you ensure
that the next freshly printed Dollar flows into circulation instead
of cannibalising an existing deposit by giving up the ghost of
a debt? And how do you exorcise excess debt without taking the
air out of the economy?
The money printed by the Fed could provide
people with the money to repay debt. Whereas this may not seem
such a bad thing, you need to be aware that any net repayment
of debts through the banking system will cause the money multiplier
process to go into reverse. This in turn will lead to a reduction
in aggregate net income of the economy as will be explained next.
The interface between money supply
and net income
The following I consider as one of the
cornerstones to my understanding of the elastic nature of money
and how it is created through fractional reserve banking.
Money supply growth up until about 2007
was driven through an increase in credit. For example, if I deposit
cash in a bank, the bank has money it can lend out. Say a businessman
borrows this money to spend on an item. Now there is twice the
amount of money to spend in the economy "at the same time".
This is because I can write a cheque against my deposit at the
bank and the businessman has money to spend. When he spends it,
the money is deposited in a seller's bank account whose bank
now also has an additional deposit to lend out. There is now
three times the amount of money available "at the same time".
Mine, assuming I have not yet spent it, the seller to the businessman
and borrower number 2 of the seller's bank who is ready to spend
his new credit. And so on money is created through the banking
system. All along private debt is rising at the same time.
To compare if there were no bank involved:
If I borrowed you the money directly,
only you could spend it and I would have to wait for you to repay
me before I can go and spend it. But not so through the banking
system as you can see above (where I have ignored deposit to
loan ratios which limited the expansion of money in the past).
I have also ignored interbank lending, which ultimately takes
more from the central bank to allow for further expansion of
the money supply.
The increased money supply/liquidity
manifests as increased net income of the sellers of the economy
(often through higher prices as there are more bidders for the
same goods).
From the above, you should see that credit
is the opposite side of the money coin in our fiat monetary system.
You should also be able to see how credit creation greases GDP.
An implosion of credit will result in
the whole process going into reverse, where banks are forced
to call in loans, which further reduces deposits for lending
(whether the loans are repaid or defaulted upon). The decrease
in liquidity manifests as income dropping faster than costs can
be cut back by businesses and individuals (who still need to
pay rent even if they lose their jobs for example).
To fully understand the above you have
to think in terms of money's "flow" nature and not
its "stock" nature. Though your cash balance at the
bank may always be the same assuming your income equals your
expenditure every month, it is always flowing like the river.
If your income stops, your cash will run out as you cannot give
up on food and rent as quickly as your income shrinks. As you
are forced to cut back on food and rent, someone else's income
shrinks. Therefore the contraction of money manifests as contraction
in total net income and ultimately net cash and money "disappears"
through the banking system as the two sides of the money coin,
credit and deposits, cancel each other out.
The above is an explanation for deflation.
I have previously argued how a deliberate policy of monetary
inflation loses its traction once we have reached the stage of
unwilling borrowers and lenders or, which is the cause, when
the private debt level becomes unsustainable.
Why the USD can soar
To understand why the US Dollar could
rise against other currencies, whose economies may be experiencing
similar problems in liquidity, you have to realise that most
of the debt worldwide is denominated in US Dollars. (2)
The pressure to buy US Dollars to repay such debts by all sovereign
nations will put upward pressure on the US Dollar. A contraction
in US Dollar export earnings (decline in US imports) will only
add to the pressure. As foreign nations start repaying or hedging
their US Dollar liabilities, money starts disappearing (loans
paid off equals deposits taken out of the banking system as the
two sides of the fiat money coin). Thus a strength in the US
Dollar does not need an economic recovery, but can be related
to a big contraction in US Dollar money being greater than all
other currencies.
In the short term, a spike in the US
Dollar can result from an unwinding of the carry trade that has
recently been taking place in the US Dollar. But in the longer
term it is the dynamics described above that may play out. This
may take time as it does not just involve reducing private credit
to more sustainable levels, but also price distortions that need
to be ironed out.
Please note (and here is where I introduce
some value considerations from which I hope to keep free in my
theoretical speculations): I am not inferring that a strong Dollar
is a “good” thing under present conditions. This
is because it is connected with a disappearance of Dollars!
It also provides us with a means of purging excess debts, however
“painful” this may yet prove to become.
Notes:
(1)
Believers in mark to model accounting could find justification
in this as long as we can be confident that those paper
Dollars in the hand find themselves back into the books of the
banks. This, however, has to assume that all activities up to
the crisis were not the result of malinvestments, something which
macroeconomics (looking at aggregate economic data) cannot show
us.
(2)
Not only Asian and third world, but even EU countries such as
Germany issue US Dollar denominated debts. The motivation should
be evident if the interest rate on US debt is lower and the US
Dollar is not expected to appreciate. It is wrong to assume that
just because such countries also hold US Dollar reserves that
you can net such reserves off against such debts. This is because
the creditors (states, municipalities, utilities and private
institutions) and the debtors (central banks) are not the same
parties.
###
Jan 27, 2010
Robert Wutscher
The Shadow Economist
email: rwutscher@telkomsa.net
The shadow
economist, Robert Wutscher, is a retired financial due diligence
specialist who has taken up the study of economics. His study
has turned to the shadow side of economics: what most economists
ignore, suppress or fail to account for in their models under
the light of mainstream economic consensus methodology. A rich
resource exists in many old economists who have passed away with
insights that do not sit comfortably in today's quantitative
models and with warnings/lessons of the past going unheeded.
The modern consensus methodology is primarily based on quantitative
methods and generally considers only economic aspects and assumptions
that are amenable to quantitative analysis, even if this can
only be done with abstraction of reality or of the mathematics
itself. It ignores other concepts essential to human decision
making, that may be too hard to quantify and that may be hidden
in the shadows of the aggregates and averages that form the edifice
of macroeconomics and econometrics.
The shadow
economist is new on the block and will generally challenge the
conventionally held wisdom even that of the gold bugs. He welcomes
constructive criticism. He can be reached at rwutscher@telkomsa.net
321gold Ltd
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