Saturday, July 18, 2009
A Little Perspective
The primary purpose of money is to bid on the real goods and services produced in the real economy without the need for direct barter exchange. In a sound money system the value of the money increases as the economy grows new goods and services on which to bid. This function allows money to have the secondary purpose of being a store of value over time.
For many decades now, we have lived in a system of credit money, where the money supply was allowed to grow along with the economy. As producers took out loans to create new goods and services, new money was created from thin air to match the value added to the system by the producer. The balance, or control in the system in case the producer died or defaulted for some other reason before he finished adding value was that the bank that issued the credit money would have to take the loss, the deficit, or "fill the hole" left when the producer failed to complete his contractual obligation. The money created at the start of the loan still circulated, but the bank now had to lose an amount roughly equivalent to the amount of value the producer failed to produce.
This control kept the system of money versus economic real value roughly in balance for a long time. But on the margin of the system was the temptation to the government and the base money printing authority to abuse the system by creating new money not matched by value added to the economy (base money or monetary base). This kept the money supply growing slightly faster than the economy at all times.
This race between money and real goods and services, with money supply always in the lead, removed the secondary function of money as a store of value. So to keep the system going, financial products were created which promised a supposedly high probability of keeping up with the money supply growth.
Scrip is a temporary substitute for money. Because of these two qualities, "temporary" and "substitute", it is not a good store of value. Instead, it is a way to facilitate the exchange of real goods and services without the need for direct barter exchange, and without the presence of money. Today California is issuing IOU's which are a form of scrip. During the depression, many localities issued scrip because money was in short supply. (Click here)
But today's banking system is actually a very large and complex scrip clearinghouse that acts as the lubricant in the economic machine. Base money is roughly 10% or less of the total money supply. So the banks issue their own scrip (checks) with which to keep trade flowing.
Imagine a carpenter, a plumber and a painter. The carpenter banks at Bank A, the plumber at Bank B, and the painter at Bank C. All in the same day the carpenter works on the plumber's home, the plumber works on the painter's home, and the painter paints the carpenter's home. The carpenter writes a $500 check to the painter, the painter writes a $500 check to the plumber and the plumber writes a $500 check to the carpenter. The next day they each deposit their checks and that night the banks pass them around and make book entries. By the next day all debts are settle, all payments made, and no money was needed at all. The banks performed their function as a giant, complex scrip clearinghouse.
In the real economy this happens every day. And it only continues to function because of faith in the banking system of fractional reserves. It functions because people trust checks. If everyone had to withdraw cash to complete transactions, the fractional reserve system would crash.
This system has been expanded even further through the use of credit cards, another system of scrip clearing.
Base money becomes important in the clearing of the scrip clearinghouses. At the end of the day, any imbalance in the scrip clearing game must be settled with base money. This function is overseen by the Federal Reserve which holds large reserves of base money for each bank and transfers the ownership of that money to balance the imbalances.
This same clearinghouse function is also needed in the global arena. The BIS (Bank for International Settlements) is the central bank of central banks. It is the clearinghouse of all the central banks of the world. It balances all international imbalances by transferring ownership of physical gold bullion deposits. Oh wait. What? It doesn't? Actually, there is NO adequate clearing mechanism for global imbalances. At least not for the last 38 years.
The global imbalance clearing mechanism is rather messy right now. Global imbalances are basically first settled in US$ base money which is then given back to the US government to spend on US Medicare, Medicaid, Social Security, government pensions, field mouse habitats and the US military global "peacekeeping" presence. And in exchange, the US government hands out Treasury Bills and Bonds to the various central banks.
This is today's global clearinghouse in a nutshell!
Why It Was So Important To Save The Investment Banks
The abstruse notion of money has been so confused over the last hundred years that almost no one understands what it once was. Today, 99% of the world stores its monetary savings in investment vehicles that are not really money. The very idea of money has been so corrupted that even the most conservative individual savers look at their "fixed income" brokerage statements and think, "this is my money". The fact of the matter is that there is actually NO money represented in that statement, even if it claims to have 10% in "cash".
This complete divergence from reality has taken nearly 100 years to accomplish. And now it is complete.
The fact of the matter is that now there is more money in the world than there are things to buy at current prices. And what's worse is that the money supply continues to grow even while the real economy contracts. This SHOULD be creating massive inflation in everything EXCEPT financial investments (of which there is no shortage). But instead the opposite seems to be happening.
How can this be?
It is because new financial investments are constantly being created by the financial industry to soak up the extra money, to keep it from bidding on the real economy. This is true for individual's money, for institutional money (like pension funds), and even for sovereign money (like China's foreign currency surplus). The financial investment industry is the giant TRAP that lures in the extra money with the simple promise of paying out MORE money! This is why it HAD to be bailed out and subsequently GUARANTEED against default.
Risk pricing MUST remain rigged!
If the risks of these "investments" were properly priced, interest rates would be sky high and the investments would be as cheap as dirt. There would be NO profit for the bankers to take home!
Now that the financial industry has been bailed-out and guaranteed, the very NATURE of financial risk has changed into something so terrible it is almost never mentioned. In fact, from what I can tell, I am one of only a handful of people that are willing to write about the true nature of today's investment risk.
But just because no one talks about it does not mean the global market "organism" doesn't smell it. It does! And this is why risk pricing MUST remain rigged. The market movers, shakers, makers and owners have quite a casino racket going right now. It is complex and computerized in the extreme. It is understood by few and managed by even fewer. Yet somehow it still masquerades as our global, capitalist free market.
Amazing, isn't it?
The fact of the matter is that a certain - specific - percentage of the global aggregate of default risk (which was certainly bearable because it only hits here and there) has been transferred to a much more demonic currency risk (which is totally UNbearable because it destroys EVERYONE)! The only thing left for the global market organism to digest is the actual SIZE of this transfer, a monumental task in the face of risk price RIGGING by diabolic forces.
In my opinion, this is the fuse. Lit and burning fast!
If you or I were to guarantee a financial asset we would want to make darn sure we wouldn't have to exercise that guarantee. Because if we had to, we would either have to give up some of our own wealth or we would have to produce real value into the economy to cover the guarantee. An insurance company faces the same danger when making guarantees. This is why it has highly paid underwriters who calculate the probability and charge the insured party enough premium to cover all claims, plus a profit.
But when the US government and the Federal Reserve make guarantees, they have none of the worries we mortals have. They each have their own way of printing new base money to cover the guarantees. In the case of the Treasury, it simply issues new debt to be purchased by the Fed. Because of this unique ability, these two entities feel very comfortable about making many guarantees. And over the past year, implicit guarantees have been issued on everything from your Chevy Tahoe to the entire money supply (all credit money is now backed by the implicit guarantee of new base money) to money market financial investments, to large insurance companies, and even to the largest financial institutions, which indirectly guarantees a mountain of financial derivatives.
Additionally, the federal government guarantees its own debt. This guarantee is supposed to be backed by the production of value into the economy through taxation, but today it is actually backed by the ability to create new base money in order to service the debt.
And finally, in the same way it guarantees its own debt (through base money printing, not taxation), the federal government implicitly (in some cases explicitly) guarantees all of its future obligations of Medicare, Medicaid, Social Security, government pensions and a global military "peacekeeping" presence.
I propose to you right now that the US government alone has guaranteed through its ability to expand the US dollar monetary base, more than the entire global monetary base combined (around US$5T); more than the entire value of all stock markets in the world combined (global equity markets estimated value US$37T); more than the entire globe produces in a year (global GDP estimated at US$70T); and even more than all the debt issued, both public and private, in the entire world (global bond markets estimated value US$83T).
In fact, because the mountain of derivatives that the guaranteed Too-Big-To-Fail banks play with is so large (somewhere between US$600T and US$2Q), I propose that the US government, without even realizing it, has verbally implied guarantees of more value than even exists on this planet! All in the name of "saving the system"!
Now, of course they don't plan to exercise all these guarantees. But that is not the point. This system of credit money ONLY works because the money supply has the ability to ROUGHLY track the growth or contraction of the real economy. And with these guarantees in place, monetary contraction is no longer an option.
Zimbabwe Versus the Dollar
The housing price crash has been called deflation. But let us look at it another way. You and I have lost some perceived wealth because we can no longer sell our houses for what we once could. But the other side of this equation is that much of the debt we took out (and even some that we have defaulted on) has either been made whole or guaranteed. So what has really been lost?
What if... the housing bubble was actually acting the same as the sponge we call the financial industry to suck massive inflation away from consumer prices? Remember, the money that was created from thin air when we bought our house is still circulating. And the debt hole that was created when prices crashed has been filled with new base money through TARP and other various "facilities", bailouts and guarantees.
The housing market is (at least for) now a dead sponge. And the financial industry is a dying sponge. So where is all the money going to go?
Recently I have read two arguments, by writers I respect, why the dollar system will not go the way of Zimbabwe. These are certainly not the full spectrum of arguments, but I think they touch on a couple good points, even if they are wrong.
The first argument is that reserve currencies are political, not market-based. And therefore the dollar's demise will be "managed" in a controlled fashion that may take another 10 or 20 years, with no sudden crashes. The one exception, this writer says, is if a geopolitical "mishap" happens.
The other recent argument was that it will take the US longer to get to "Zimbabwe-style" inflation since real productive assets in the US are not being totally seized, as they stole all the white people's farms in Zimbabwe.
The biggest weakness in the first argument is the terms "political" and "managed". These both mean "manipulated". Clearly the dollar is market-based because it is used to pay for real good in markets all over the world. It is also traded openly on foreign currency exchange markets. A currency like the SDR would be more purely political, but not the dollar. The dollar is simply "managed", as Another explained to us many years ago. And a simple "truism" about manipulation is that it cannot defeat the primary market trend for very long. And often when it does, the correction can be brutal.
The second argument is interesting because it deals with the economic side of the equation. It is true that Zimbabwe's slide into the depths of hell began in early 2000, when Mugabe tried to change the Zimbabwe constitution to give himself the dictatorial powers of additional terms in office, immunity from prosecution for all his friends in government, and the authorized government seizure of all white-owned land. When his referendum to change the constitution was defeated, he assumed those powers through force and violence.
Zimbabwe's economy began shrinking in 2000 and has continued to shrink ever since. It has been plagued by political turmoil, capital flight, monetary mismanagement and high inflation. The core underpinnings of the economy, agriculture and industry, have virtually disappeared since 2000.
From 2000 to 2002, the annual rate of inflation in Zimbabwe quadrupled. By 2006 the value of the Zimbabwe dollar had fallen by a factor of a million. In August of 2006 they introduced a new currency at an exchange rate of 1 new Zdollar for 1000 old Zdollars. This new Zdollar, at its inception, was only worth about a tenth of a US penny (Z$10=One penny). From there it fell even faster as the government funded EVERYTHING, including a LAVISH lifestyle for its leaders, with the printing press.
In less than two years the annual inflation rate rose from 1,000% to 231,000,000% by July of 2008.
I ask you: Is this history so different from the US? Look at the 8 year chart. Much of the core underpinnings of our economy were shipped overseas during the last 15 years. What is left is an economy driven by consumerism to the tune of 70%! Now even that is fading.
Shrinking economy! Monetary mismanagement! Government funding itself with the printing press! Lavish plans, one - after - another, coming out of Washington!
What if we are now living the above chart, and we are still in the first two years of the chart? Relatively flat, huh?
The last issue I want to discuss is the nature of Zimbabwe's money supply during the last years of its life. Credit had disappeared. Government debt disappeared. There was no interest rate high enough to lure in real capital. The entire money supply, M1, M2, M3 etc... was replaced with BASE MONEY! In hyperinflation, it is only BASE MONEY that matters! This is because hyperinflation IS currency collapse!
What if all of our government guarantees are used? Every "perceived" dollar becomes a real base dollar! When future liabilities are funded by the printing press, this is all BASE MONEY flowing into the system. When the Fed buys government debt, this is BASE MONEY the government is spending. And when a bank is bailed out by either TARP or the Fed, it is BASE MONEY being exchanged for bad debt that should have SHRUNK the money supply.
And what if... the mere GUARANTEE of all this debt actually changes its core NATURE to that of base money? I'm just saying what if. If this is the case then it is up to the markets, the producers of REAL ECONOMIC GOODS to determine the meaning. A monumental task in the face of risk-price rigging by diabolical forces, but not impossible.
In my view, the only hope they have to avoid this terrible fate (other than blind hope alone) is a FREE gold revaluation to preempt the market revaluation of everything. But I'm afraid they may mistakenly take matters into their own (incapable) hands and attempt a controlled devaluation through devious means (like a bank holiday). In any case, the dollar's immediate future is grim.
Monetary theory is FAR from being a settled science. We should not rest comfortably on untested, possibly false assumptions. Preparation for the worst while hoping for the best is the only sane course of action. Please be well.