Thursday, November 5, 2009

The Fed's Explosion of Money

There is a lot of research that I want to do for this blog. Some is reasonablely interesting like looking at the thoughts of capitalist economists and supporters of freedom. Some is like driving nails into your head, e.g., looking at government statistics. Of particular interest to me is the activities of the Fed. The Fed is always important, because it is so important to the economy, unfortunately. It is even more so now, and I have been in their website lately.

Specifically, I wanted to look at the manipulation of bank credit by the Fed. The Fed makes a lot of information available online. Some is very revealing. Other parts are difficult to dig through. I am only in the early phase of my work, but I found something that you might find interesting, and frightening.

I was looking for member bank’s deposit information. I found two such listed entries in a release of weekly data on the Fed’s open market operations page. These two entries were derived in different ways, in spite of being listed with identical titles. They tracked each other, so I don’t think that it is a major issue. They also vary a lot from one week to the next. I haven’t yet figured out why. The Fed does a lot of different things to the member’s deposit accounts, so there are a lot of moving parts. I also figure that over time you can see trends. But what I found is amazing.

I began collecting the data from the two listings beginning with the first week in 2007. Throughout 2007 and most of 2008, the levels of the two listings vary with a band of about $15 B on what I call MD1, with a bottom of say $5 B, and $25 B on MD2, with a lower figure of maybe $8 B (approximations). Then in September 2007, all hell broke loose.

Why is this important? The Member’s Deposits is the primary tool the Fed uses to expand bank credit and thus the money supply. Each bank (I am talking about the large banks) must have 10% of its demand deposits (checking account deposits) in its “reserve” account at the Fed. If it falls short the bank can borrow (from the discount window or from another bank). The Fed can also add or take money away from this account. When it adds, the bank can expand its demand deposits by making more loans. The Fed can also change the percent of deposits required and what constitutes the required deposits. The current practice is one of the loosest that I know of since the Fed was created.

So here we have these important deposits staying fairly level for a year to two. Actually the records accessible online go back into the 90’s. I want to look at it all. Now I say level. Actually when I look closer I expect to see an upward trend. I haven’t looked because what I found just blew everything else away.
Okay. What did I find? Up until mid-September, 2008, the average for MP1 was, say, $8 B, and for MP2 $15 B. By the end of September each was about $100 B, by the end of the year $800 B, today $1 T. There is no limit on bank lending. This isn’t a gentle push. This is a demand that banks loan money, lots of money. They aren’t, not yet, but they will. (I've got an Excell graph. If I figure out how to upload it, I'll put it in. It is the hockey stick!)

Notes and Commentary On "Crash Proof 2.0" Part 2

Chapter 5, p. 148: 2009 UPDATE

This chapter is about the stock market and the Dow Jones Industrial Average, which was at its recent low under 7000 when Schiff was writing. It is now in the 9600 range. Probably, Schiff would call this a bear rally.

p. 150: He expects to Dow to go to 4000 to 5000 and last for 5 to 10 years. ???? Unexplained.

p. 151: He refers to GE, which hit $5.72 in March, 2009 is now at $16.08 at a P/E of 12. He considers the Price/Earnings Ratio to be important. 12 is way below the traditional average.

p. 152: “Therefore, much of the big profits earned by such companies through their financial activities from the 1990’s on…were phony.” Here we are again. Jump. Phony because the financing was supported and the interest rates kept low by the Fed’s massive money creation. But how that makes the finance arm’s profits more phony than any other part of the company I do not know. It is true that those activities cannot be sustained because the Fed’s inflationary policies cannot be sustained. But dollars from one sector spend just as well (or poorly) as dollars from another sector.

Chapter 6, p. 186: 2009 UPDATE

For this chapter I have nothing to add or criticize. Not bad

Chapter 7, p. 227: 2009 UPDATE

p. 228: “As I noted in the chapter [of the first edition], the Social Security Trust Fund is a pure case in point [of a Ponzi scam].” Okay, this is not a big point, as far as the book is concerned. It is as far as he goes, however. He did not explain the Social Security Trust Fund in the chapter. He mentioned it. He did explain Social Security. He did not explain that Social Security is a very big problem looming just around the corner.

Nor did he explain that Medicare, which is already bursting out of its direct tax revenue and eating into the General Account, i.e., income taxes, etc., is an even bigger problem than Social Security, and it is starting now. The correct description is that Medicare is selling its special Treasury Bonds in its Trust Fund back to the Treasury. It is a fraud.

Perhaps, and this is just a perhaps, Schiff is so much of a finance guy that no other issues are big to him.

p. 231: “Out of this pseudo economy emerged the now-dominant service sector….” Here we are back to the service sector. Now, at least, it is only “dominant” in stead of providing services as the only thing we do rather than manufacturing.

I do not want to attribute this to Schiff without some evidence, but maybe the reason why he places the service sector here is because he cannot find another culprit for the deficit. I don’t know. But harping on the service sector only undermines what is often decent material. What he sees as the service sector is also very narrow. But, ultimately, he just doesn’t look at our economy as part of the world economy. It is. So is our service sector. Services, as long as your not restricting the definition narrowly to menial tasks done locally, are actually easier to transport and provide than physical goods. Looking at the U.S. as part of the world, offering services makes us very flexible in a rapidly changing technological world.

p. 234: “China funds about 50 percent of our borrowing,….” The numbers do not add up. Let’s say that our trade deficit is $800 B and that our federal deficit is $1 T. So, Schiff is saying that China receives three fourths of our trade deficit, and the put all of it into our Treasuries. Our total imports, which went down this year, were only $2.4 T, which means that China would have to be on the selling end of more than half of our imports. No, they weren’t. If he is going to throw numbers out, I wish he would give us some idea where they came from. I do not want to accuse him of making them up, really.

What numbers that I can find shows that out of the total U.S. federal debt of over $10 T, 25% is foreign owned. It could be that foreigners are buying 50% of new debt, expanded debt. I would still like to see his source.

p. 235: “In effect we imported foreign goods and exported inflation.” My very words. Where do services stand in this statement?

“…foreigners get to keep their goods….” This is part of his “decoupling” thesis, often mentioned but not explained in this book in either edition. I think I know what he is trying to say. The problem derives as to why the Chinese exports are so attractive, to focus on the country that Schiff refers to most often. They do not want many of the things that they build for us. The goods they do want they buy in as large a quantities that they can afford. I don’t see that the production capacity that they use for export is of much value within their country. Their general population is, after all, low income.

I will say that I generally agree with his analysis of the federal bond market. The current low rates cannot continue, the market will not buy a continuous stream that shows no end, ultimately, the buying of bonds by the Fed, with or without the trick of expanding bank credit, will reach consumer prices, with the help of dollars held overseas coming home. Price inflation will rise, and tend to rise at an increasing rate.

A general note, which applies since the last chapters are about investment advise. Schiff has not discussed the Fed’s major tactic of expanding the credit supply via the use of member bank’s deposits. It may not be relevant, or desirable in this book, but I often wonder if he knows.

Chapter 8, p. 273: 2009 UPDATE

p. 275: Schiff apparently has many other writings on the internet in which he explains much of his thinking. He left a lot out of the earlier edition of this book. Now, in the revision/add on, he sort of writes as if the reader had read the other stuff as well. Here, finally, he recounts some of his broader views that make some sense of the first edition.

p. 280: Another problem I have here is that he states several events as facts. They vary well might be, but I would like to see myself. Schiff does not give me a way to find out. There are no references. Okay, finding out is not as difficult as it once was. Go internet.

“The world is rapidly waking up to reality.” This time some evidence would really be worthwhile. I do not see this happening. I think that the central bankers around the world are still the same central bankers. They have not all of a sudden had a brain transplant. Private actors, currency traders, businessmen, investors, etc., may be, but again, having some reference to substantiate this would be helpful. Schiff acts as if anything he says is to be totally accepted. Please.

“I’m talking prosperity and growth unlike anything we could imagine when those nations had their wings freighted with the United States’ excessive debt and trade imbalances.” Does Schiff realize that all of these countries are less free than the U.S. was prior to the 60’s? Further, I do not understand how their internal economies, or even several countries, or the entire rest of the world, is going to absorb the production that the U.S. has received, or even a significant portion of it, without experiencing drastic reductions in the prices of everything. It isn’t as if there is all kinds of ready money, real or otherwise, sitting around to buy what the U.S. can no longer buy. How does Schiff expect that to work. The central banks in the other countries look at their economies not that differently from the Fed. If they see prices begin to drop they may just as well act as the Fed would and pump money into their economies, and bang, have the same problems we have. Schiff needs to explain how this works. I don’t see it.

“We are already seeing signs of decoupling….” Meaning that foreigners are tending to buy fewer U.S. Treasury Bonds, sell dollars, and not expect to sell goods to the U.S.. So, where does he see this?

p. 281: As the world’s producers begin making more for themselves and less for us, they will demand even more basic commodities, while recent capacity reductions will further limit supply.” But also, we will be demanding less, and therefore some supply will be opened up. But, as I said before, it is less obvious how the other countries are going to be able to take advantage of “making less for us” without prices dropping, which means that they will have less ability to pay higher commodity prices.

Chapter 9, p. 309: 2009 UPDATE

p. 311: “I do not believe there will be an official decree to replace the dollar as the world’s reserve. It will simply lose that status due to independent market forces. My guess is that central banks will began [sic] to hold more of their reserves in other currencies, such as the euro, yen, or Chinese renminbi, and significantly higher percentages in gold.”

Let’s consider what the situation would be if the U.S. had not been exporting inflation, i.e., made up dollars. Let’s say that the $10 T that is currently being held by foreign central banks and the $1 T held by foreign private interests were part of a stable currency. Of course, that could not have happened, because about 30 years ago our total liquid money supply was about $1 T. What would have happened is that as we sent dollars overseas to buy goods, they would have held on to them, pretty much as they held on to the made up money. Dollars would have disappeared from circulation in the U.S., and prices would have had to go down, simply because there were fewer dollars around to spend on things. Wages would have gone down, too, but not as much. This scenario would be just like the last few decades of the 19C. Internationally, the dollar would be bid up consistently, year by year, making foreign goods even cheaper and more attractive. Our standard of living would improve, especially as we became more productive and allowed our creative people to create. What a world.

The point of going through that scenario is to point out what would happen in countries whose currencies would be chosen to be reserves. Every yen taken out of circulation in Japan is one less yen being used for prices in that country. There isn’t much of a yen bond market. The situation would be similar for the euro.

As I mentioned in an earlier note in this commentary, the central banks in those countries do not view falling prices as a good, and would tend to make more money to replace money that was effectively exported, and the cycle would begin, as it did here.

I do not think that gold would be the general response because it is too restrictive. Central banks could not do what they consider their responsible activities of controlling the business activity within their countries.

Schiff has this unrealistic view of what other countries are like. They have an even lower attitude toward the free market than our “leaders” do, and less experience. (I am willing to consider exceptions, but those would not be major economies, I expect.) I would not expect milk and honey in China, Japan, Korea, and certainly not in Europe.

On the other hand, I think that Schiff’s expectation that gold will continue to rise in the long run, or even intermediate, is accurate. What’s to stop it?

“…the fact is that the world does not need a reserve currency. Rather than replacing the dollar with some other flawed fiat alternative, the world could simply return to the traditional gold standard that existed prior to Brentton Woods.”
Well, yes, that is what it should do. But, to do so, it would have to recognize why. The Chinese do not. And I see no reason to think that anyone in the governments of the other major players understand either. The fact is that governments that exist today prefer fiat currencies, and really have no problem with a fiat currency as a reserve. If they have a problem with the dollar it is because the U.S. has gone overboard, in their opinion.

p. 313: “…but I’m also surprised at the extent to which the European Central Bank (ECB) and other foreign central banks have adapted inflationary policies.”
Mr. Schiff, U.S. central bank policies were patterned upon foreign central banks. We did not invent the central bank, the Europeans did.

The balance of this section is, in my opinion, sound.

Chapter 10, p. 335: 2009 UPDATE

In this section Schiff sort of ping-pongs around, accurately demonstrating the problem with suggesting the thing to do in our current situation. What to do?

If his expected economic disasters come to pass, it is very unclear when they will. This leaves the asset holder in a difficult quandary. If his second collapse is as drastic as he expects, then holding the right things will wipe them out just as much as holding the wrong things. The most important assets to hold may be gold, food, and weapons. That is the worst-case scenerio. Frankly, if you expect the worst case, you should be moving to a small town in an agricultural area, get to know your neighbors, help on farms, buy some gold coins and bullion, and hunker down. Holding foreign stocks might not be helpful.

If, on the other hand, you expect things to be hard fought, that the efforts by yourself and other Objectivists and people who want freedom are going to have enough of an effect to keep things running well and then turn around, owning foreign stocks, gold indirectly, and a selection of solid U.S. companies would make sense. I do not think that someone who felt that reason has a good chance of prevailing today would give up entirely on U.S. companies.
Not a good set of choices, sorry.