Post by RogerRafter on the FOOL
[I sure wish Heinz was here on this board so that we could have conversations on this stuff a lot easier - mish]
Money is created by banks whenever somebody wants to go into debt and a bank is willing to lend to them. It is created out of thin air, and it can be destroyed just as easily. If you take out a loan, the bank simply creates the money by boosting the value of your account. If you pay back the loan, default on the loan, or if the bank gets in trouble and calls back in the loan, the money disappears. Sounds crazy, but its true. This is the nature of fractional reserve banking and the main reason why the economy goes through periods of boom and bust.
The Federal Reserve can create money also, just by buying something. If the Fed says the money exists, it exists. The Fed's favorite thing to monetize (buy, thus creating money) is US debt. The Fed simply creates the money by buying the notes via repurchase agreements and/or on the open market. The bond seller's bank records the purchase by boosting the value of the seller's account, and the Fed takes over ownership of the treasuries. The Fed can buy anything it wants this way. Greenspan could monetize his lunch if he wants to. He'd get his hot dog, and the vendor's bank would record a deposit in the vendor's account. Sounds crazy, but its true. This is the nature of the Federal Reserve System and why we've had inflation through almost all of the Fed's history.
When the money supply is growing, it finds its way to into corporate accounts as profits and gets spent on capital investments. When the money supply is shrinking, it gets hard to make a profit, and people and companies get very conservative with what they have.
A Fed board member (Bernanke, I believe) recently gave a speech where he said that the Fed could just drop money out of helicopters if it ever wanted to keep the money supply from contracting. Unfortunately it isn't that easy because the private sector has far more impact on the money supply than the Fed does with its direct actions. If the fed did drop money onto the streets, people might take the money out of circulation by depositing it to pay down their credit card balances and home equity loans. If they did, the money supply could contract, not expand. The banks would send the cash nobody wanted back to the Fed and the money created from the customer's debt would evaporate. If the banks also chose to reduce their short term borrowing to reflect the drop in loans outstanding, the net reduction in money created by debt would be more than the added amount that eventually found its way into cash accounts as a result of the helicopter drops.
The Fed has been trying hard to increase the money supply by suppressing short term interest rates and monetizing government debt. The Fed has bought up on average about $1.5 Billion worth of treasuries every week all year. These have mainly been in yields of less than a year, but recently, they've moved out to the 1 to 5 year range. Suppressing short term interest rates with direct intervention in the markets encourages institutions to borrow and expand the money supply, usually by a factor many times greater than the initial monetary injection.
Even with this stimulus, however, the money supply has stopped expanding. M1 has been declining in July. This money stock measure estimates the amount of money people intend to spend by looking at the amount of currency in circulation and the money in people's checking accounts. The decline may just be a blip, but it is more likely that homeowners who no longer are in position to refinance have less money to spend and are cutting back.
For the past year or so, corporations have been taking the easy profits that have been made during the the refinancing and carry-trade boom and paying down their debts, thus offsetting some of the Fed's monetary stimulus. This defensive move makes sense for individual companies, but when a large number of them do it, it causes an economic contraction that hurts all of their profits.
Hedge funds have been create a tremendous amount of money by borrowing on margin. The total created over the past 4 years by hedge fund borrowing is probably over a trillion dollars. When a fund increases its borrowing, they use it to buy some type of stock, bond or other asset and the money circulates until it winds up being saved in some institution's or somebody's money market fund or other type of account.
The expansion of the highly leveraged hedge fund industry has added a tremendous boost the to money supply and the economy, but the repayment of all that debt can do just as much damage. If the market declines much and causes many hedge funds to take a big hit, the overall money supply could decline in a very significant way. If a $2 billion dollar hedge fund, with $2 billion in assets is forced to take $1 billion in losses and only borrow $1 billion in the future, then that is $1 billion that simply evaporates from the money supply.
In July, the four week averages for M2 & M3 have also declined. These numbers mainly measure the amount of money being saved in cash accounts, and grew especially rapidly during the boom and reflation years. Their contraction is a symptom of a decline in profits and a weakening economy. If the economy continues to weaken, and interest rates rise to a level more in line with inflation, the contraction of the money supply could accelerate.
A slowing economy could ease inflation and give and put pressure on the Fed to stop raising rates. However, the cost of production may not drop as much as demand drops, especially if the dollar declines. In a bad economy, companies get defensive and cut production, which only makes the situation worse.
Also, I think we've been witnessing a schizophrenic transformation in Alan Greenspan from his more common "Easy Al" personality to his other personality "Psycho Killer Al." He's now dead set on raising rates and ending the "policy of accommodation" that "Easy Al" was so proud of. Just as Psycho Killer Al did in 1994, I think we can expect him to keep raising rates until their has been sufficient pain in the economy and financial markets to meet his sinister motives.
But seriously, I hope this post does a good job of explaining the nature of our money system and some of the limitations and obstacles faced by the Fed. Based on history, it would be foolish to assume that the Fed can do an effective job of keeping the money supply and economy stable, whether or not their motives are sinister. The rapid economic and monetary expansion of 2003 and early 2004, is almost certain to be followed by a period of significant contraction. The fact that the expansion didn't do much to help the position of workers and consumers suggests that the contraction will be especially hard on those groups when it hits.
Money Supply data here:
federalreserve.gov |
