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Pastimes : The Naked Truth - Big Kahuna a Myth -- Ignore unavailable to you. Want to Upgrade?

To: Les H who wrote (78269)	12/6/1999 7:53:00 PM
From: Ken98	Read Replies (2) \| Respond to of 86076

Les, sorry, I still can not get the link to to the specific article to work. I was actually referring to the December 2d M3 article (that you can get to from the link in my last post) which contains a good explanation of how the creation of money works. A few parts: <<In what sense are bank credit and M3 created out of thin air? When banks and other depository institutions, in the aggregate, extend more credit, there is an increase in their assets. When spent, the proceeds of this new credit end up as deposits and other liabilities of these banks and thrifts -- i.e., as an increase in M3. Can banks extend credit willy-nilly? No. The banking system can create credit only to the extent that the central bank, the Fed, allows it to. Even if not required to, banks would hold some level of reserves (either currency or immediately available funds on deposit at the Fed). They would want to be able to meet normal demands by their depositors for currency. They also would want to protect themselves against unexpected clearing deficits with other banks. Suppose that banks are holding the exact amount of reserves they desire. Now, a good customer comes to Bank A for a loan of $1,000. After Bank A extends the loan, the proceeds get spent and end up as deposits in Bank B. Bank A loses reserves to Bank B in the amount of $1000. Where does Bank A get the reserves it owes Bank B? Instead of the actual reserves, Bank B might take an interest-bearing IOU from Bank A for some of the reserves it is owed. Suppose Bank B is accustomed to holding 10% in reserves, or immediately available funds, against its deposits. Because Bank B just experienced a deposit inflow of $1,000, it will want to hold an extra $100 in reserves. So, it is willing to take an IOU from Bank A for $900. But Bank A has got to come up with $100 in actual reserves for Bank B. Bank A will start to bid for $100 in the fed funds market. This will put upward pressure on the fed funds rate. Because the Fed is targeting the funds rate at a particular level, it will inject $100 of reserves into the banking system, perhaps by purchasing $100 of Treasury securities from Bank A, in order to keep the funds rate from rising above target. Bank A can then pay Bank B the $100 it still owes. Where does the Fed get the reserves to pay Bank A for the Treasury securities? Figuratively, from thin air. Whereas it is illegal for you and me to print money, the Fed legally can create reserves through a mere bookkeeping entry. So, with the aid of "seed money" created by the Fed, the banking system can create credit and money, which allows total nominal expenditures in the economy to increase. So, what's wrong with the Fed creating credit and money out of thin air? It's good for the stock market and the economy, isn't it? Well, if the creation of credit and money out of thin air were good for the economy, then I would submit to you that all the world's economic problems would be over. The Fed and other central banks can create credit and money at practically a zero cost. Although the creation of money and credit by the Fed causes the demand curves for goods and services to shift out, it does not cause the supply curves also to shift out. Unless the supplies of goods and services are available in unlimited quantities at constant or falling prices, this increase in demand for them emanating from the Fed-created credit will lead to increases in their prices. That's called inflation. If the Fed had not been creating so much credit recently, the rise in oil prices would not have translated into higher consumer inflation. For starters, oil prices would not have risen as high as they have had M3 growth been kept under wraps. Why? Because some of the Fed-created credit has allowed for increased demand for oil. But as important, the prices of non-energy goods and services would have risen less or fallen more had M3 growth been kept slower. The Fed's creation of credit has allowed households and businesses to maintain or increase their spending rates on non-energy goods and services at the same time that they are having to spend more on energy. The fact that M3 growth is accelerating at the same time that the Fed is raising its funds rate target is an indication that the higher target interest rate still is too low. Households and businesses perceive that the returns on the funds borrowed are rising relative to the higher borrowing rates that the Fed now is imposing on the economy. By keeping the fed funds rate low in relation to the return on investments of various sorts, the Fed is, in effect, subsidizing borrowers. By preventing the funds rate from rising to its "equilibrium" level, the Fed is introducing "price" distortions into one of the most important markets in the economy - the market for current spending vs. future spending. Households want more goods and services now. Businesses want more resources now so that they can produce more consumer goods later. This is setting up a bidding process for resources that ultimately will reduce the profitability of many investment projects that have yet to be completed. The abandonment of these unprofitable investment projects will have a downward multiplier effect (please forgive me Herr Doktor Hayek for the use of the term "multiplier") on the rest of the economy. At this stage of the business cycle, double-digit M3 growth is inflationary dynamite. The Fed may choose to ignore the rapid growth in credit and money that it has a hand in creating. But investors ignore it at their own peril. Unless there is some autonomous fall in the demand for credit, the Fed is going to have to raise rates more in 2000, perhaps even more than the 50 basis points we now are projecting. The bond market is likely to sell off more in this environment. It is beyond me how the stock market could continue to be immune to further increases in both short-term and long-term interest rates. >> Regards, Ken.