Archive for the ‘Banking Crisis’ Category

Inflation Versus Deflation: Part Two

December 17, 2008

In my previous blog entry, I explained that:

  • The current economic crisis could result in either deflation or inflation;
  • Deflation and inflation have very different effects on savings and investment vehicles, so understanding the probability of one or the other can help you make better decisions with your money;
  • Whether we end up with deflation or inflation depends on whether or not the Federal Reserve can succeed at getting money to move through the economy again.

Our task now is to assess the likelihood of the Federal Reserve achieving its goal.

The Zero-Bound Problem

Ordinarily, the Federal Reserve controls the rate at which money flows through the economy (its “velocity”) by changing the interest rate that it charges member banks for overnight loans (the “Fed funds rate”). Through the mechanics of the commercial banking system, lower short term rates cause a reduction in the rates that banks charge for long term lending, such as car loans and mortgages. Lower long term rates, in turn, stimulate economic activity.

Despite the Fed’s aggressive program of lowering the funds rate in the past year, commercial banks have remained reluctant to lend, and long term interest rates have not declined. Just yesterday, with falling consumer prices raising further fears of deflation, the Fed lowered its funds rate to a record low of 0.25%.

The Fed has arrived at the “zero-bound” problem: it cannot lower interest rates below zero. The Fed has reached the end of the rate reduction paradigm for controlling the velocity of money.

The zero-bound problem explains why, in addition to announcing the rate cut, the Fed announced its readiness to “move to a new phase of monetary policy in which it prints vast amounts of money.” To prevent a deflationary spiral, the Fed must employ other means to get money to move through the system to return the economy to an inflationary track.

Unconventional Measures

In 2002, before he became Chairman Of the Federal Reserve, Ben Bernanke addressed precisely this issue in a speech that earned him the epithet “helicopter Ben.” In his talk, Bernanke reminded his audience of Milton Friedman’s description of a central banker dropping money onto the populace from a helicopter. Also known as the “printing press speech,” Bernanke’s address included the following formulation:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

In my last blog entry I explained that inflation is a monetary phenomenon: very simply, an increase in the supply of money relative to the goods and services produced by the economy causes prices to rise. A steady increase in the nominal prices of goods and services discourages savings because, unless interest rates keep pace, unspent money rapidly loses its value. Thus, the plan to “reduce the value of a dollar” serves as a mechanism to fight deflation. Dollar devaluation, we shall see, lies at the core of the Fed’s deflation fighting strategy.

The Fed has done a lot of creative thinking about the uses to which it can put the printing press in order to revive spending. In 2005, Robert Blumen published an article in which he analyzes a number of papers and speeches on this topic by Bernanke and other Fed officials.   Few people have the interest or patience to wade through this kind of material. But understanding the Fed’s thinking about deflation fighting gives a good deal of insight into current events, such as yesterday’s announcement. Blumen has done a great public service with his analysis. With his help, I shall now enumerate some of the Fed’s tactics.

  • Long-Term Interest Rate Intervention: The Fed can influence long-term interest rates by buying long-term bonds on the open-market.  The Fed has already implemented this strategy in order to lower mortgage rates by purchasing mortgage backed securities. Yesterday’s statement makes it clear that the Fed will continue purchasing mortgage securities as well as long-term US Treasury bonds.
  • Lending: A 1999 paper, Monetary Policy and Price Stability, explains that “A central bank can also attempt to spur private aggregate demand by extending loans to depositories, other financial intermediaries, or firms and households.” The Fed has already engaged in a record level of lending through its discount window and has been buying commercial paper. Yesterday’s announcement says the Fed now intends to implement a “Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.”
  • Currency Devaluation: In a paper entitled Monetary Policy When the Nominal Short-Term Interest Rate is Zero, Fed officials describe the concept of a “money rain” whereby it would “give money away either through directly disbursing currency to the public or by disbursing it through the banking system.” As I observed above, devaluation forces people to spend their dollars to avoid losing their savings. Devaluation, by the way, can also be achieved through what these papers refer to as “exchange rate intervention.” The central banks of other countries might, for example, agree to sell enough of their dollar reserves into the open market so as to effect a deliberate fall in the dollar.
  • Imposition of Negative Interest Rate: In the paper Monetary Policy in a Zero-Interest-Rate Economy, a Fed official observes that the Fed could induce people to spend by a mechanism to “make money pay a negative nominal interest rate, by imposing some type of ‘carry tax’ on currency and deposits.” In other words, people saving money in dollars would have to pay for the privilege of doing so.
  • Direct Purchase of Goods and Services: By exchanging federal government debt for freshly printed money, the Fed could indirectly “conduct an open market purchase of real goods and services.”  This idea, also presented in Monetary Policy in a Zero-Interest-Rate Economy, may sound far-fetched. But it might be what yesterday’s Fed statement hints at by saying it will “continue to consider ways of using its balance sheet to further support credit markets and economic activity.”

This inventory of ideas gives a pretty good idea of just how far the Fed will go to reflate the economy. As a  student of the Great Depresion, Ben Bernanke believes it necesary to fight deflation with these types of tools to avoid long-term economic suffering. As one can see from the developments of the past several months and from yesterday’s Fed statement, we must take these ideas at face value. We must understand them not as theoretical possibilities, but as an armamentarium of tactics that it fully intends to deploy now that it has reached the zero-bound. Very simply, the Fed will stop at nothing to prevent deflation.

With this understanding of the Fed’s strategies as background, I am confident that the deflationary trend of the past months will not last long. It could continue for a number of months into 2009, or perhaps even into 2010. But I have little doubt that, by dint of its creative application of monetary authority, the Federal Reserve will prevail.

What Will Happen To All That Money?

Mainstream economists view inflation of around 3% or so as benign. A bank CD paying interest of 5%, or a long-term bond paying 8%, would compensate for inflation and leave the investor with a reasonable return. The mainstream investment and economic community assumes that, one way or another, the Fed will target a reasonable level of inflation once the crisis has subsided.

And, indeed, the Fed has mechanisms for “mopping up” the excess money it creates in order to prevent excessive inflation. The Treasury can deposit the proceeds of bond sales with the Fed, taking those dollars out of circulation and reducing their inflationary effect. The Fed can also increase the reserve requirements for banks. For example, by increasing the deposit to loan ratio from 10% to 15%, less money would circulate through the economy. And of course the Fed can raise interest rates.

But one has to wonder whether the Fed, or the government, would have the discipline to throw cold water on an economy recovering from a severe recession. A monetarily responsible Fed under Alan Greenspan should have raised interest rates when the economy showed signs of recovery from the bust. Its failure to do so led to the housing bubble that caused the current recession. Our economy’s  addiction to credit as a vehicle of economic “growth” will make the Fed reluctant to slow down credit expansion as the economy recovers.

More importantly, in the coming decades our government will be forced to adopt a deliberate policy of inflation to cope with the national debt. Our national debt has reached over $10 trillion. Adding future entitlements such as Social Security and Medicare to the mix brings the total in coming years to a mind-boggling $70 trillion. And, of course, all of the bad corporate debt that the Fed continues to buy in order to rescue the banks adds to this burden.

Inflation can serve as a release valve for any government facing this level of debt obligation. You’ll recall from my discussion of the mortgage as a hedge against inflation that inflation transfers wealth from creditors to debtors because the nominal value of the loan decreases as the nominal value of the underlying asset inflates. In a similar way, the government’s obligation to entitlement beneficiaries (most notably retirees) becomes a smaller burden when inflation persistently and steadily devalues the nominal value of the fixed payment. It has the same effect on the government’s debt to international creditors, such as China, who hold large dollar reserves in treasury debt.

Bear in mind, too, that since the government controls inflation statistics, it can control whether and to what extent entitlement payments keep pace with true inflation. Please review John Williams’ work on inflation for more about the true rate of inflation.

Ultimately, an economy that depends on an indefinite expansion of credit to sustain its growth cannot go on forever. Eventually, debts must be paid. In the current crisis the Fed is introducing the world to the printing-press approach that will later serve to cope with the country’s debt.

But eventually this strategy must fail. Relentless devaluation of currency renders it worthless.  The dollar must die eventually.

How To Save And Invest

I do not believe that a currency collapse is imminent. The more likely scenario is a slow burn lasting for decades in which a series of booms and busts will obfuscate the underlying trend towards hyperinflation.

In the short term (for the next year or so), the prices of stocks and consumer goods may continue to fall due to the the effects of defaulting credit and gloomy economic reports. In any economic climate, a prudent savings and investment strategy would keep enough emergency funds in cash (short-term bonds and bank CDs) in case of protracted unemployment or other exigencies. Just bear in mind that the cash you would need in the short term for emergencies will lose its value over the long term as the Federal Reserve pursues its policy of relentless and deliberate devaluation of the dollar.

A long-term portfolio should include some percentage of investments that hold their value independently of the monetary system, such as commodities, precious metals, and businesses that produce food and energy.

DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.

© 2008 Philip Glaser


Inflation Versus Deflation: Part One

December 14, 2008

Benjamin Roth’s Depression Diary chronicles the impressions of an Ohio lawyer during the Great Depression. He paints a poignant picture of things that happened to investors in that era. “For over a year now,” he writes in 1931, “people have been buying stocks at what they think are bargain prices.” But, he adds later in 1936, “these early buyers were badly mistaken and many of them were wiped out.”

The process that took stock values down by 90% from 1929 to 1932, and depressed the prices of virtually everything else, is known as “deflation.” The story makes plain the danger of investing in any financial asset during a deflationary spiral: if that asset’s market has not truly bottomed, you risk great losses. Today one frequently hears in the financial news what a bargain good companies are selling for on the stock market. Roth’s journal entries provide a scary backdrop to this advice.

Last week I alluded to a debate that his been raging for several years within the contrarian financial community between the inflationaistas and the deflationistas. Both sides have always agreed that excess consumer and government debt would lead to an economic crisis.  They continue to disagree about the outcome, even as the outcome unfolds before our eyes.

Roth’s diary should clue us in to the fact that either outcome, deflation or inflation,  bears more than academic curiosity. Either one can change the results of any particular savings and investment strategy. It matters even — or rather, especially — if all you ever do is save money in a passbook savings account or Certificate of Deposit. Deflation would magnify the purchasing power of your savings , whereas inflation would diminish it. Generally, the strategies for dealing with inflation and deflation have little overlap. In making up your mind about how to proceed, you’ll want to have some idea about the probability of one outcome over the other.

My discussion will be lengthy and will occupy this week’s and next week’s blog entries. It will challenge your attention span and your willingness to follow technical detail.  So please bear with me. I promise to reward your attention with a greater understanding of current economic events.

Credit: Bubbles And Contraction

To understand how a deflationary spiral works, you have to understand the inflationary bubble that precedes it. The bubble begins with the availability of cheap credit. First the central bank lowers the interest rate on short term loans.  Then, through the mechanics of fractional reserve lending, the member commercial banks offer lower interest rates on long term loans to their customers. As more money enters the system, nominal asset prices rise. But eventually prices get so high that buyers stop buying and the bubble reverses itself. The weakness in such bubbles lies in the understatement of risk by lenders.

Let’s look closer at this phenomenon through the lens of the subprime mortgage meltdown.  Subprime mortgage lenders (and apparently rating agencies) assumed that the economy would remain strong enough for borrowers to sustain their mortgage payments. They also assumed that the values of homes would remain high enough to cover the mortgages in the case of default.

Of course, the inevitable happened.  Home prices got so high that, even at low interest rates, buyers stopped buying, and prices began to fall. And when initially low “teaser rates” on mortgages re-adjusted to their higher long-term rates, borrowers became unable to make their mortgage payments. An increase in defaults put more homes on the market in distressed circumstances, reducing the value of homes to below the amount of the mortgages that financed them.

Such loan defaults end up as losses on the balance sheets of the banks, causing some of them to go out of business. If those banks owe money, their creditors also suffer losses. As loan defaults cascade through the banking system, banks hoard their cash to maintain the integrity of their balance sheets and become reluctant to lend.  When they lend, they do so at prohibitively high interest rates.

The contraction of credit wreaks havoc on other financial assets.  In our day, hedge funds had attempted to magnify their earnings by borrowing heavily against their assets. As credit tightened due to subprime mortgage losses, the hedge funds’ creditors  raised borrowing rates and demanded additional collateral even for relatively safe investments. To raise cash, the hedge funds had to sell off holdings in stocks and commodities, resulting in price declines.

Credit contraction also slows down economic activity. For example, the banks’ unwillingness to extend letters of credit has seriously affected international trade. Many businesses depend on short-term loans known as commercial paper in order to function on a day-to-day basis. Commercial paper, too, has suffered from the credit contraction.

As businesses fail or contract from the paucity of credit, they lay people off. Fewer people have money to spend or are afraid to spend it for fear of losing their jobs, slowing the economy even further.

If it continues unchecked, credit contraction leads to the general price decline known as deflation.

Inflation And Deflation Are Monetary Phenomena

Almost everyone has heard of the law of supply and demand. Very simply, the more scarce a product or service, the higher its price. The requirement that plastic surgeons go through many years and hundreds of thousands of dollars in medical training makes them relatively scarce. But almost anyone can, with enough motivation, clean a house. Thus you pay a plastic surgeon thousands of dollars for the few hours of time it takes her to fix your nose,  whereas the house cleaner earns $10 per hour.

The price effects of inflation and deflation differ quite a bit from supply-demand dynamics. For many economists,  and for the purpose of our discussion, changes in the money supply cause inflation and deflation. The great economist Milton Friedman is famous for saying that “Inflation is always and everywhere a monetary phenom­enon.”  That is, inflation results from an increase in the supply of money relative to the goods and services in the economy; deflation results from a decrease of money supply.

With this point in mind, remember that, in our system, all money is debt. All money flowing through the system began as the transfer of money from a creditor to a debtor. If everyone in the world paid off their loans at once, all money would disappear from the economy. Availability of credit increases the money supply and thus creates “economic growth,” while the unavailability of credit results in economic contraction. Please watch Paul Grigon’s documentary, Money As Debt, for a really good explanation of this concept.

So, credit contraction plays the lead role in the drama of a deflationary spiral.

For the moment, although the price of oil and other commodities has dropped, true deflation has not yet taken hold of the economy. The prices of food, housing, and health care remain relatively stable. But if the contraction of credit continues, the supply of money to the economy will eventually decrease and all prices will fall.

How To Save Or Invest For Deflation

In investing and saving, inflation and deflation have different consequences. In deflation, the dollar-denominated value of everything drops. Relative to goods and services, then, the purchasing power of cash increases. But since less of it flows through the economy, cash is hard to come by.

Although I do not believe that true deflation has taken hold at this point, the desire for cash in a credit contraction might explain the behavior of investors in US bonds. The demand for short-term US bonds has pushed their yield almost to zero. When transaction fees are figured in, investors are paying a premium over par value for these securities because of their perceived safety.

In inflation, on the other hand, cash becomes less valuable because prices expressed in the currency become higher. In such an environment, it becomes advantageous to buy stocks, commodities, and real estate because their prices will rise in nominal value, thus preserving the original value of the investment.

I should add that deflationista extraordinaire Mish Shedlock believes gold to be a good investment for both deflation and inflation because of its true role as money.  Robert Prechter, on the other hand, insists that even precious metals will decline in nominal value under deflation.

What Can Be Done?

Though complicated by the many intracacies of modern economics and finance, the argument between the deflationistas and the inflationistas boils down to one fundamental question: will the monetary authorities succeed in reflating the economy?

Once deflation sets in, stopping it becomes very difficult. The deflationistas assume that the monetary authorities are ultimately powerless against the economic forces driving deflation. They foresee a sustained period of monetary contraction resulting in a global depression with chronic and high unemployment. The inflationistas argue that the monetary authorities will succeed in getting money to move through the economy again and thus put the economy back on the inflationary track to “growth.”

To make up your own mind about this question, you will need to understand  how the Federal Reserve seeks to accomplish this goal. I shall examine the Fed’s strategy in my next blog entry.

© 2008 Philip Glaser

How Do We Pay For The Bailouts?

November 21, 2008

The Federal Reserve and Treasury are making a desperate attempt to prevent the kind of deflationary spiral that led to the Great Depression.  In such a spiral, creditors, coping with defaults on existing credit, refuse to lend or lend only at prohibitive interest rates . As less money flows through the system, people lose jobs and cannot spend. Others fear losing their jobs and become conservative in their spending. This reduction in spending further reduces the flow of money, resulting in further job losses.  It’s an ugly scenario.

A major focus of the prevention effort lies in purchasing the bad mortgage and credit card debt held by major banks. By exchanging bad debt for cash, the Treasury enables the banks to remain viable because their balance sheets will demonstrate cash in place of bad debt. When they are viable, the banks will resume lending. Lending will increase the flow of money through the economy, which in turn will cause a resumption of what mainstream economists refer to as “economic growth.”

It would be a good thing if these actions in fact prevent a prolonged recession or depression. But I want to briefly explain some rather disturbing consequences of what the government is doing. I’m afraid the discussion will be rather technical, but I believe that it is important for folks to understand some of the mechanics of money creation, debt, and currency valuations. So please bear with me.

Revenues from taxes do not provide the funds with which to purchase the bad debt from the banks. So the government has to borrow the money. To do so, the Treasury issues bonds. In 2009 the US government will have to find buyers for upwards of two trillion dollars in new debt.

China has been a major buyer of US Treasury securities. It had a surplus of American dollars because of its exports to the US. By exchanging the dollars it received from its exports for Treasury debt, China helped finance the US debt and, in a self-reinforcing cycle, enabled the US to continue importing China’s products.

But the reduced spending and imports by US consumers has diminished the amount of cash with which China can purchase securities. (This may explain recent slowdown in the growth of dollar- denominated debt instruments held by foreign countries.)  And now, China plans to spend over $500 billion on its own domestic  stimulus package. To finance this package, it may sell some of its dollar reserves. China may be poised to shift from being a net buyer to a net seller of US securities.

The supply-demand dynamics of the credit markets could counteract the Federal Reserve’s effort to increase money flow by lowering interest rates. When the level of debt to be sold exceeds the number of willing buyers, the buyers must be rewarded with higher interest rates. Very simply, the “investment” must be made to appear more attractive. But the Fed must avoid raising interest rates: high interest rates constrict the flow of money and impede economic growth.

The Treasury and The Fed can take a couple of different routes to financing the debt without increasing interest rates. the Federal Reserve can create money out of thin air. When no other buyer can be found, the Fed can “monetize” the treasury debt by exchanging it for money that comes into existence at the flick of a switch. When China purchased US Treasuries, it exchanged cash already in the system for those debts. The effect was to exchange existing money for the promise of future money. It did not increase the amount of money in the system. But monetization increases the amount of money in circulation. Thus the Fed’s inevitable purchase of billions of dollars in treasury debt will increase inflation significantly. Some observers believe that monetization has already begun. Indeed, by its own numbers, the aggregate base of money has increased in recent months by almost 800%.

A deliberate and coordinated devaluation of the dollar could also help with the debt problem. A dollar devaluation would enable foreigners to buy US debt at a discount due to the relative strength of their currencies, without raising interest rates. It’s not clear to me exactly how such a devaluation could be controlled, though unleashing the Plunge Protection Team on the currency markets might do the trick.

Both monetization and devaluation would hurt anyone who saves their money in the traditional “safe haven” assets: certificates of deposit and US Treasury securities. I have already said a good deal about how to protect one’s assets against this type of scenario in this blog. You might to review past articles to get a feel for these options.

© 2008 Philip Glaser

It’s Time To Hoard Some Cash

October 12, 2008

In constructing an intelligible picture of the unfolding global banking crisis, I came across a useful piece by Axel Merk, whose voice I have come to appreciate hearing on the Financial Sense Newshour. Aside from his typically clear (if rather technical) explanation of events, Axel suggests hoarding some cash along with precious metals. Notwithstanding the U.S. Dollar’s future as toilet paper, current events make me inclined to agree with this suggestion.

We need to understand the gravity of what might happen to our banking system.

In my discussion of counterparty risk last week, I touched upon the technical workings of the fractional reserve banking system. You tend to think of a bank as an institution that keeps your money safe and rewards you with interest.  A more useful description takes into account that the interest constitutes your share in the bank’s profit from lending your money. Really, the bank functions as a broker that lets you lend your money out to counterparties.

All of this works just fine as long as:

  1. You and the other depositors in the bank agree not to demand all your money all at once (remember, the bank’s borrower’s hold 90% of the bank’s assets); and
  2. The counterparties to whom the bank lent your money make payments on the money you lent them reliably until they pay the bank back.

In other words, the financial health of a bank depends upon the reliability of the creditors whose loans make up the lion’s share of the bank’s balance sheet. For this scheme to have integrity, the bank must be able to count the money owed to it as a viable asset. The credit crisis now in progress stems from point 2 above: The counterparties to a massive amount of debt cannot make their loan payments.  As creditors fail, the banks’ balance sheets look more and more precarious. Sub-prime mortgage holders make up the bulk of today’s failed counterparties. But the amount of this debt pales in comparison to the mountain of credit default swap “assets” that will fail as the recession deepens.

To avoid putting themselves deeper in the hole, banks have stopped lending. In our credit-driven economy, Axel Merk points out, many otherwise sound businesses depend heavily on short-term loans known as commercial paper in order to run their businesses. Unless the credit starts flowing through the system again, many companies risk going out of business. A wave of such failures could cause a downward spiral into a depression.

This past week, the central banks of the US and Europe lowered interest rates to make it easier for their member banks to get access to cash. The central banks want their member banks to use the inexpensive cash to compensate for the failing debt in their balance sheets. But the banks, rationally, have not taken up the central banks on their offer: Taking on more debt just makes their position more precarious.

In the solutions now being undertaken, the treasury departments of the United States and Europe would recapitalize the banks directly: rather than lend money to the banks, they would give them the money in return for an ownership stake.

This nationalization of US and European banks has a nauseating and unavoidable ring of socialism. Having grown up with the world’s two superpowers threatening to anihilate each other over a disagreement about distribution of wealth, I find this development hard to swallow. But preventing a cataclysmic failure of the banking system has to take precedence over ideology, for the moment. The global financial system has been breaking for a long time, but you don’t rearrange the deck chairs when the ship is sinking.

No one can predict the outcome of this crisis. But the risk of systemic bank failure should not be ignored. In the long term, the hyperinflation resulting from the governments’ attempt to save the system or to revivie it after it crashes will make precious metals the most reliable safe haven. But hyperinflation has not yet arrived, and an immediate and systemic bank failure would make it difficult to get your hands on plain old cash to buy basic necessities.

So, as Axel suggests, it’s a good idea to go to your local bank and get some dead presidents. Bury them under the proverbial matress or, preferably, in a more original hiding place. It would also be wise to stockpile some canned food and bottled water.

I apologize for sounding apocalyptic. But this is serious business. I’d rather act a little panicky now than end up unable to feed my family. I hope that in a few weeks you can justifiably accuse me of being a drama queen today. I’d prefer that embarassment to the outcomes that seem a bit too plausible at the moment.

© 2008 Philip Glaser