Erg, Dummy needs help!

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npwebb's picture
npwebb
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Erg, Dummy needs help!

Introduction:

 

Back in October/November of 08 I sat up and took notice of what was happening in the economy.  Prior to that I was content (for the most part…I’ve know for years that the Gov’t had been cooking the books when it came to CPI and GDP) at accepting the at face value the business news reported by the mainstream media. 

 

As I was trying to educate myself on macroeconomics and current events, I found the Crash Course through a link on inflation at dshort.com.  I soaked it up! (btw, great job Chris – THANK YOU).  I’ve subsequently had my wife and two teenage kids complete the course as well.  I’ve spent a lot of time trying to understand the Austrian school of economics as I began to get exposed through CC, IOUSA, Agora Financial (Daily Reckoning, Whiskey & Gunpowder, Rude Awakening, 5 min Forecast, etc), Mises.org, etc.

 

Applying CC to headlines:

 

Bloomberg 7/7/09 – “The Fed lowered its main interest rate almost to zero in December, switching to asset purchases and credit programs as the main policy levers. Chairman Ben S. Bernanke is leading plans to buy as much as $1.25 trillion of mortgage-backed securities and $200 billion of federal agency debt by year-end, along with $300 billion of long-term Treasuries by September.”

 

 

I thought I had at least a working understanding of the basics but when I tried to apply my basic understanding to the economic news of the day it yielded more questions than answers and confusion.

 

One of the biggest dilemmas I’ve had trouble wrapping my mind around relates to the deflation vs. inflation debate.  Particularly, I’m having trouble understanding whether the action of the Fed to purchase $1.3 TRILLION dollars of Mortgage Back Securities (MBS) is inflationary or not as it relates to the monetary supply and by implication or consequence price future price inflation.

 

I’ve lurked around the boards here and there are obviously some very capable individuals participating in the discussions.  I’m hoping to solicit your help in getting my head screwed on right on this.

 

I know that all money is loaned into existence.  Conversely, money is destroyed (removed from the economy) when debt is defaulted on. 

 

Q: When the Fed purchases MBS is new money being created (as is the case when the FED purchases US debt directly from the Treasury)?

 

Someone please help me connect the dots.

 

This is a direct request for clarification.

 

The below is for comment:

 

I took some comfort today when I read the following and realized that I’m not the only one struggling to understand this:

 


Whiskey & Gunpowder wrote:

 

That brings us back to the problem growing at the back of our mind yesterday. Can a massive deflating credit bubble nullify the liquidity measures by central bankers, which are puny in comparison to the nominal value of the assets at risk? “Yes you can!” comes the answer from some of the friends we put the question to.

“I’m tempted to disagree that expansion in government credit won’t reach the economy and therefore won’t be inflationary,” replied Money Morning editor Kris Sayce. “I’m not mistaken, the Fed is buying up these ‘assets’ in order to take them off the banks and also to help price them. If the Fed didn’t do this then the banks wouldn’t be able to lend extra money to customers as they would breach their lending limits.”

“It’s not so much that the Fed is directly feeding the banks money which flows through to the economy, it’s more that the Fed is feeding the banks money which allows them to expand lending which they otherwise wouldn’t be able to do. Thus at the very least is preventing prices from falling, or from falling as much as they ordinarily would without the intervention. In effect there is more money flowing in than there otherwise would be. There already IS inflation.”

Another colleague in the States replied that, “I am leaning more and more to the idea that the credit-based stuff will deflate (real estate, stock prices) but the cash-based stuff could rise (like foodstuffs, energy). In a way, it’s not a debate about inflation or deflation, but which assets inflate and which deflate. There might be a strong dichotomy within the economy between the two.”

To the extent that you cannot eat a mortgage-backed security, we see the wisdom in this view. The world has a lot of people. They have a lot of real needs. Regardless of the value of derivatives and opaque financial assets, a certain level of economic activity for a certain kind of tangible good will still be there. The challenge for investors is to determine if you can profit from this in traditional ways (stocks and bonds) or if you have to venture into less traditional asset classes and forms of ownership (land, real commodities, precious metals).

And of course, the thesis could be incorrect. If credit is not money-or if the large lending and government guarantee programs don’t reignite a lending boom in the real economy-then you may simply see a lot of wealth disappear down the memory hole.

Finally, a mystery Aussie commentator who wishes to remain anonymous but whom you may hear from in the future in this space sent a philosophical yet practical reply.

“What is money? Currently, that’s what the Federal Reserve (and other central banks) put in the reserve accounts of their member banks. The banks then use this as a base to create their own money, or ‘like money’. I guess this is also known as credit. So yes, credit is not money.

“And this bank credit is now contracting as the natural force of the market tries to drive prices lower and correct the boom. The Fed is offsetting this process by swapping ‘money’ (fed funds) for the impaired assets. But the banks are sitting on the cash, and obviously do not have the risk appetite (or the demand) to lend it out.”

“So at this point additional base money is not being lent out as inflationary ‘like money’. I’m not sure the Fed has the mechanism to make out and out purchases of assets other than through lending facilities, unless they are Treasury or Agency purchases. As far as I’m aware, the Fed can only distribute its newly created money through the banking system, and no other way. The banks have always been the source of inflation, and they need to lend to create this. They will probably use their excess reserves to buy Treasury’s in the coming years, and then the Fed can but the Treasury’s back off them in time. This will be inflationary.”

While it’s good to know that I’m not a total numb skull for not getting it, I not sure I’m any closer to enlightenment. 

Is there anybody out there that would care to take a crack at edjumakating me?

 

Cloudfire's picture
Cloudfire
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Threadiquette

 

Now, don't jump all over me, folks . . . Just a gentle suggestion that the subject line be a bit more revealing.  I had to navigate to this thread to discover that it was an economic question, and I am completely unqualified to offer assistance.  It's a small thing, but the accumulated time involved in click, click, clicking adds up . . . . OK, I'm off my soapbox now. 

 

 

mpelchat's picture
mpelchat
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Re: Erg, Dummy needs help!

Ok 1st off you are not a Dummy, you just need knowledge.  Having the courage ask a quest is great and insightful. 

That done, in the easiest terms supply and demand is the base rule of economics.  Governments can fight it but in the end supply and demand will win.  If you have more of something in a market place (supply) than people want it than prices go down.  It is the reverse way for money as well, if you have more money (demand) than supply prices go up. 

This works in a free market economy and even works in a closed market economy as well.  If price setting is put in place like what happened in Zimbabwe, than stores can not afford to buy items and sell them at a profit so the stores close their doors.  This makes foreign or black market good much more expensive, hence inflation even if the government forces prices.

Even if the government can continue to force people to make food than give to markets and sell it but sooner or later the external environment ((outside your country)) comes into effect.

Lets look at another example with an international flavor.  A bag of wheat costs $40, but the government prints a lot of money ((lets say increases the amount of money in the system) and the dollar is worth much less than lets say the Yen.  People from Japan are happy to buy the bag of wheat for even  for 50% more than the now rate due to they can buy a lot of dollars for Yen so the bag of wheat is auctioned off for $60.  This price needs to be paid by everyone due to the farmer wants to make the most money for his wheat.  So everyone pays this price.  All products that are made with wheat increase in price and we get inflation.

I hope this helps.

 

anton95's picture
anton95
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Re: Erg, Dummy needs help!

The Inflation v Deflation question seems like the $64,000 question of the moment.  The inflationary argument says expanding the money supply will lead to inflation.  The deflationary side says we have bigger problems, and falling prices are all around us.

My 2 cents:

On the issue of the Fed buying MBSs or treasuries, it depends on what happens next. If the commercial bank offloads its MBSs and puts the proceeds back in a deposit account at the Fed, then as far as economic activity is concerned, nothing has happened (except that the taxpayer is on the hook for the MBS write-offs and the commercial bank is a little healthier, which may be the real point of the exercise).

On the other hand if the commercial bank uses the proceeds to lend to households and businesses, then economic activity has increased.  There is more money in the system and this is inflationary.  The first scenario is merely potentially inflationary, and will not actually be so until the bank decides to put the money into the economy.

What I understand from reading Davos' Daily Digest is that it is the first scenario that we are seeing for the moment.

On the Inflation v Deflation question, the FT had an interesting interview http://www.ft.com/cms/893ac9c8-757e-11dc-b7cb-0000779fd2ac.html  with Hugh Hendry, a London based hedge fund manager who is famously contrarian.  He believes that the consensus crowds towards inflation, but that the $1.5-$2 trillion of Quantatative Easing is drowned by the $13 trillion of lost wealth of the last 12 months.  He also says that the US money supply is growing at only 9% per annum at present (I have no reference for that number).

npwebb's picture
npwebb
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Re: Erg, Dummy needs help!
Quote:

On the Inflation v Deflation question, the FT had an interesting interview http://www.ft.com/cms/893ac9c8-757e-11dc-b7cb-0000779fd2ac.html  with Hugh Hendry, a London based hedge fund manager who is famously contrarian.  He believes that the consensus crowds towards inflation, but that the $1.5-$2 trillion of Quantatative Easing is drowned by the $13 trillion of lost wealth of the last 12 months.  He also says that the US money supply is growing at only 9% per annum at present (I have no reference for that number).

I've been thinking along those lines as well.  Whether we've lost $10 trillion or $13 trillion isn't really that important.  As best I can figure the amount of money supply that has been destroyed as a result of default outstrips the level of "quantitative easing" performed by the Fed...and the creative destructive process is just beginning.

If that assesment is correct, then the economic pain that is present now will help sustain what is a fundementally flawed money system by putting a pinch (however small) on the exponential growth of money.  That being said our rate of increased debt if off the hook so it may have no significant impact.

 

As for the 9% growth of US money supply, it looks like M2 fits the bill.

From Shadowstats.com

Shadow Stats Money Supply

Quote:

On the issue of the Fed buying MBSs or treasuries, it depends on what happens next. If the commercial bank offloads its MBSs and puts the proceeds back in a deposit account at the Fed, then as far as economic activity is concerned, nothing has happened (except that the taxpayer is on the hook for the MBS write-offs and the commercial bank is a little healthier, which may be the real point of the exercise).

On the other hand if the commercial bank uses the proceeds to lend to households and businesses, then economic activity has increased.  There is more money in the system and this is inflationary.  The first scenario is merely potentially inflationary, and will not actually be so until the bank decides to put the money into the economy.

In scenario #1 isn't it inevitable that the potential inflation will be realized at some point in the future?  If I understand you, you are saying that the Fed has essentially credited the bank(s) for the total amount which they can use when and where they please.  At some point the Fed credit to the bank will work it's way back into the economy it's really a question of "when" not "if".  In that case is there really any difference between your scenario #1 and #2 other than timing?

 

agitating prop's picture
agitating prop
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Re: Erg, Dummy needs help!

NObody gets it, totally.

I think we could easily have this:

"Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices".

So many businesses are going to fail, that a drop in supply could be greater than the drop in demand, too.

Cost push inflation and the attendant unemployment is what the govt will likely try to curtail through massive infrastructure projects, and research and development, expansion of health care, etc... through several more cycles of stimulus spending. They'll create a different kind of inflation by buying their own treasuries, at this point, because foreigners sure aren't going to be purchasing them. This is pure Weimer style printing backed by nothing. It doesn't even rise to the level of borrowing or lending money into existence, because the concept of the money being actually paid back becomes almost esoteric.

And then you have houses and credit sensitive items that will continue to decline in price, perhaps in a shallower way, but they will still decline in price.

The inflationary forces, so far, don't appear to exceed the deflationary forces, appreciably....but they will. Give it a year.

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