When George Bush took office in 2000, the U.S. public debt—the amount the Federal Government owes in treasury bonds—was $3.4 trillion. When George Bush left office, it was $5.8 trillion. For all of his misspending, it pales compared to our current situation. Today, as of this writing, with Obama holding office for a mere 2 years, the public debt stands at $9.2 trillion.
The average tax payer owes around $7000 for each trillion dollars of government spending, so Obama has spent over $20,000 for each tax paying citizen in two years. Do we have $20,000 per head worth of a better country? I guess that is a personal decision each citizen needs to make.
This is what the government owes. It is different than the gross national debt, which is in the neighborhood of $14 trillion—this is what we always see on the national debt clock. The extra $5 trillion is intra-governmental debt, or debt that will one day need to be taken in order to meet Social Security and Medicare obligations. But to the degree the federal government functions as a single economic entity, which it does, it is not debt that actually exists, not yet, and truth be told, anything could still happen regarding Social Security and Medicare obligations.
The public debt is what the government actually needs to pay back today, and I think is overall the more sensible number to look at than gross debt when considering government solvency.
$9.2 trillion is a lot of money, which leaves a lot of question about the government's ability to pay it back. GDP estimates are around $14 trillion for the U.S., and yearly tax revenues (first column in the link) are in the $2.5 trillion range for the federal government. If the intest on the public debt stands at 5% on average, which I think overestimates it given how very low rates are now, then yearly interest payments on $10T would be $500B, which sits pretty manageably within $2.5 trillion of revenues, provided revenues hold constant and do not recede.
I'm going to guess the government could at least double the debt before default (or hyperinflation) would be a genuine concern. To the degree that government spending draws money away from private markets and burdens the productive capacity of the economy—the recent exponential growth of debt is still unwelcome.
Friday, December 3, 2010
Saturday, November 27, 2010
QE2
To the degree that taking out a second credit card when deeply in debt can be regarded as "prosperity," America's current economic state can be regarded as "recovery."
At least Wall Street has been doing well with ongoing government interventions. Elsewhere economic activity would have to be viewed as tepid, but certainly things aren't crashing and burning. So recovery I guess it is.
Driving this recovery, the Fed first dropped the prime lending rate to zero, for the first time in history, late in 2008, where they've been ever since and show no signs of turning around. Any recovery has to be viewed in the light that the Fed is handing dollars to banks and investment banks scott free.
These lower borrowing costs trickle down to the rest of the nation as somewhat lower mortgage rates, lower bond rates in general, and, I've argued, higher stock prices.
But when that's not good enough, when the Fed has to do more before deflationary forces assert themselves, there is quantitive easing. Here the central bank starts buying bonds—typically treasury but any kind will do—with freshly printed money. This accomplishes two things: (1) it drives bond rates down since bond sellers no longer have to offer interest rates which are as attractive, so borrowing costs overall are lower, and (2) it introduces a bolus infusion of cash into the economy, which is a temporary inflationary force to be reversed as the bonds mature and the minted cash returns to the bowells of the Fed.
The Fed began quantitative easing early in 2009, for around $2 trillion worth of treasury bonds and GSE debt, which recently came to completion.
Surveying the economy, the Fed determined that more quantitive easing was necessary to stave away deflation. So, earlier this month a $600 treasury bond purchase was initiated by the Fed, known as "QE2." this wasn't unexpected to anyone following Fed activities, but did happen quietly and with little fanfare. Pretty much, it is a continuation of "QE1" rather than anything distinct.
It does suggest that what economic forces and motives that dropped interest rates to 0% in the first place, and then initiated the first round of quantitive easing, are still with us today.
Enjoy your recovery.
At least Wall Street has been doing well with ongoing government interventions. Elsewhere economic activity would have to be viewed as tepid, but certainly things aren't crashing and burning. So recovery I guess it is.
Driving this recovery, the Fed first dropped the prime lending rate to zero, for the first time in history, late in 2008, where they've been ever since and show no signs of turning around. Any recovery has to be viewed in the light that the Fed is handing dollars to banks and investment banks scott free.
These lower borrowing costs trickle down to the rest of the nation as somewhat lower mortgage rates, lower bond rates in general, and, I've argued, higher stock prices.
But when that's not good enough, when the Fed has to do more before deflationary forces assert themselves, there is quantitive easing. Here the central bank starts buying bonds—typically treasury but any kind will do—with freshly printed money. This accomplishes two things: (1) it drives bond rates down since bond sellers no longer have to offer interest rates which are as attractive, so borrowing costs overall are lower, and (2) it introduces a bolus infusion of cash into the economy, which is a temporary inflationary force to be reversed as the bonds mature and the minted cash returns to the bowells of the Fed.
The Fed began quantitative easing early in 2009, for around $2 trillion worth of treasury bonds and GSE debt, which recently came to completion.
Surveying the economy, the Fed determined that more quantitive easing was necessary to stave away deflation. So, earlier this month a $600 treasury bond purchase was initiated by the Fed, known as "QE2." this wasn't unexpected to anyone following Fed activities, but did happen quietly and with little fanfare. Pretty much, it is a continuation of "QE1" rather than anything distinct.
It does suggest that what economic forces and motives that dropped interest rates to 0% in the first place, and then initiated the first round of quantitive easing, are still with us today.
Enjoy your recovery.
Thursday, October 28, 2010
Thomas Jefferson said...
"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks to the people!"
Wise words indeed, succinctly stating the problems of leaving the printing of legal tender in the hands of a single authority, such as an organized banking cartel. But the solution he poses, which is a democratically controlled money supply, has problems too.
He states banks gain power and property through inflating the currency, and then deflating it—in other words lending inflated (lesser value) currency out then having deflated (greater value) currency paid back to them. We've certainly seen the inflated part of the equation, and I anticipate soon we will see deflation, and Thomas Jefferson's warning bearing out in reality. In housing we see significant deflation already, and a new wave of foreclusures and further price drops will be here soon. Paper money and credit cycles are an old game.
But paper money in the hands of the people would quickly devalue through inflation when everybody starts voting themselves pay raises and forgiveness of their debt. Whereas banking controlled money supply will have inflation followed by deflation through which the banks profit from the amplitudes of currency fluctuation both high and low—a democratically controlled money supply will see rampant inflation, moving to hyperinflation probably, and no looking back.
Back when paper money was backed by gold or other precious metals, there were episodes of inflation and deflation, but small compared to what we see today. So, many who favor stable currency support reversion to a gold standard, where natural limitations on the amount of gold keep inflationary and deflationary forces in check. I think a gold standard is sensible and support it, but the compromise of power that would entail to people who currently hold power, I don't see that as a practical solution.
Now, the Federal Reserve Bank is governed by a mix of appointees from both private banks and the President (and approved by the Senate), so there is some democratic influence. By numbers, government appointees have a slight majority over bank appointees, but in practice, the Fed tends to side with banking interests. Possibly a checks and balances system from a separate review committee, with government appointees of two year terms rather than 14 (as currently exists for Federal Reserve positions), might be able to put the brakes on uncontrolled Federal Reserve policy.
I don't know, since I doubt any democratically driven body would ever want to stop inflation; when banks and the Fed want to start the inflation party, no governmental body is going to stop them. But, once that happens, it would be only banks and wealthy interests motivated to reel things back with deflation, creating some semblance of balance over time. Those who hold wealth, particularly bonds, would not want much inflation, and one can only guess where the power lies. We see now that Congress and the President remain opposed to any deflationary correction, so I'm not sure that thowing more democratic control into the system will make much of a difference.
The solution is--if the gold standard is inviable--a more distrustful social attitude toward credit, such that fewer people get caught up in the inflation/deflation traps the banks seem to set every few decades.
Wise words indeed, succinctly stating the problems of leaving the printing of legal tender in the hands of a single authority, such as an organized banking cartel. But the solution he poses, which is a democratically controlled money supply, has problems too.
He states banks gain power and property through inflating the currency, and then deflating it—in other words lending inflated (lesser value) currency out then having deflated (greater value) currency paid back to them. We've certainly seen the inflated part of the equation, and I anticipate soon we will see deflation, and Thomas Jefferson's warning bearing out in reality. In housing we see significant deflation already, and a new wave of foreclusures and further price drops will be here soon. Paper money and credit cycles are an old game.
But paper money in the hands of the people would quickly devalue through inflation when everybody starts voting themselves pay raises and forgiveness of their debt. Whereas banking controlled money supply will have inflation followed by deflation through which the banks profit from the amplitudes of currency fluctuation both high and low—a democratically controlled money supply will see rampant inflation, moving to hyperinflation probably, and no looking back.
Back when paper money was backed by gold or other precious metals, there were episodes of inflation and deflation, but small compared to what we see today. So, many who favor stable currency support reversion to a gold standard, where natural limitations on the amount of gold keep inflationary and deflationary forces in check. I think a gold standard is sensible and support it, but the compromise of power that would entail to people who currently hold power, I don't see that as a practical solution.
Now, the Federal Reserve Bank is governed by a mix of appointees from both private banks and the President (and approved by the Senate), so there is some democratic influence. By numbers, government appointees have a slight majority over bank appointees, but in practice, the Fed tends to side with banking interests. Possibly a checks and balances system from a separate review committee, with government appointees of two year terms rather than 14 (as currently exists for Federal Reserve positions), might be able to put the brakes on uncontrolled Federal Reserve policy.
I don't know, since I doubt any democratically driven body would ever want to stop inflation; when banks and the Fed want to start the inflation party, no governmental body is going to stop them. But, once that happens, it would be only banks and wealthy interests motivated to reel things back with deflation, creating some semblance of balance over time. Those who hold wealth, particularly bonds, would not want much inflation, and one can only guess where the power lies. We see now that Congress and the President remain opposed to any deflationary correction, so I'm not sure that thowing more democratic control into the system will make much of a difference.
The solution is--if the gold standard is inviable--a more distrustful social attitude toward credit, such that fewer people get caught up in the inflation/deflation traps the banks seem to set every few decades.
Thursday, September 9, 2010
How Money Supply Limits Prices
Today I’d like to revisit an idea that was the focal point of my last blog, The Ca$h Bull: which is the relationship between money supply and prices.
It is common observation and defined in the Quantity Theory of Money that when money supply increases substantially and rapidly, prices tend to rise. That the reverse is true seems sensible as well, though it is rare for money supply to contract so historical examples would be uncommon.
I tried to more precisely define the relationship of money supply and inventory by equating the two: that the sum of all things for sale would self-adjust in price to equal the money supply. I did this because I was trying to define a value for cash, and postulated that the money supply is exactly equal to the sum of all goods that can be bought with it, much like all stock certificates added together would exactly equal the value of the corporation that sells them. The value of a dollar is the collection of all goods for sale, divided by the number of dollars in circulation. That was the theory.
It was pretty detailed how I built the argument and led to some concepts which I think are still valid, but as I delved into the nuts and bolts of the mathematics, I concluded it was completely wrong, and terminated the blog because I didn’t see any way to reconcile the rest of the blog with that realization. In short: inventory prices do not gravitate toward the standing money supply, rather inventory prices gravitate toward zero. In an ideal economy, everything is sold the moment it is produced. That which does not sell immediately becomes a burden on production, where either prices will have to drop or production will have to slow to accommodate standing inventory. The ideal inventory is zero. What inventory that does exist is simply a necessary error in real systems based on lag between production and sales.
So then, how can money supply and prices relate as we see in the Quantity Theory of Money? The relationship comes through both money and sales velocity, not standing amounts.
Inventory (in dollar amounts) cannot be sustainably produced in an amount that exceeds rate of spending. If goods are produced faster than money can be spent, then excess inventory goes unsold. In the next round of production, not only what is produced has to be sold, but it has to compete against unsold inventory, and if any inventory remains standing in a prolonged way, it means that producers are not being paid for their work. For standing items to sell, either production must slow or prices drop.
Now, say the money supply is doubled and dispersed through the population. Now twice the amount of money is capable of being spent per unit time, which either allows more to be produced at the same price, or more to be charged if production is kept the same. Say money supply stays the same but you double the rate people are inclined to spend it, then same thing. So absolute money supply is not a hard and fast limit on production capacity—to the degree people can be encouraged to spend money faster, prices can still rise even with a stable money supply.
But eventually there is a limit to the rate of spending—the rate people spend money cannot rise to infinity. Even with policies that encourage spending, eventually society reaches the upper limit, and at that point, whatever that rate of spending may be, money supply becomes the limiting factor of production.
So, if society is spending money at its natural rate, in a way that cannot be increased in a sustainable way, then the only way for prices to increase is for money supply to increase. The maximum production (in dollars) over a given time period is limited by maximum rate of spending over the same period of time.
It is common observation and defined in the Quantity Theory of Money that when money supply increases substantially and rapidly, prices tend to rise. That the reverse is true seems sensible as well, though it is rare for money supply to contract so historical examples would be uncommon.
I tried to more precisely define the relationship of money supply and inventory by equating the two: that the sum of all things for sale would self-adjust in price to equal the money supply. I did this because I was trying to define a value for cash, and postulated that the money supply is exactly equal to the sum of all goods that can be bought with it, much like all stock certificates added together would exactly equal the value of the corporation that sells them. The value of a dollar is the collection of all goods for sale, divided by the number of dollars in circulation. That was the theory.
It was pretty detailed how I built the argument and led to some concepts which I think are still valid, but as I delved into the nuts and bolts of the mathematics, I concluded it was completely wrong, and terminated the blog because I didn’t see any way to reconcile the rest of the blog with that realization. In short: inventory prices do not gravitate toward the standing money supply, rather inventory prices gravitate toward zero. In an ideal economy, everything is sold the moment it is produced. That which does not sell immediately becomes a burden on production, where either prices will have to drop or production will have to slow to accommodate standing inventory. The ideal inventory is zero. What inventory that does exist is simply a necessary error in real systems based on lag between production and sales.
So then, how can money supply and prices relate as we see in the Quantity Theory of Money? The relationship comes through both money and sales velocity, not standing amounts.
Inventory (in dollar amounts) cannot be sustainably produced in an amount that exceeds rate of spending. If goods are produced faster than money can be spent, then excess inventory goes unsold. In the next round of production, not only what is produced has to be sold, but it has to compete against unsold inventory, and if any inventory remains standing in a prolonged way, it means that producers are not being paid for their work. For standing items to sell, either production must slow or prices drop.
Now, say the money supply is doubled and dispersed through the population. Now twice the amount of money is capable of being spent per unit time, which either allows more to be produced at the same price, or more to be charged if production is kept the same. Say money supply stays the same but you double the rate people are inclined to spend it, then same thing. So absolute money supply is not a hard and fast limit on production capacity—to the degree people can be encouraged to spend money faster, prices can still rise even with a stable money supply.
But eventually there is a limit to the rate of spending—the rate people spend money cannot rise to infinity. Even with policies that encourage spending, eventually society reaches the upper limit, and at that point, whatever that rate of spending may be, money supply becomes the limiting factor of production.
So, if society is spending money at its natural rate, in a way that cannot be increased in a sustainable way, then the only way for prices to increase is for money supply to increase. The maximum production (in dollars) over a given time period is limited by maximum rate of spending over the same period of time.
Wednesday, August 25, 2010
Core Thesis
I realize this blog is off to a slow start.
Part of it is: the United States is still far away from this titular “zero hour” as I call it, where governments can no longer sell treasury bonds. The U.S. is years away, but some countries like Iceland and Greece are there. Even with bailouts from the Eurozone, Greece is still there, and Iceland has no France and Germany it can rely on for help. State governments are heading there. For municipal and county governments, “zero hour” would be happening in many places, but for now public services they provide are shifted to higher levels of government. As long as a local government is under the umbrella of a larger solvent or credit worthy government, debt burdens seem to mostly be shifting higher up the totem pole, placing additional stress on the larger government.
Another part is: bailout activity has been slow in the news lately. Not that hundreds of billions aren’t pouring forth from the Fed and Treasury Department in support of wealthy banking interests, but reports on noteworthy details have been meager in the news lately.
So let me take a moment to explain why “zero hour” matters to me. I oppose the government rescue of our economy after the credit bubble popped. I believe the best solution is for the corporations that caused this mess to go bankrupt, and prices to fall as they naturally would in a free market, particularly for houses and other investment classes. I am opposed to government attempts to maintain house prices and credit-based assets above the market price, as it is doing now, and believe that it only delays the solution to the current economic downturn, which is lower prices.
When it comes to spending tax money, our government is showing little self-restraint. Worse, politicians are not only spending tax money they actually have, but are borrowing it from future taxpayers to benefit politically-invested interests today.
This government practice will stop when one of two things happen: either (1) a democratic majority agrees with me and start voting in politicians who will seek to stop bailouts and otherwise support responsible and sustainable government spending, or (2) the government runs out of money. The U.S. government already spends more than it takes in with taxes by selling Treasury Bonds, so #2 will only happen when the government can no longer sell Treasury Bonds, or more precisely, when people no longer buy them.
This I see as an advantageous outcome because it brings society back to a point where it has to live within its means. Even if a large chunk of our tax dollars is wasted in the future to pay interest on misspent bailout money today, and maybe the government services we receive are only half what we are paying in taxes because of interest payments on the debt, I still feel a society with a less meddlesome and more economically restrained government is better than the mess that exists now.
So I think zero hour is a good thing and welcome it. What would be better though is to control spending before we reach that point.
Part of it is: the United States is still far away from this titular “zero hour” as I call it, where governments can no longer sell treasury bonds. The U.S. is years away, but some countries like Iceland and Greece are there. Even with bailouts from the Eurozone, Greece is still there, and Iceland has no France and Germany it can rely on for help. State governments are heading there. For municipal and county governments, “zero hour” would be happening in many places, but for now public services they provide are shifted to higher levels of government. As long as a local government is under the umbrella of a larger solvent or credit worthy government, debt burdens seem to mostly be shifting higher up the totem pole, placing additional stress on the larger government.
Another part is: bailout activity has been slow in the news lately. Not that hundreds of billions aren’t pouring forth from the Fed and Treasury Department in support of wealthy banking interests, but reports on noteworthy details have been meager in the news lately.
So let me take a moment to explain why “zero hour” matters to me. I oppose the government rescue of our economy after the credit bubble popped. I believe the best solution is for the corporations that caused this mess to go bankrupt, and prices to fall as they naturally would in a free market, particularly for houses and other investment classes. I am opposed to government attempts to maintain house prices and credit-based assets above the market price, as it is doing now, and believe that it only delays the solution to the current economic downturn, which is lower prices.
When it comes to spending tax money, our government is showing little self-restraint. Worse, politicians are not only spending tax money they actually have, but are borrowing it from future taxpayers to benefit politically-invested interests today.
This government practice will stop when one of two things happen: either (1) a democratic majority agrees with me and start voting in politicians who will seek to stop bailouts and otherwise support responsible and sustainable government spending, or (2) the government runs out of money. The U.S. government already spends more than it takes in with taxes by selling Treasury Bonds, so #2 will only happen when the government can no longer sell Treasury Bonds, or more precisely, when people no longer buy them.
This I see as an advantageous outcome because it brings society back to a point where it has to live within its means. Even if a large chunk of our tax dollars is wasted in the future to pay interest on misspent bailout money today, and maybe the government services we receive are only half what we are paying in taxes because of interest payments on the debt, I still feel a society with a less meddlesome and more economically restrained government is better than the mess that exists now.
So I think zero hour is a good thing and welcome it. What would be better though is to control spending before we reach that point.
Sunday, July 4, 2010
Yields and Risk
Over the couple years I've blogged on the economy, I have been pretty bad at prediciting the behavior of the stock market. Despite this, I would like to share a couple of insights over this time.
I have blogged before on the inherent fluctuation of the market, as it swings back and forth around the trend line. Financial commentators will always have an explanation for why the DJIA went up or down 50 points today—they will always find some piece of economic news to link it to—but really, 50 points, and probably even 100, is well within the margin of error, so swings up and down of that degree are just artifactual noise and have no meaning. Admittedly, if you want to be invited back on CNBC as a financial commentator, you had better find a better answer than: "Today's 75 drop was probably mostly just random noise and bears no particular association with any financial event. It will probably reverse course tomorrow."
So today, I would like to discuss two other factors that play a role in stock valuations that buck the trend line and account for movement outside of the margin of error.
Yields are the bottom line of any investment. Unless an investment delivers a competitive yield, or return on your principle, it has no value as an investment. Now speculative run-ups can happen and have happened a lot lately where the prices of stocks or houses or whatever rise in a detached way from yields and people can make a lot of money from capital gains—but this is the definition of a bubble, and it is always time-limited and a risky game to play. In the heart of a bubble, investors will say things like "new paradigm" and believe that the principle is now detached from the yield, but sooner or later, things will return to earth. It is a speculative game and the last of the greater fools will eventually get burned.
While yields have generally been pretty low in the last rise of the DJIA, since its lows in the 6000s in March 2009, this last bull market may have actually been supported by fundamentals. The problem is, with the Federal Reserve lending out money at close to 0%, investments have not needed to perform very well to be marketable. If you are an investment bank that can borrow money from the Fed at, say, 1%, and then invest it in stocks with a meager 2 or 3% yield, that is still profitable. If interest rates are closer to their historical average at 5%, a 2 or 3% yield would be unprofitable, and the base price of stocks would have to fall before it would be sensible to buy them as an investment. The recent peak of the DJIA in the 11000s is understandable given the generally poor yields of all investment classes today.
A less tangible factor that affects stock valuations is risk. If one fears a business going bankrupt, even a 20% yield is uncompetitive if it causes you to lose your entire principle. If a business is extremely stable, its stock hardly needs to outperform treasury bonds to be a worthwhile investment. If the overall business environment is optimistic, yields can drop, raising the base price of the stock. Conversely in a worrisome climate, yields must rise for the stock to be competitive.
Since yields are fairly fixed and cannot go up or down on a whim, it is the principle, or base cost of the share, that must adjust to the desired yields. In a climate where low yields are tolerated then stocks prices have room to rise, or if higher yields are needed, then there is a downward pressure on share price.
So, random variations, yields, and risk are the current factors I have in my mind that account for shifts in the value of stock, or other investment classes. Random variations account for small changes of up to a few percentage points. Yields are straightforward and easy to measure, and if a stable corporation can outperform Treasury Bonds by a percentage point or two, its price is understandable and consistent with fundamentals.
Risk is the x-factor in all of this. It is hard for outsiders to gage what the inherent business outlook will be, and in addition, risk is mitigated by upcoming government bailouts which again is knowledge that will be privy only insiders.
The stock market has declined significantly lately. Though yields are poor they are in line with those of other investments. So, using this model, recent declines are accounted for by a general sense of risk in the system.
I have blogged before on the inherent fluctuation of the market, as it swings back and forth around the trend line. Financial commentators will always have an explanation for why the DJIA went up or down 50 points today—they will always find some piece of economic news to link it to—but really, 50 points, and probably even 100, is well within the margin of error, so swings up and down of that degree are just artifactual noise and have no meaning. Admittedly, if you want to be invited back on CNBC as a financial commentator, you had better find a better answer than: "Today's 75 drop was probably mostly just random noise and bears no particular association with any financial event. It will probably reverse course tomorrow."
So today, I would like to discuss two other factors that play a role in stock valuations that buck the trend line and account for movement outside of the margin of error.
Yields are the bottom line of any investment. Unless an investment delivers a competitive yield, or return on your principle, it has no value as an investment. Now speculative run-ups can happen and have happened a lot lately where the prices of stocks or houses or whatever rise in a detached way from yields and people can make a lot of money from capital gains—but this is the definition of a bubble, and it is always time-limited and a risky game to play. In the heart of a bubble, investors will say things like "new paradigm" and believe that the principle is now detached from the yield, but sooner or later, things will return to earth. It is a speculative game and the last of the greater fools will eventually get burned.
While yields have generally been pretty low in the last rise of the DJIA, since its lows in the 6000s in March 2009, this last bull market may have actually been supported by fundamentals. The problem is, with the Federal Reserve lending out money at close to 0%, investments have not needed to perform very well to be marketable. If you are an investment bank that can borrow money from the Fed at, say, 1%, and then invest it in stocks with a meager 2 or 3% yield, that is still profitable. If interest rates are closer to their historical average at 5%, a 2 or 3% yield would be unprofitable, and the base price of stocks would have to fall before it would be sensible to buy them as an investment. The recent peak of the DJIA in the 11000s is understandable given the generally poor yields of all investment classes today.
A less tangible factor that affects stock valuations is risk. If one fears a business going bankrupt, even a 20% yield is uncompetitive if it causes you to lose your entire principle. If a business is extremely stable, its stock hardly needs to outperform treasury bonds to be a worthwhile investment. If the overall business environment is optimistic, yields can drop, raising the base price of the stock. Conversely in a worrisome climate, yields must rise for the stock to be competitive.
Since yields are fairly fixed and cannot go up or down on a whim, it is the principle, or base cost of the share, that must adjust to the desired yields. In a climate where low yields are tolerated then stocks prices have room to rise, or if higher yields are needed, then there is a downward pressure on share price.
So, random variations, yields, and risk are the current factors I have in my mind that account for shifts in the value of stock, or other investment classes. Random variations account for small changes of up to a few percentage points. Yields are straightforward and easy to measure, and if a stable corporation can outperform Treasury Bonds by a percentage point or two, its price is understandable and consistent with fundamentals.
Risk is the x-factor in all of this. It is hard for outsiders to gage what the inherent business outlook will be, and in addition, risk is mitigated by upcoming government bailouts which again is knowledge that will be privy only insiders.
The stock market has declined significantly lately. Though yields are poor they are in line with those of other investments. So, using this model, recent declines are accounted for by a general sense of risk in the system.
Friday, June 11, 2010
So, Who Runs the Fed?
I'd like to comment today on the organization of the Federal Reserve System, and whether it is truly a function of the Federal Government and under democratic purview as is commonly understood—or whether it is a quasi-governmental intermediary that enables the interests of private banks to be enacted into law. As it turns out, it is a mix of the two, split nearly evenly down the middle.
Federal Reserve operations are handled by 12 regional banks, with 25 branches, across the United States. These operate the discount window and monitor the overall economy within their regions. Each regional bank is run like a private bank, independently incorporated, with shares held by member banks. Each has a 9-member board of directors: 6 elected by the shareholders, and 3 appointed by the Board of Governors (explained below). They are like private banks in how they are organized, except profits are relinquished to the Treasury Department, rather than shareholders.
At the federal level of policy-making, decisions that affect the whole of the economy and money supply are made by the Federal Open Market Committee (FOMC), comprised of 12 members. Five of the 12 are chosen out of the presidents of the 12 regional banks, who are elected by the shareholders (private banks). The remaining seven are the Board of Governors, each of which are selected by the President of the United States and confirmed by the Senate in staggered 14-year terms.
So the Fed is an independent government institution that has private aspects. Its everyday operations are run by, essentially, private banks. Broad policy decisions are made by a committee of 12, five of whom come from private industry, and seven who are appointed by the President and approved by the Senate. While seven versus five shifts the FOMC in favor of democratic control, any democratic influence is mitigated by the lengthy terms, and it would be surprising if the banking lobby didn't have a lot of say on the canditates submitted for the position. In the end, it is rare for the FOMC to have a dissenting vote.
Now it is fine with me to have restricted democratic influence over money supply. If it were possible, the democratic majority would vote themselves massive pay raises. For a society heavily in debt, as ours is, its willingness to forgive all debt through hyperinflation would be practically unstoppable. Paper money originated from private banks as gold notes, and within the private sector money creation should probably stay.
The problem with private interests running central banks is this: not all citizens will have the same opportunity to access the discount window for cheap capital. Those who do will have a carry trade advantage over those of us unable to tap into the easy money available from Federal Reserve printing presses.
Federal Reserve operations are handled by 12 regional banks, with 25 branches, across the United States. These operate the discount window and monitor the overall economy within their regions. Each regional bank is run like a private bank, independently incorporated, with shares held by member banks. Each has a 9-member board of directors: 6 elected by the shareholders, and 3 appointed by the Board of Governors (explained below). They are like private banks in how they are organized, except profits are relinquished to the Treasury Department, rather than shareholders.
At the federal level of policy-making, decisions that affect the whole of the economy and money supply are made by the Federal Open Market Committee (FOMC), comprised of 12 members. Five of the 12 are chosen out of the presidents of the 12 regional banks, who are elected by the shareholders (private banks). The remaining seven are the Board of Governors, each of which are selected by the President of the United States and confirmed by the Senate in staggered 14-year terms.
So the Fed is an independent government institution that has private aspects. Its everyday operations are run by, essentially, private banks. Broad policy decisions are made by a committee of 12, five of whom come from private industry, and seven who are appointed by the President and approved by the Senate. While seven versus five shifts the FOMC in favor of democratic control, any democratic influence is mitigated by the lengthy terms, and it would be surprising if the banking lobby didn't have a lot of say on the canditates submitted for the position. In the end, it is rare for the FOMC to have a dissenting vote.
Now it is fine with me to have restricted democratic influence over money supply. If it were possible, the democratic majority would vote themselves massive pay raises. For a society heavily in debt, as ours is, its willingness to forgive all debt through hyperinflation would be practically unstoppable. Paper money originated from private banks as gold notes, and within the private sector money creation should probably stay.
The problem with private interests running central banks is this: not all citizens will have the same opportunity to access the discount window for cheap capital. Those who do will have a carry trade advantage over those of us unable to tap into the easy money available from Federal Reserve printing presses.
Tuesday, June 1, 2010
An Endless Money Supply
I've been wondering lately: can the Fed print or electrically create money and then spend it, or give it away to somebody else for personal or government spending? My answer to that from reviewing Fed policy and open market actions is that it cannot. The only way for the Fed to let loose newly-created currency would be to lend it out. It can lend it directly through the discount window to banks, with Treasury Bonds as collateral, or it can buy bonds directly, and then either sell them or hold them until the bond matures. In any case, releasing newly created money acts as a loan. No money can be released from the Fed without an expectation it will be paid back. Money dispersed in this way will sooner or later make its way back to the vaults of the Fed.
Now there is a way to game the system: if the Fed knowingly buys a junk bond that is obviously going to be defaulted on, without recourse, then newly minted money has been let loose in the system and is there to stay. Otherwise, all other money minted and lent by the Fed eventually disappears when it is paid back. The only way to achieve a stable money supply is where debt issuance equals the rate it is paid back.
The essence of our money supply is the willingness of people to take on debt. We know this is the case with fractional reserve banking, where loans in this way account for the creation of most of America's money supply. But it looks like a similar principle applies to base money as well. All dollars originate from loans. Whatever the total money supply is, that entire amount is owed back to the banks. If people, corporations, and governments were to stop borrowing, money supply eventually would dwindle to nothing as loans are paid off.
Maintaining a stable money supply depends on regulating the flow of credit. Inflation can be contained if the Fed increases the prime lending rate. Higher borrowing costs would discourage new loans. In a deflationary environment, to maintain stable prices, interest rates can be lowered and borrowing encouraged. We have seen a lot of that lately. But in a society mostly exhausted of credit, lending cannot be forced.
If people cannot take on as much credit as before, then there is no way to expand the money supply. Without a fundamental change in Fed policy enacted by Congress, deflation is the only legal option in America. There is no way now for the Fed to hyperinflate the economy (unless the exception I mentioned in the second paragraph becomes rampant).
We see this already in a recent expansion of base money starting in September of 2008. This base money expansion has been matched exactly by money sitting in bank reserves. The new money isn't being lent—it isn't finding any outlet into the general economy, and it is not creating inflation.
The point here is that the Fed is sitting on a virtual money supply that is infinite. From a supply perspective, the Fed cannot expand money beyond what it already is, because that amount is unlimited. What contains money supply from skyrocketing to infinity is demand for credit. If prices destabilize through expansions or contractions of credit, the Fed can attempt to maintain price stability by regulating interest rates or purchasing bonds. Unlike a gold standard where money is limited by the quantity of gold, our economy has no fixed limit for credit and is constrained only by peoples willingness to borrow from banks, and banks willingness to lend.
Now there is a way to game the system: if the Fed knowingly buys a junk bond that is obviously going to be defaulted on, without recourse, then newly minted money has been let loose in the system and is there to stay. Otherwise, all other money minted and lent by the Fed eventually disappears when it is paid back. The only way to achieve a stable money supply is where debt issuance equals the rate it is paid back.
The essence of our money supply is the willingness of people to take on debt. We know this is the case with fractional reserve banking, where loans in this way account for the creation of most of America's money supply. But it looks like a similar principle applies to base money as well. All dollars originate from loans. Whatever the total money supply is, that entire amount is owed back to the banks. If people, corporations, and governments were to stop borrowing, money supply eventually would dwindle to nothing as loans are paid off.
Maintaining a stable money supply depends on regulating the flow of credit. Inflation can be contained if the Fed increases the prime lending rate. Higher borrowing costs would discourage new loans. In a deflationary environment, to maintain stable prices, interest rates can be lowered and borrowing encouraged. We have seen a lot of that lately. But in a society mostly exhausted of credit, lending cannot be forced.
If people cannot take on as much credit as before, then there is no way to expand the money supply. Without a fundamental change in Fed policy enacted by Congress, deflation is the only legal option in America. There is no way now for the Fed to hyperinflate the economy (unless the exception I mentioned in the second paragraph becomes rampant).
We see this already in a recent expansion of base money starting in September of 2008. This base money expansion has been matched exactly by money sitting in bank reserves. The new money isn't being lent—it isn't finding any outlet into the general economy, and it is not creating inflation.
The point here is that the Fed is sitting on a virtual money supply that is infinite. From a supply perspective, the Fed cannot expand money beyond what it already is, because that amount is unlimited. What contains money supply from skyrocketing to infinity is demand for credit. If prices destabilize through expansions or contractions of credit, the Fed can attempt to maintain price stability by regulating interest rates or purchasing bonds. Unlike a gold standard where money is limited by the quantity of gold, our economy has no fixed limit for credit and is constrained only by peoples willingness to borrow from banks, and banks willingness to lend.
Thursday, May 20, 2010
Review: Meltup
The National Inflation Association has produced a video called "Meltup" that proposes hyperinflation is about to hit America, if it hasn't already. It is making rounds among the economic blogs and has been very successful on YouTube with a third of a million hits within a week of release. The vast majority of viewers who rated it gave favorable ratings.
It uses a lot of fearmongering, half-truths, and misinterpretation of data to arrive at its conclusions. While watching it, I wondered if it is not a straight up advertisement for silver bullion.
Still, I gave it a thumbs up myself, because hyperinflation is a risk in a struggling economy, it does an okay job of explaining that risk, and casts hyperinflation in a bad light (unlike some numbskulls), and also concluded that hyperinflation does not have to happen and it can be stopped with better economic understanding and political activism.
Here is a link to the video.
The NIA website offers a list of charts which I've placed in "Links" to the right. Ironically, most of the graphs look more deflationary than inflationary. The main exception is the 17th graph down showing the St. Louis Adjusted Monetary Base that shows skyrocketing base money production since September 2008. Even this, however, must be weighed against the 37th and 38th graph showing bank reserves, which have always perfectly matched base money production and strongly suggest all newly created Fed money is doing nothing but sitting in bank reserves, and not inflating the general economy.
I believe deflation is the more likely scenario to play out than hyperinflation when government bailouts exhaust themselves. More of this argument will be discussed in upcoming posts. Since my investments are heavily skewed to a deflationary scenario, I've always paid particularly close attention to inflationary arguments. I've signed up for the NIAs mailing list, and if they keep their charts up to date I think it is a good general barometer of the state of prices, money supply, and the overall economy.
It uses a lot of fearmongering, half-truths, and misinterpretation of data to arrive at its conclusions. While watching it, I wondered if it is not a straight up advertisement for silver bullion.
Still, I gave it a thumbs up myself, because hyperinflation is a risk in a struggling economy, it does an okay job of explaining that risk, and casts hyperinflation in a bad light (unlike some numbskulls), and also concluded that hyperinflation does not have to happen and it can be stopped with better economic understanding and political activism.
Here is a link to the video.
The NIA website offers a list of charts which I've placed in "Links" to the right. Ironically, most of the graphs look more deflationary than inflationary. The main exception is the 17th graph down showing the St. Louis Adjusted Monetary Base that shows skyrocketing base money production since September 2008. Even this, however, must be weighed against the 37th and 38th graph showing bank reserves, which have always perfectly matched base money production and strongly suggest all newly created Fed money is doing nothing but sitting in bank reserves, and not inflating the general economy.
I believe deflation is the more likely scenario to play out than hyperinflation when government bailouts exhaust themselves. More of this argument will be discussed in upcoming posts. Since my investments are heavily skewed to a deflationary scenario, I've always paid particularly close attention to inflationary arguments. I've signed up for the NIAs mailing list, and if they keep their charts up to date I think it is a good general barometer of the state of prices, money supply, and the overall economy.
Wednesday, May 19, 2010
Fed Holds $1.25T in Mortgage Backed Securities
It is hard to say how many of what assets the Federal Reserve Bank has on its balance sheet, not without a full audit, but I'll post what information there is. MarketWatch is reporting the Fed has accumulated $1.25T in mortgage backed securities [1] through a program which ended last March. Today in an FOMC meeting they announced their hesitation to sell these securities[2], until the economy settles better.
I'd guess this hesitation lies with the fact these mortgage backed securities are toxic and have insubstantial market value, which putting them up for sale would reveal. It is my understanding these purchases are non-recourse, so whatever money is not paid pack on these securities amounts to a gift of free money to whoever gave them to the Fed. This is inflationary, to be sure, but deflationary forces are greater, and keeping asset prices down from their 2007 highs.
The $1.25T comes from a quantitative easing program announced in March 2009 and outlined in June 2009. It was announced then the Fed would buy $1.25T in agency MBS's, and by "agency" they mean the GSEs (Fannie Mae and Freddie Mac), and in addition another $200B in agency debt, and by "debt" I never encountered an adequate definition. Then there was a final $300B in Treasury Bonds the Fed would buy for a total of $1.75T.
Since the Fed hasn't been able to lower interest rates below 0%, which happened on December 16, 2008, quantitative easing is the next step in loose monetary policy. It is a temporary infusion of liquid cash, where the Fed prints money to buy bonds. Any bonds will do, usually it involves Treasury bonds, but in this case Mortgage Backed Securities were also used. The printed money returns to the Fed as the bond is paid off over years. Selling these bonds, as was considered this FOMC meeting, has the opposite effect of draining money out of the economy and back into the vaults of the Fed.
So long as the bond is fully paid off, there is no net infusion of cash over time, but if it isn't, then the Fed has essentially given away the cost of the bond to the seller of the bond. In this case it would be the GSEs so this is a roundabout way for the Fed to hand money to the government. Since GSEs support the banks, banks are the ultimate private beneficiaries in all of this.
As of March, it would appear quantitative easing efforts have ended and I've seen no new ones announced. If some in the Fed are even contemplating removing MBS's from its balance sheet, this might be viewed as a positive sign—amid the sea of pessimism that quantitative easing with mortgage backed securities conjures.
Sources:
1. Fed won't sell mortgage holdings anytime soon.
2. Fed Majority in no rush to sell assets.
I'd guess this hesitation lies with the fact these mortgage backed securities are toxic and have insubstantial market value, which putting them up for sale would reveal. It is my understanding these purchases are non-recourse, so whatever money is not paid pack on these securities amounts to a gift of free money to whoever gave them to the Fed. This is inflationary, to be sure, but deflationary forces are greater, and keeping asset prices down from their 2007 highs.
The $1.25T comes from a quantitative easing program announced in March 2009 and outlined in June 2009. It was announced then the Fed would buy $1.25T in agency MBS's, and by "agency" they mean the GSEs (Fannie Mae and Freddie Mac), and in addition another $200B in agency debt, and by "debt" I never encountered an adequate definition. Then there was a final $300B in Treasury Bonds the Fed would buy for a total of $1.75T.
Since the Fed hasn't been able to lower interest rates below 0%, which happened on December 16, 2008, quantitative easing is the next step in loose monetary policy. It is a temporary infusion of liquid cash, where the Fed prints money to buy bonds. Any bonds will do, usually it involves Treasury bonds, but in this case Mortgage Backed Securities were also used. The printed money returns to the Fed as the bond is paid off over years. Selling these bonds, as was considered this FOMC meeting, has the opposite effect of draining money out of the economy and back into the vaults of the Fed.
So long as the bond is fully paid off, there is no net infusion of cash over time, but if it isn't, then the Fed has essentially given away the cost of the bond to the seller of the bond. In this case it would be the GSEs so this is a roundabout way for the Fed to hand money to the government. Since GSEs support the banks, banks are the ultimate private beneficiaries in all of this.
As of March, it would appear quantitative easing efforts have ended and I've seen no new ones announced. If some in the Fed are even contemplating removing MBS's from its balance sheet, this might be viewed as a positive sign—amid the sea of pessimism that quantitative easing with mortgage backed securities conjures.
Sources:
1. Fed won't sell mortgage holdings anytime soon.
2. Fed Majority in no rush to sell assets.
Thursday, May 6, 2010
A Bailout Economy
Following World War II, American manufacturing thrived while many industrialized nations rebuilt themselves in the wake of the war. A nascent technology industry formed and expanded, to be duplicated by the rest of the world, and sometimes improved upon, but what was there mostly originated in America. The technology boom drove new developments in art and culture. In the mid 90's, from local bulletin board services and usenet servers, the Internet would arise, and around it whole new business models formed.
These were all good times for investors in the American economy which enjoyed steady growth and few pitfalls. But most of the new dot.com ventures had no clear plan for revenue, and many of those that did still failed. A few thrived—like Google, Amazon, E*Trade, and Ebay—but most would struggle or collapse. Such would lead to the bust of the dot.com bubble where the NASDAQ fell from 5000 at the peak in 2001, down to under 2000 less than 2 years later. One might have expected a return to normalcy from the manic highs of the dot.com bubble. But that never happened.
The economy was never permitted a deflationary correction. In order to keep the excitement alive the Fed collapsed Interest rates from a general average of 5-10%, down to below 2%. But rather than keep the tech bubble rolling, the easy and cheap credit instead went into the housing market, creating a new bubble right on the heels of the last one. Money that was lost on the Internet could now be recovered as Americans flipped houses from 2003-7.
In a climate of marginal lending standards, in order to encourage the origination of loans, lenders would offer teaser rates, where the homeowner would only pay interest, or even negative amortize, so long as the teaser period lasted.
The first challenge to inflated real estate prices happened in 2007. At that time, subprime loans, which had the shortest teaser rate of 2 or 3 years, were beginning to reset in mass. Defaults began to skyrocket once the very low teaser payments came to an end, and mortgage backed securites built on subprime loans were running into severe problems even in the safer tranches, and came to be seen for the toxic waste they are. At the end of 2007, still early in the wave of subprime resets, credit markets based on private capital froze. The U.S. government and Federal Reserve Bank saw it as their place to intervene.
During this time, the stock market was in a bubble of its own, and similarly would collapse from its peak in the 14000's in Oct. 2007, down to the 6000s by March 2009, before recovering to 11000 today. In the more volatile areas house prices fell by a similar percentage, but generally they have remained down. Any recovery today in the housing market is a tepid one.
In late 2007, the Fed initiated multiple lending relief programs (or facilities) in order to replace losses of private capital. The Federal Funds Rate had recovered to 5% by 2006, but steadly fell to an all-time low of 0% by the end of 2008. For the first time ever, our nation was ZIRP'd. The executive branch pushed through Congress the $700B TARP bailout plan, and later a $787B state stimulus package. Many billions were spent to rescue Fannie Mae, Freddie Mac, and the insurance company AIG (who insured many billions worth of toxic securities for banks).
The scope of the bailouts is unknown, and cannot be determined without a full audit of the Fed. An attempt is underway in Congress, but faces stiff opposition from the banking industry and lobby efforts from the Fed itself.
What is known is that an economy that was once driven by manufacturing and production, and then was later driven by developments in technology and the Internet, and when those came to an end was driven by artificial bubbles in the housing and stock market, then after those crashed the driving force spearheading the economy today is bailouts (from either the U.S. government or the Federal Reserve Bank; this blog will regard the two as economically separate). Wherever one sees elements of recovery, one also sees excessive government spending. Where one sees rising asset prices, one must compare that with exceedingly low rates on bonds, and thus the low yield expectations on riskier assets. While asset prices have risen lately, and risen well in stocks, yields and dividends have been greatly deflationary. Stocks now face little competition from bonds, since the Fed is lending money at zero interest.
In the present bailout economy, this blog asks: how long can this course be sustained? How long can the government keep doing it before it runs out of money? While the Fed never has to run out of money, at the same time it can't give it away—it can only lend it. The U.S. government can give money away, but one day it is going to run out, and that day is when it can no longer sell Treasury Bonds.
This blog will examine the coming of that day.
These were all good times for investors in the American economy which enjoyed steady growth and few pitfalls. But most of the new dot.com ventures had no clear plan for revenue, and many of those that did still failed. A few thrived—like Google, Amazon, E*Trade, and Ebay—but most would struggle or collapse. Such would lead to the bust of the dot.com bubble where the NASDAQ fell from 5000 at the peak in 2001, down to under 2000 less than 2 years later. One might have expected a return to normalcy from the manic highs of the dot.com bubble. But that never happened.
The economy was never permitted a deflationary correction. In order to keep the excitement alive the Fed collapsed Interest rates from a general average of 5-10%, down to below 2%. But rather than keep the tech bubble rolling, the easy and cheap credit instead went into the housing market, creating a new bubble right on the heels of the last one. Money that was lost on the Internet could now be recovered as Americans flipped houses from 2003-7.
In a climate of marginal lending standards, in order to encourage the origination of loans, lenders would offer teaser rates, where the homeowner would only pay interest, or even negative amortize, so long as the teaser period lasted.
The first challenge to inflated real estate prices happened in 2007. At that time, subprime loans, which had the shortest teaser rate of 2 or 3 years, were beginning to reset in mass. Defaults began to skyrocket once the very low teaser payments came to an end, and mortgage backed securites built on subprime loans were running into severe problems even in the safer tranches, and came to be seen for the toxic waste they are. At the end of 2007, still early in the wave of subprime resets, credit markets based on private capital froze. The U.S. government and Federal Reserve Bank saw it as their place to intervene.
During this time, the stock market was in a bubble of its own, and similarly would collapse from its peak in the 14000's in Oct. 2007, down to the 6000s by March 2009, before recovering to 11000 today. In the more volatile areas house prices fell by a similar percentage, but generally they have remained down. Any recovery today in the housing market is a tepid one.
In late 2007, the Fed initiated multiple lending relief programs (or facilities) in order to replace losses of private capital. The Federal Funds Rate had recovered to 5% by 2006, but steadly fell to an all-time low of 0% by the end of 2008. For the first time ever, our nation was ZIRP'd. The executive branch pushed through Congress the $700B TARP bailout plan, and later a $787B state stimulus package. Many billions were spent to rescue Fannie Mae, Freddie Mac, and the insurance company AIG (who insured many billions worth of toxic securities for banks).
The scope of the bailouts is unknown, and cannot be determined without a full audit of the Fed. An attempt is underway in Congress, but faces stiff opposition from the banking industry and lobby efforts from the Fed itself.
What is known is that an economy that was once driven by manufacturing and production, and then was later driven by developments in technology and the Internet, and when those came to an end was driven by artificial bubbles in the housing and stock market, then after those crashed the driving force spearheading the economy today is bailouts (from either the U.S. government or the Federal Reserve Bank; this blog will regard the two as economically separate). Wherever one sees elements of recovery, one also sees excessive government spending. Where one sees rising asset prices, one must compare that with exceedingly low rates on bonds, and thus the low yield expectations on riskier assets. While asset prices have risen lately, and risen well in stocks, yields and dividends have been greatly deflationary. Stocks now face little competition from bonds, since the Fed is lending money at zero interest.
In the present bailout economy, this blog asks: how long can this course be sustained? How long can the government keep doing it before it runs out of money? While the Fed never has to run out of money, at the same time it can't give it away—it can only lend it. The U.S. government can give money away, but one day it is going to run out, and that day is when it can no longer sell Treasury Bonds.
This blog will examine the coming of that day.
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