Basic Economics: Savings Accounts

Looking at the modern relationships between interest rates, taxes, and price inflation, I have wondered why anyone would put money into savings accounts or buy bonds, especially U.S. government bonds. A savings account, earning 1.6% (The top rate offered by my credit union recently.), after taxes of say 20% and price inflation of 2% gives you a guaranteed annual loss of 0.72%! The situation for bonds isn’t that much better, if at all. For someone with a higher income, with higher tax rates, the loss is substantially greater .

On the other hand, I know that savings accounts have historically been the primary savings vehicle in the U.S. I know from 100 Voices that Ayn Rand held her money from the sales of her novels in savings accounts. What is the difference between then, even as late as the 1970s and the 1990s, which is when I first realized the problem.

In thinking about this issue, one of the first things I saw is that interest rates have been declining as a trend since the spike in 1990. At that time I had a mortgage at 10.75%. The decline in interest rates since then has been the consequence of the Fed’s view that below market interest rates on loans encourages consumption and business activity and that if they don’t have the economic activity that they want, they decide they should lower rates more. Each round of recession and boom and financial crisis over the last twenty plus years has seen the Fed pushing short-term interest rates lower and lower. Today, the short-term rates are about as low as then can go. The rate the Fed controls directly, the rate it charges banks to borrow overnight funds for their Fed “reserves” (deposits) is zero to 0.25%. (Some recent auctions of German government short-term bonds have seen negative interest rates.) And, for the third time since 2009, they are trying to lower medium and long-term rates with “quantitative easing.”

So, first, the problem I am seeing is a very recent event. What are some of the consequences?

First there is the complete disassociation of savings and capital. The creation and use of capital is a vitally important activity in an economy. The creation and use of capital causes prosperity, not to mention the survival of our population. A population as large as ours cannot survive (or occur) without industrialization. Just to maintain industrialization requires capital. Economies either grow or contract. There is no equilibrium.

Over the last twenty years the number of households that have ownership in corporations, i.e., own stocks, has gone up significantly. One major reason is that people recognize that they have to have a more rapid growth in their retirement savings than can be provided by bank savings accounts. The need is two fold. With taxes and other restraints on creating wealth, they are not able to save enough. And then, price inflation has a double impact in that not only will it make the process of saving enough difficult, but it will also make the amount the retiree needs to live increase significantly and unpredictably. Even a 2% price inflation rate is a danger. That means that in just twenty years, a retiree would need 25% more cash for the same standard of living. Since many retirees live longer than that in retirement, and the percentage of people with such long lives is growing, the impact of even small amounts of price inflation is significant and ignored by the government planners. Bernanke has recently remarked that the effect of the Fed’s goal of 2% price inflation on retirees is unimportant in policy decisions.

You might think that a higher percentage of stockownerships is good for the economy. I’m not so sure. I was, but my view is changing. There is a difference between creating capital and owning existing capital. Saving and putting your money directly into a new or growing business is creating capital. Buying a stock from another owner is not.

Consider what should happen when you put your money into a bank savings account. (I am going to ignore the consumer loans and the loans to business for normal business activities.) Businesses come to banks for the purpose of borrowing money to start a new business or grow their existing company. This is the direct application of capital, i.e., new productive activity. Here we also see the division of labor at work. The person who saved the capital is engaged in his own profession or job and by saving, he is putting money into the hands of the banker whose profession is apprising risk and opportunity in expanding production. Then there are the businessmen who compete for funds by presenting their plans and expectations of profit.

The normal person does not have the expertise to appraise business opportunities. (Although in a rational culture he would have a better understand of the reality of business activity than people do today.) This is true in the case where people already know something about the industry. Some financial writers have advised investors to place their money in industries in which they are familiar. It isn’t a bad idea, but it does not address the additional need to be able to appraise the financial, managerial, and competitive strength of a company. Correctly understanding the context for investing is difficult enough for the professional, especially in today’s complex economy. For those who do not have the relevant education, experience or time, the prospects are very poor. No wonder everyone is so hopped up on the gambling metaphor for investing.

The need for non-professional investors to put their savings into asset markets is part of the make-up of the two recent booms: tech stocks and residential real estate. Without the amateur investor, both booms would have been less dramatic. Note that many of these investors lost lots of money, right along side the so-called professionals. This is over and above the normal losses that the non-professional investor tends to lose in the normal course of events. Some professionals use the activity of the individual investor as a contra indicator. If individual investors are buying, the reasoning goes, it is time to sell. Every study that I have seen clearly concludes that the non-professional consistently looses money investing in asset markets.

Then, over the last twelve years, as I have indicated in a previous post, the equity markets have failed to bring positive returns. Comparing equal dollars of purchasing power, today’s Dow (without including dividends or taxes) is 20% to 25% below the level at the end of the tech stock boom.

In fact, the only asset class that has shown consistent positive returns in the last decade is long-term bonds. But that brings us back to the beginning point, the Fed’s push to lower interest rates, because the reason long-term bonds have shown a gain is that interest rates keep falling. When interest rates begin to go up, watch out. Look at the returns of the bondholders of Greece, Spain, and Italy. When the interest rates on these dead bonds moved from less than 3% to near 6% or more, bond holders lost about 50% of their capital on the secondary market. To me, even 6% or 7% doesn’t seem very high when I wonder if the bonds will be repaid, or repaid with money worth anything.

There are surely lots of other consequences of the Fed’s disastrous decisions. Many are clearly visible, including the continued recession we are suffering through. (Officially the recession ended, but the psychology is still that of a recession, the unemployment level is that of a recession, and the government is doing all it can to keep us there, just like it did in the 1930s.) But the consequences that I have discussed are the ones I have recently added to my list.

But then there is the important question: Is the use of savings accounts by people who aren’t financial professionals a good thing in a laissez-faire economy and how?

The first thing to realize is that in a laissez-faire economy prices and wages tend to fall over time, which is the consequence of having a money immune from government manipulation. Prices fall faster than wages so that there is a continuous raise in the standard of living. That means that the dollar you place in a savings account will have a greater purchasing power over time even without consideration of interest paid.

The second important issue is the level of what is called the ordinary interest rate. That is the amount of return required for a person to delay consumption. This interest rate does not include consideration of risk, etc. I have seen suggestions that the rate of ordinary interest tends to be around 1%. That is, the normal person would be willing to put off spending $100 if in one year they had $101, assuming a laissez-faire economy. Other issues, such as the supply of physical capital (one market where supply does play a role in price) and risk factors, increase the interest rate within different market contexts.

So, if a savings account offered 2% interest, it was a great deal. The same is true for bonds issued by businesses. Saving for retirement would require much less of a struggle, later medical bills would be less of a problem, and our standard of living would continue to raise and we could have the flying car (see, my avatar means something – what we have lost due to government interference!).

Then, money placed into savings accounts was then loaned by banks to businesses who were credit worthy and had the best available plans for additional profits. Savings, that is capital, was accumulated and placed in the service of wealth creation, capitalism. That is basic banking.

I think much of the concern and fuss over fractional banking is based upon the view that banks are warehouses rather than institutions involved in the accumulation of capital. In the modern world, even ignoring the stupid, forced level of interest rates required by welfare state banking theory, savings have been diverted from banks and their major source of funds are demand deposits.

While unused demand deposits, and the goods represented by that money, are a kind of unintentional savings, real savings involves conscious decision and results in the funds being placed accordingly. When real savings is placed into profitable enterprise, and market rates of interest paid, investing and profit making activity would actually be a less risky activity.

With the manipulation of the money supply, the extensive regulation of the financial community, and the control of interest rates, none of the prices for savings or the factors of production reflect any part of the reality of business activity, market opportunities, or costs (not to mention political pull). Who knows what can or will happen when no facts are available for reason to evaluate.

So my conclusion is that in a laissez-faire economy, placing your money in savings accounts and buying bonds (of businesses) is a sane and personally beneficial decision.

In our economy, the government has pretty much taken way sane and beneficial opportunities. If you accept the idea that one should know what one is doing, then probably 90% of the investing public is acting irrationally. They do not understand the world as it currently functions, including the existing markets and the impact of government regulations and manipulations. Yes, I think that is true of many of my readers. Sorry.

A Note on Greek Banks Recapitalization

A Note on Greek Banks Recapitalization

You might have noted in the news stories about the Greek government debt problem that there was talk of needing to recapitalize the Greek banks later. What is going to happen, one way or another, is that the Greek banks, as well as other banks all over Europe eventually (and maybe a few elsewhere), will have to recognize, on their balance sheet, that the Greek government bonds that they hold are worth less than when they were purchased. It is true that the Greek government debt has been worth less on the secondary market for some time, but accounting rules do not necessarily require that that change be recognized on a balance sheet at that time. (I will let an accountant explain that issue, which isn’t necessarily corrupt.)

For the bondholder, buying the bond is the same as loaning money. The bond will pay a certain interest rate for its lifetime, and at a certain point, the issurer, which could be a government or a business, will return the borrowed amount, called a redemption. It is a timed, interest-only loan.

The bank holds the loan as an asset, just as it does all of its loans. But it does have to evaluate the loans that it has on its books. Are they performing? That is, is the borrower following the terms of the loan? Will the borrower be able to pay back the loan?

Accounting rules for banks recognize that loaning money is a risky business. Borrowers can get into trouble and fail to pay the interest and fail to repay the loan itself. In order to protect itself, a bank has to maintain reserves against potential default of a borrower. With this reserve the bank is protected from becoming insolvent and bankrupt when borrowers default. The reserve is actually capital. The more reserves a bank holds against potential loan losses the more of its capital it has tied up. That capital cannot be working and adding to the revenue or profit of the bank when it is held as a reserve. (Do confuse reserves the bank has with “reserves” required by banking authorities, such as the Fed. Those are not reserves in fact, but deposits that provide no protection or income for the bank.)

Due to the standard statist misunderstanding of how banking works, how capitalism works, and what the real benefits of government controls are, governments have established regulations as to what percentage of reserves a bank must have in its loss-loan reserves for different types of loans. Banks in the European Common Market have been heavily regulated for at least as long as U.S. banks, most likely much longer. They are well used to doing what they are told. I think that the experience and knowledge of how to properly rate the risk of most loans does not exist in Europe. Furthermore, the government decisions as to what percentage of a loan the bank must hold in reserve is heavily influenced by political considerations and populist biases. Certainly, if the ability to repay debt were a consideration, the debt of most of the European nations would be rated very low.

The developed governments of the world have gotten together over the years in Basel Switzerland to establish international standards of loan-loss reserve percentages, hence, the Basel Accords and Basel I and Basel II (Basel III is in the works, I think). They agreed that loans to sovereign, national governments required either low or zero percentage reserves. That’s right, a loan to Greece was considered safer than a loan to Apple or Microsoft or GE.

What banks did was to load up on government loans because those loans required fewer reserves. Reserves cost money, that is, reserves are idle cash. If no reserves are required, then the bank’s funds can be loaned and contribute to operating income, and maybe profits and bonuses for employees. Even European banks have some characteristics of a business.

In addition, European banks are much closer to their governments than U.S. banks. They are sensitive to the interests, biases, policies, and intentions of the ruling politicians. They have to be. The politicians have a lot of power and use it against the banks if they wish. What the politicians have wanted, in all of the European countries, is for the banks to help fund the government spending, cheaply. The banks have helped the central European bank and each country central bank to keep interest rates on government debt low by buying significant amounts of government bonds. The Greek banks have done this perhaps more than others and hold massive amounts of Greek government debt (which is a direct path of the country’s savings into the hands of the government, which spent it in a continuous, drunken shopping spree – buying votes, really). The estimate I have seen is 50B euros.

As a result of the various government actions and the way the governments have set things up, the Greek banks are now looking at losses on Greek government debt of seventy percent or more, yes, that is 70% losses. Losses for which they have little or no loss reserves. This degree of loss means that the banks’ total capital, its investment from its shareholders, whatever profits it has ever retained, and all of the reserves of any kind, have been wiped out. The Greek banks are bankrupt. They are bankrupt right now. It just hasn’t appeared on their balance sheet yet.

So, if there are to be any banks in Greece, they need to have an injection of capital. Not loans, but new ownership money. The requirement being discussed is ten percent of loans by 2013. Remember, Greece is something like five percent of the Euro zone. I have seen estimates that the recapitalization of all Euro zone banks, with all of the Euro debt problems, is one trillion euros, which is about $1.3T.

Who would want to put money into Greek banks? Not foreign investors. Not domestic investors (if there is anyone with real money to invest). No, there is only one source: the government.

Yes, the bankrupt Greek government is going to put money into Greek banks. The Greek government doesn’t have any money so it aquire the funds from outside the country, just as the government is doing for all of the other help the government is getting. The way it will probably work is that some one like the IMF, the European Central Bank, or one of the two entities that have been created to deal with the sovereign debt crisis will give/loan the money to the Greek government which will then put the money into the banks.

But, the Greek government won’t just hand over the money to the banks. No. It will “invest” the money, i.e., it will buy stock. The Greek government will nationalize the banks. There is some talk about making the stock the government buys a special, non-voting stock, thus preserving an illusion that the original owners have some standing in the bank’s ownership. But, that is what it is, an illusion. The banks will be even more tied to the Greek government than they were.

So, as an overview, here is what we have:
The Greeks (actually you can insert any European Common Market country you want because the pattern is consistent throughout) borrowed from anywhere they could for a massive spending spree.
They required the banks to be a major lender.
They required the banks to have little or no reserves against the loans to the government.
The government can’t repay the loans.
The banks are failing.
The government, with money acquired from elsewhere because it has done stupid, insane things, is going to buy the failed banks.
The banks are even more tied to government policies than before.
The government has ownership and control of the banks.
Does anyone think that the Greek banks will be better off?

Makes sense, doesn’t it. When you live by force, you “win” by force. And you all go down the tubes together. Moreover, I have seen no comment or hint that anyone writing about the European situation has anything to say about the matter. Perhaps they haven’t even noticed.

But the failure of putting two and two together is a common theme in the entire European debt crisis. It is most blatant with the Greeks.

This week there have been more “strikes,” riots, and protests against the terms required by the agencies that would bail out the Greeks. Many of the chanted slogans and posters and banners declare that the foreigners are dictators and imperialists. The protestors want the politicians to “resist”! The Greeks appear like angry four year olds who have been told that they can’t have the toy on the shelf because mommy doesn’t have the money. How and what are the politicians suppose to resist? They are suppose to resist the requirement that they do not incur more debt. They are suppose to resist the requirement that they try to pay back their existing debt. They are suppose to resist the requirement that if they are given money they spend it wisely instead of like a drunken sailor (my apologies to sailors). The Greek protestors have no contact with reality. None. They have no idea that money has some connection to real things. That real things are made by someone who wants to be paid for their efforts. That borrowing actually means that the lender expects to be paid back. The Greek country is a testament to modern education and economic “thinking.”

Green Jobs; Obama’s Jobs Program and Inflation

This idiot program has been discussed in other places regarding its failings as a stimulas, as a provider of real jobs, as a wealth producer, and as a drag on the economy. I want to talk about it regarding its impact on inflation.

This is a direct price inflation input into the economy.

As we know from economists, inflation affects industries and people unevenly. Its first impact is where the new money enters the economy. There are at least two sectors in our economy that have been receiving made up money for decades which are major distributors of consumer level price inflation. They are very obvious: health care and higher education (the costs of which have been raising at over 7% a year for decades).

Most of the rest of the inflation has been coming in via the expansion of bank credit, i.e., exported inflation by way of the trade deficit, and asset balloons like the tech stock bubble and the residential real estate bubble.

Here we have money to be pumped directly into the consumer economy by way of unproductive jobs. The good news is that this entry point into the economy will not cause asset bubbles or significantly increase our trade deficit. The bad news is that it will feed directly into consumer prices.

A major technical hurtle in understanding how newly made money filters through our economy is understanding why prices haven’t risen more over the past twenty years. Don’t yell at me that the government CPI under measures inflation, it doesn’t matter. My standard is real, corporate profits, which is to say, their real, ongoing costs of production. If we had significant price inflation, those costs would be causing ongoing corporate profit problems because the cost of replacing materials would be higher each cycle, and you would see problems. We don’t see cost problems to speak of. The inflation is going elsewhere.

We do have other consequences of inflation: the trade deficit, or actually, the money that leaves and doesn’t come back (yet) and asset bubbles. Some suggest that our rising productivity soaks up made up money, and thus prices don’t drop as they normally would. I don’t disagree with this suggestion. I don’t think that it’s large enough to make up the difference between the actual amount of inflation and the experienced level of price inflation. I admit that I don’t have figures (if it is actually possible to have “figures”).

We do see in front of us on a daily basis the method that made up money makes it into the economy: the federal payroll and federal retirement benefits, plus social security. To the extent that the government finances itself via inflation, the federal payroll, etc., is a dispenser of money that goes directly into consumer prices. How does the federal government do that? I mean that I am on record as saying that as long as the deficit is funded by selling bonds, then there is no inflation stemming from the deficit. No body called me on that. You see, a significant portion of the annual federal deficit is funded by foreign central banks and other foreigners buying federal bonds. All of the money coming from foreign central banks is made up money. Plus, some of the federal debt is purchased by the Fed, though not much. Therefore, a lot of the federal spending each year is in made up money, which goes directly into the consumer markets, and is a source of the rise of prices and price inflation. It’s nice to figure these things out.
So, the conclusion about Obama’s grand unproductive jobs program is that he will be adding yet another source for inflating the prices we see when we go out to the market. Thank you B.O.

The Gold Market: Update on Central Bank Activity and More

People get excited about central banks because they have lots of money (called inflation) and they tend to make big moves. The central banks do not move as a group. Some may be buying while others are selling. You also have to factor in the IMF, which has a lot of gold and is selling to support its activities. When the IMF sells and some central bank is buying, they tend to set the transaction between them, so there is no impact on the gold market. The IMF has been selling around 400 metric tons a year. There is an agreement among the major central banks called the Central Bank Gold Agreement in which they voluntarily limit the amount of gold they sell a year, currently 400 metric tons. That doesn’t mean that they are selling that amount, just that they won’t as a group sell more than that. It is suggested that they aren’t selling at all. Who can know? We won’t know for some time. There is reason to think that some central banks, small countries, are buying, probably from the IMF.

One writer suggested that central banks do not pay attention to price, once they decide that they want to buy. On the other hand, a spokesman for the Chinese Central Bank said that they would not buy when the price was “high”. I think that belittling the bankers is reasonable when writing about them, but when devising a gold purchase strategy, it is risky. Overestimating the reasoning power of other market players is a better approach to risk management, keeping in mind their motivations and perspectives.

An article I came across recently reminded me that over the last two decades the central bankers have been selling gold. Even last year, on balance, they sold. I think that period has ended. It ended primarily because of the realization of the weakness of the dollar and, more importantly, the U.S. financial system and economy. They might have the wrong idea as to why the U.S. financial system is weak, blaming the banks rather than the Fed, but they do understand that the recent worldwide recession began in the U.S. financial system. What has happened since has done nothing to reassure anyone.




From a wider perspective, the relation between gold and inflation is not direct. The effect, the ability of gold to keep pace with the drop in value of the dollar is in the long term, over years, sometimes decades. This is the result of the activities of the different elements of the market. The big drop had to do with the waining of the U.S. price inflation and gold selling by the central banks. The movement of gold upward now is due to fears and uncertainty, not a response to specific changes in the purchasing power of the dollar or other currencies, but expectations of deteriorating conditions. If conditions do not deteriorate within a certain time, the attention in gold will be reduced and the price will flatten, at best, maybe drop.

With the certainty that the Fed will be expanding the money supply by expanding credit as forcefully as it can, as it has been doing for the last year, we will see something happen. It could be another asset bubble, it could be a huge increase in our trade deficit, a significant drop in the value of the dollar, or, because of Obama’s spending, it could be real price inflation. We do not know where all that money will pop up, maybe many places at once. Just keep your eyes open.