1-Jul-10 News -- World economy in deflationary spiral

[vincecate]

Can you explain in your own words your current conception of how money is created?

These are my own words:

http://pair.offshore.ai/38yearcycle/#moneylaundering

[Guest]

Can you explain right here, in two or three concise paragraphs, written in your own words, without linking elsewhere, your current conception of how money is created?

[vincecate]

Can you explain right here, in two or three concise paragraphs, written in your own words, without linking elsewhere, your current conception of how money is created?

No. I think I need 4 small paragraphs and hyperlinks to other things from some parts of that. What they are doing now is just a bit too sneaky for me to get it that short. Do you have a more concise description?

http://pair.offshore.ai/38yearcycle/#moneylaundering

[Higgenbotham]

Can you explain right here, in two or three concise paragraphs, written in your own words, without linking elsewhere, your current conception of how money is created?

I was going to ask a similar question last night but didn't quite get around to it.

70% of GDP is services.

Of the 30% of GDP that is goods, most of that is intangible value added. For example, most of the cost of a $4 box of cereal is intangibles and profit, not raw material, which is pennies.

As an example of a large non goods based category of the economy, we could use advertising. It is virtually impossible for the government to drive up the price or usage of advertising in the deflationary environment we are in. The government cannot force people to go back to print advertising and stop using craigslist and other online services. The government cannot force people who now work at home in the advertising industry to start commuting again. As more and more workers no longer commute (and are no longer in the work force for that matter - the employment ratio has dropped 5-6% in 3 years), any goods based consumption related to the automotive industry decreases, and it is decreasing markedly.

Practically our whole economy works similarly. If the government had a monopoly on communications, for example, they could increase the price of postage and force inflation into the economy by that and similar routes. But they can't even do that because every time they increase postage, fewer letters are sent and more people use electronic alternatives. The process of increasing postage rates turns out to be deflationary.

[Higgenbotham]

Looking at the 70% of the US economy that is services, I'm envisioning driving down a typical commercial street in a typical US city that has a lot of strip malls.

We see an oil change shop, actually several. Outside the shop, a man is standing with a sign that says "$12 off on an oil change". I saw that yesterday. There's an oil change shop every few miles, but driving has been decreasing across America for 3 years. Meanwhile, more people are unemployed and are changing their own oil.

We see things like hair salons, nail salons, tanning salons, dog grooming shops, etc. I don't know how the government can force people to get their hair cut more often or to take their pet in more often for a toenail clip, unless they were to put a credit on everyone's credit card or mail out some checks directly to consumers. We all know what the Chinese who are holding $2 trillion in bonds would say about that. In fact, they've already said it. We also know that a lot of unemployment checks were suddenly cut off last week. No more trips to the nail salon for those folks.

And we know what the Fed has said about this.

In the Fed's own words,

8.1 Money Rains

Money rains are a clean way to study theoretically the effects of increases in the supply
of money. In practice, it seems a bit diffcult to envision how the Federal Reserve could
literally implement a money rain - that is give money away either through directly
disbursing currency to the public or by disbursing it through the banking system.
The political difficulties that are likely to arise from the Federal Reserve determining
the distribution of this new wealth would be daunting.

Even if the Federal Reserve were to find a way to physically conduct a money rain,
the Federal Reserve Act does not appear to provide authorization for such activities.
Under section 7 of the Federal Reserve Act,

After all necessary expenses of a Federal reserve bank have been paid or
provided for, the stockholders of the bank shall be entitled to receive an
annual dividend of 6 percent on paid-in capital
That portion of net earnings of each Federal reserve bank which remains
after dividend claims ... have been fully met shall be deposited in the
surplus fund of the bank.

Thus, any transfers to the public must either be claimed to be "expenses" or be
transfers from the surplus fund.85

85 The Federal Reserve currently remits to the U.S. Treasury all net earnings after providing for dividends and the amount necessary to equate surplus with paid-in capital. These payments are classified as interest on Federal Reserve notes and as expenses of the Federal Reserve, and not as transfers from the surplus fund. The authority of the Board of Governors to determine that the Federal Reserve Banks will pay interest on Federal Reserve notes to the U.S. Treasury is granted in section 16(4) of the Federal Reserve Act.

But Section 7 of the Federal Reserve Act only provides for disposition of surplus
in the event of dissolution or liquidation of the Federal Reserve Banks. A direct
transfer of funds from the surplus account for any other reason - and to the public
in particular - would appear to be beyond the authority of the Reserve Banks. Ap-
parently, then, a money rain would have to be declared an "expense" of the Federal
Reserve. The legal foundation for doing so seems highly questionable.

A second way to distribute newly created money would be to use it to finance a
federal tax cut. A money-financed tax cut could be brought about by the Treasury
financing a tax cut by issuing debt, and the Federal Reserve purchasing that debt. If
the stimulative effects of such open market purchases have already been exhausted by
the Federal Reserve in its attempts to stimulate the economy, the total effect would
come from the fiscal stimulus. Of course, if the fiscal stimulus were large enough
to raise the nominal interest rate above zero, then standard open market operations
would regain their stimulative impact.

These are only two of many possible ways a central bank could attempt to increase
private-sector wealth and thereby stimulate aggregate demand. Putting possible legal
limitations aside, wealth could also be created by purchasing assets at above market
prices or by extending loans at subsidized interest rates. Because these policies de-
liberately create budget deficits, they would seem to be more the province of fiscal
authorities. A consideration of the such attempts to increase private sector wealth is
outside the scope of this paper.

From the Fed white paper, "Monetary Policy When the Nominal Short-Term Interest Rate is Zero."

[Higgenbotham]

Can you explain in your own words your current conception of how money is created?

These are my own words:

http://pair.offshore.ai/38yearcycle/#moneylaundering

US Government Laundering Money?

If the Federal Reserve makes new money and then buys government debt directly people understand that this can cause inflation, and so would react. The original Fed law limited any purchase of government debt to those with a maturity from date of purchase of not exceeding six months. However, when the Fed buys debt from banks (bad things like toxic assets and 30 year 4% fixed rate mortgages) it gives the banks the cash to buy a slightly more reasonable short term US government debt and people are not alarmed. Also, the Fed is loaning money to the banks at 0% which they can then loan to the government at 1% or more. This is their cut for laundering the money. I understand normal money laundering pays about 1% for each hop of the money.

Fannie Mae and Freddie Mac are really owned by and fully backed by the US government at this point (effectively nationalized). So when the Fed buys bonds from these it is really the same as buying Treasury debt. While everyone knows that if the Fed buys Treasury debt it is monetizing the debt which will cause inflation, people don't yet seem to realize that the Fed buying FM&FM debt is also monetizing debt. They also ignore FM&FM when looking at foreign holdings of government debt.

The Fed is also paying interest to banks to get them to hold excess reserves off the market. This is about the same as if the banks had bought Treasury bonds and the money was off the market. It is best to just think of The Fed, The Government, and FM&FM as all inside the same box. Just think about what is going in or out of that box.

The net is the Fed is creating over $1 trillion in new money per year and over $1 trillion in money is ending up with the treasury each year. But if the new trillion went directly from the Fed to the treasury people would panic.

Let's start with the first few steps.

The banks had $1.25 trillion in mortgages that the Fed swapped from the banks. Now the Fed has those mortgages on its balance sheet.

When the $1.25 trillion in mortgages were good, they paid an interest rate. I don't know what it was and don't know if it can be found out. Since the mortgages were probably mostly junk mortages, they may have paid 6% to the banks.

The mortgages became illiquid and the payment streams decreased because many of the home owners stopped making payments. So the banks lost some of the 6% interest they were getting on the mortgages.

The banks swapped the mortgages to the Fed and got money in return. Now instead of getting a 6% income stream, the banks have money they can use to purchase government bonds that pay let's say 3%. Or they can keep it on deposit with the Fed and get 1% or whatever it is.

How is that inflationary? The 6% in interest on the mortages is gone and has been replaced with a lower rate of interest. The mortages that are on the Fed's balance sheet are effectively removed from the money supply and have only been replaced.

[vincecate]

The banks had $1.25 trillion in mortgages that the Fed swapped from the banks. Now the Fed has those mortgages on its balance sheet.
[...]
The mortgages became illiquid and the payment streams decreased because many of the home owners stopped making payments.
[...]
How is that inflationary?

Try looking at it from the view of cash going in and out of the Fed.
I believe those $1.2 tril are really worth far less that what the Fed paid, since so many people stopped paying their mortgages and the banks sold the worst stuff to the Fed. So for arguments sake lets say they are worth half that or $600 bil. Now the Fed has put out $1.2 tril in cash but it could only pull back in $600 bil in cash by selling all those mortgages. So there is now an extra $600 bil in cash out in the wild that the Fed can not pull back in. That is inflationary.

Look at this page for more on this explanation:
http://en.wikipedia.org/wiki/Real_bills_doctrine

When the European bank decided to break its rules and accept junk bonds as collateral for cash the market understood that the value of the Euro should go down. The central bank would print money for Greek bonds but it could not expect to get full value when it sold them, so there would be more Euros in the wild.

[Higgenbotham]

The banks had $1.25 trillion in mortgages that the Fed swapped from the banks. Now the Fed has those mortgages on its balance sheet.
[...]
The mortgages became illiquid and the payment streams decreased because many of the home owners stopped making payments.
[...]
How is that inflationary?

Try looking at it from the view of cash going in and out of the Fed.
I believe those $1.2 tril are really worth far less that what the Fed paid, since so many people stopped paying their mortgages and the banks sold the worst stuff to the Fed. So for arguments sake lets say they are worth half that or $600 bil. Now the Fed has put out $1.2 tril in cash but it could only pull back in $600 bil in cash by selling all those mortgages. So there is now an extra $600 bil in cash out in the wild that the Fed can not pull back in. That is inflationary.

Look at this page for more on this explanation:
http://en.wikipedia.org/wiki/Real_bills_doctrine

While we don't know, I agree the Fed probably paid far more for the mortgages than what they would bring on the market today. I'm not up on that current debate.

As of now, there are $1.2 trillion in mortgages (in pre-crisis terms) that have been pulled out of circulation and sit on the Fed's balance sheet doing nothing. The $1.2 trillion in mortgages were swapped for $1.2 trillion in cash. I don't see the present state of affairs as being inflationary, especially relative to what existed before the crisis hit.

The fact that there's an estimated $600 billion gap indicates that there's a deflationary gap that can't be fully offset (because the Fed didn't swap all the bad mortgages that are out there). If the mortgages were to return to closer to face value (indicating inflationary pressures building in the economy) and the Fed did not act soon enough to pull the excess money back in, then inflation could become a problem.

[vincecate]

As of now, there are $1.2 trillion in mortgages (in pre-crisis terms) that have been pulled out of circulation and sit on the Fed's balance sheet doing nothing. The $1.2 trillion in mortgages were swapped for $1.2 trillion in cash. I don't see the present state of affairs as being inflationary, especially relative to what existed before the crisis hit.

Imagine a really simple toy world. To start with there is $1.2 tril in cash at the banks. People with houses turn their houses into ATMs and borrow this $1.2 tril from the banks to buy stuff from China. So now China has $1.2 tril in cash and the banks have $1.2 tril in mortages. Then half the mortages go bad, so they are only really worth $600 bil. China still has the $1.2 tril even if the mortgages go bad. Next the Fed pays $1.2 tril in new cash for the mortages. Now the banks have $1.2 tril in cash and China has $1.2 tril in cash. At this point our toy world has $2.4 tril in cash, double the cash we started with. The Fed could sell the mortages and pull out $600 bil, to bring the cash down to $1.8 tril, or 50% more than the start.

The fact that there's an estimated $600 billion gap indicates that there's a deflationary gap that can't be fully offset (because the Fed didn't swap all the bad mortgages that are out there). If the mortgages were to return to closer to face value (indicating inflationary pressures building in the economy) and the Fed did not act soon enough to pull the excess money back in, then inflation could become a problem.

I think there is a real danger that inflation shows up but the Fed can still not sell those mortgages for what they paid for them. Some of those mortgages have gone bad and will never go good again.

Our toy world above is not inflationary if China loans their $1.2 tril to the US treasury. But if China has short term treasuries and spends the money as they mature, it could become inflationary very fast.

[Higgenbotham]

As of now, there are $1.2 trillion in mortgages (in pre-crisis terms) that have been pulled out of circulation and sit on the Fed's balance sheet doing nothing. The $1.2 trillion in mortgages were swapped for $1.2 trillion in cash. I don't see the present state of affairs as being inflationary, especially relative to what existed before the crisis hit.

Imagine a really simple toy world. To start with there is $1.2 tril in cash at the banks. People with houses turn their houses into ATMs and borrow this $1.2 tril from the banks to buy stuff from China. So now China has $1.2 tril in cash and the banks have $1.2 tril in mortages. Then half the mortages go bad, so they are only really worth $600 bil. China still has the $1.2 tril even if the mortgages go bad. Next the Fed pays $1.2 tril in new cash for the mortages. Now the banks have $1.2 tril in cash and China has $1.2 tril in cash. At this point our toy world has $2.4 tril in cash, double the cash we started with. The Fed could sell the mortages and pull out $600 bil, to bring the cash down to $1.8 tril, or 50% more than the start.

The fact that there's an estimated $600 billion gap indicates that there's a deflationary gap that can't be fully offset (because the Fed didn't swap all the bad mortgages that are out there). If the mortgages were to return to closer to face value (indicating inflationary pressures building in the economy) and the Fed did not act soon enough to pull the excess money back in, then inflation could become a problem.

I think there is a real danger that inflation shows up but the Fed can still not sell those mortgages for what they paid for them. Some of those mortgages have gone bad and will never go good again.

We don't know how big the deflationary hole is at any given time, but let's just say for the sake of argument that it is $6 trillion in the mortgage market at present, that the present value of all mortgages has decreased by $6 trillion from the peak. Let's also say for the sake of argument that the rest of the economy is at pre-crisis levels on average even though we know that isn't true. The Fed has plugged that hole with $1.2 trillion in cash. Now we have two variables - the $6 trillion deflationary hole is changing in value and there is potential for the cash to act as reserves and multiply. If the banks were able to leverage the cash to be greater than the deflationary hole, that would be inflationary.

The second part of your reply. If what the Fed took off the banks' hands had been the only bad mortgages out there, and everything else in the real estate market and the economy were operating at pre-crisis levels and stayed there, then the Fed action would certainly be inflationary. Or if everything else in the real estate market and the economy except the mortgages purchased by the Fed were to return to pre-crisis levels on average and the Fed did not or could not pull the money back in soon enough, then it would also be inflationary.