http://www.gold-eagle.com/editorials_02/champeau011402.html Money - Part I At New Year's Eve dinner I asked my friends "Where does money come from?" My veterinary friend, college educated, did not know, No one volunteered an answer. Of course most readers of Gold-Eagle know that in today's world money comes from debt. I explain that every time someone takes out a loan from the bank new money is created. But I also like to try to explain to them why this is a system in self-destruct mode. So I describe the following scenario. Assume that 8 people are sitting around a kitchen or dining room table. "Let me describe our monetary system in simple terms. Pretend we are our own little community. We need something to allow us to do business together. We need a form of money. So, I will be the central bank. I will loan all of you 100 Dave Notes (DN) at 5% per year in exchange for the right to some of your property. "Now, we all do business with each other for 1 year. After the year is up you all owe me 105 DNs. See the problem? You may be able to pay me back to original 100 DNs. But where does the other 5 Dave Notes come from? It can only be worked off. You will be my slave until you work off your debt. Or you can exchange me some of your personal property." At this point you get a lot of heads nodding and the idea sinks in. Then we continue. "Now, let's say that Mary is an astute business women and she has 150 DNs and Tony only has 50 DNs. Mary can pay me back the 105 DNs or she can pay me only the interest of 5 DNs or something in between. Let's say she only pays the interest. Tony on the other hand, needs more money to stay in business, so Tony, I'll tell you what, I will loan you another 100 DNs at 5% and next year you will owe me a little more than 215 DNs total or 15 DNs in interest. "Now, something very important just happened here. What was it? (Pause) We just INCREASED THE MONEY SUPPLY. What's this called? Inflation. Each new loan, without an equal loan payoff, increases the money supply. "So in our little community we now have 895 Dave Notes floating (Mary paid me 5) instead of the original 800. "Now, what would happen if all of you tried to pay me the full amount of your loans? (Pause) Two things, first, you cannot. There is not enough money to pay all the loans off plus interest, therefore, I will continue to make new loans to people in need. Second, if you do pay off most of your loans, there will not be any money in circulation to do business. If you pay me back a substantial portion of the loans, there will be no money and we will have to revert back to a barter system. It is not in my best interest, as your banker, to have you pay be back the loans in full because I cannot collect any interest. "So the next time a politician says that he wants to pay off the national debt, either he is a liar or he does not know what he is talking about, probably both. " This little scenario has worked quite well in describing to lay people how our current monetary system works.
harry I enjoy reading posts like these. I am sure you realize that pehaps the implications of this little scenario are flawed. What if someone invests the money in a business that creates cars and then sells those cars to people for far more gold than the loan. And the banker is willing to accept gold as a payback. Now we have the potential for a well balanced system do we not.
harrytrader, That's a very nice explanation of a central bank system based on fiat money. I have a few comments that I'd like to throw into the mix. Paying Off the National Debt: I'm not sure why can't the government pay off its debt in your example? Say this little community decides to form a government to provide shared infrastructure. They set up a government account at the bank, but it has nothing in it (the government is a 9th entity in the community). Although the central bank could print more money and give it to the government, the community members vote against this. Instead, they propose creating some infrastructure using a modest year-end tax of 5 DN per person per year (OK, its a horribly regressive head tax, but that's what the voters asked for). Thus the government can expect tax revenues of 40 DN per year from its 8 citizens. Now the problem is that everybody wants the infrastructure now and its going to cost 38 DN. Rather than wait until after the first year of tax revenues, the government proposes a bond issue. They will sell a 1-year zero-coupon bond that returns 40 DN at the end of the year. The bond sells for 38 DN and thus has a yield slightly in excess of 5%. Joe is looking for a safe place to put his money and buys the bond. The government gets its 38 DN, hires members of the community with it (creating jobs) and builds the infrastructure. Joe has less of his borrowed cash, but also has a nice secure bond that pays more than 5%. So, what do we have now? The government is back to having 0 DN cash (it spent the borrowed money), the government is in debt to Joe, some members of the community have a share of the 38 DN in government contract work, and Joe is holding a 1-year T-bill. Assuming nothing else happens, at the end of the year the government will collect its 40 DN in taxes, distribute the money to the bondholder, and be out of debt. Value Creation: Jem's point about the existence of alternative hard currencies such as gold is good, but does not go far enough. The point is that while the central bank can create money by fiat, the members of the community can create value through their labors and through the resources that they control. Extracting gold and oil, growing crops, manufacturing goods, and thinking up patentable products all create value. The accumulation of value creates the basis for assets that collateralize and repay debt and grow the economy. Equity as a Form of Money: I also think that you underestimate the potential of equity as an alternative to debt. Expanding on jem's example, what happens if Mary comes up with a good idea for a business and uses her borrowed 100 DN to hire workers, buy supplies, and create a business? Say that the business generates 15 DN per year in earnings. That entity has value and is worth money (at a P/E ratio of 15 based on trailing earnings, its worth 225 DN). Mary decides to do an IPO and sells about 44% of the company for 100 DN (Mary retains the majority of equity, valued at 125 DN after the IPO). Mary then uses the 100 DN raised by the IPO plus the first year's earnings of 15 DN to more than double the size of the business and improve its economies of scale. The result is that the business grows to 40 DN in earnings per year and the share price triples on the strong rate of growth, excellent return on capital, and proven track record. Now Mary is sitting on 375 DN worth of shares and outside shareholders own 300 DN worth of shares. The point is that 200 DN in borrowed money has turned into 675 DN in wealth. What can Mary do with these shares? She can then use these shares to pay workers (reducing the cost of labor and further boosting earnings). She can buy other companies with equity and reduce costs or boost revenues through the synergies of the merger. She can do a secondary offering to raise additional capital for further business growth. The point is that the shares become a form of money that can be used to buy other companies and pay workers for their labor. Equity in Mary's company is less fungible than DN, but it is still a partial replacement for the money issued by the central bank. Inflation is Controllable (Sort Of): You are right that creating additional money can lead to inflation, but only if the additional money creates demand for goods and services in excess of the supply. If the central bankers do their job correctly, the money supply can expand and contract in sync with the supply of value latent in the economy. In your example of Tony needing another 100 DN, a prudent central banker would weigh the impact of letting Tony go bankrupt (from tightened credit) vs. the risk of inflation (from loosened credit). Inflation/deflation is not inevitable, but it is very likely giving the lags in the feedback loops, poor quality of information about the economy, and uncertainty about future events. Conclusion: You are Right: Despite the preceding quibbles, I do agree that the economy is a house of cards. The monetary value that is assigned to goods, services, and labor are all tautologically defined. I expect to be paid enough to cover my costs. The U.S. dollar, like the DN, has no intrinsic value -- its value is defined by the prices for goods and services as defined by the members of the dollar-using community. Self-referential loops pervade the economy and have the potential to kick into vicious cycles of hyperinflation (I have a 20 billion Mark postage stamp from depression-era Germany that attests to that). By the same token the economy could drop down into deflation. Thanks for a very interesting discussion, Traden4Alpha
A house of cards! Surely you are jesting ;o) What are your thoughts on the current levels of Government debt (Federal, State, Local), Corporate debt, and Consumer debt in the United States? Have you noticed that Gold has been steadily rising on the weekly charts? Maybe some folks are trading their paper currency for a metal one. I agree with the house of cards idea. I like this topic quite a bit, thanks. Banker
Bankedout, What makes the economy feel like a house of cards to me is the animal spirit nature of confidence. What makes consumers confident enough to buy rather than conserve? What makes businesses confident enough to invest in upgraded facilities, training, new products, etc.? What makes foreign investors confident enough to invest in the U.S.? The economy really depends on everyone being confident and acting as if the future is bright. I agree that debt is a big problem if repayment of debt becomes uncertain -- defaulting on debt has a way of destroying confidence, especially these days. I think that most investors knew that the stock market was overvalued and risky. But if investors flee to "safer" debt-based investments and get burned there, they will be in a truly foul mood. I'm probably most concerned about consumer debt, especially the overly aggressive valuation and lending practices in the home equity/mortgage business. Although corporate debt is ugly and there will be more bankruptcies in many industries, most companies have the sense to foresee their problems and declare Chapter 11 to preserve the company and repay at least some fraction of their obligations. In contrast, consumers tend to spend their way into the ground and totally crater themselves. The danger embodied in government debt is bit harder to judge because how the government deals with the debt (e.g., which taxes they raise vs. which services they cut) has a such a big impact on outcome. The hard part is that all of this is complicated by the global nature of the economy. For years economists have been arguing the that U.S. dollar would fall from the weight of deficit spending, trade imbalances, etc. Yet it has not happened because it seems that the U.S. is still a promising destination for global capital. Japan is in an increasingly worse shape as they don't seem to have the political will to take the increasing harsh steps required for recover. Europe is rising in power but still quite risky as more less-developed countries get added to the EU, Germany's growth is stalled, and various people question just how unified Europe should be. China looks extremely dynamic but many wonder about the stability of the economy, the future of the state-run enterprises, unrest in the poorer agrarian interior of the country, and the pitfalls of doing business in China. Maybe the U.S. is the creme of the crap, but that's not saying much. Hmmmm.... Now I'm not sure whether I should "Buy American" or buy gold and crawl under a rock..... Cheers, Traden4Alpha
Traden4Alpha, LOL "creme of the crap", that's a good one. Maybe it was a typo. I can see foreign investors thinking that way though. Confidence is definitely a problem. The low interest rate environment helps to fuel that problem in my mind. When you can go out and buy furniture etc. with "no interest, and no payments until 200X", it doesn't seem too painful to assume the debt. Or if you buy a car with ZERO percent financing, the pain of taking on the debt is diminished. I agree, the debt investors will be up a creek if/when their debt investments turns sour. I could see that happening at some point. It's an interesting problem. In the end, I'm sure the house of cards will crumble. I don't see any other way out. All the great empires I have read about have come to pass with time. What makes the US any different? China is an exciting possibility. I don't know how to capitalize on that one though. Putting everything in Gold and crawling under a rock is no way to live life, as far as I am concerned. I guess we just have to accept whatever happens, and deal with it. In the meantime, my quest is to accumulate the paper currencies, creme of the crap so to speak. Banker
Bankedout, "Creme of the crap" was no typo. Sometimes I think that the best that today's investor can do is to diversity across the least-worst of a wide array of bad alternatives (a choice between very low returns or very high risks). As a trader I do think it is useful to understand the mentality of investors and gauge the likely bias of their sentiments. I don't believe that markets are preordained to always increase in the long-term. I agree that credit has been far too easy of late. Retailers look at 0% financing as having no costs to themselves (because the cost of money is so low) and only the see potential benefits of getting another customer. And lenders are bending over backwards to encourage people to borrow more and more money. I think that low mortgage rates are the worst offender because they create the illusion that houses are getting more valuable -- think of it as a change in the P/E ratio of the house. A house that is worth $1000 per month goes from being about a $150,000 house at 8% mortgage rate to a $200,000 house when the rate drops to 6%. (And the effect actually amplifies as people sell houses at inflated prices and trade-up with a low-rate mortgage.) Add to that the feeling that the low rates are a once-in-a-lifetime occurrence and everyone is jumping to borrow as much as they can. Everyone thinks that real estate is a great investment that can only go up. When rates go back up or lenders turn off the free money faucet, prices will revert and many a borrower will find themselves in the hole. China is pretty dicey -- ugly issues with how the stock market is run, transparency, governance, and capital allocation policies. I'm not sure how foreign capital can best get in and get out. I doubt that the U.S. is an empire on its way out, even if it faces some serious problems. The key is cohesive adaptivity -- the ability of the people, business, and government to work together and change when change is needed. In this regard I suspect that the U.S is far more flexible and adaptive than is Europe or Japan (and don't know about China). And regardless of one's opinion of Bush, his high approval rating suggests the potential for cohesiveness (better than Europe's, but worse than Japan's). I agree about living life rather than hiding from it. I feel sorry for those that buy gold and hunker down. I feel especially sorry for them when I consider that the price of gold is just as arbitrary as the price of the dollar. Thanks for the great discussion, Traden4Alpha
Traden4Alpha, I enjoyed reading your last post, and agree with much of what you have said. I did bring up the strong longer term chart of Gold, and since then I have stumbled across another one. The Euro, as a currency. The Euro appears to be in a Bull market. I guess there are other options besides converting US dollars to gold and hiding under a rock. Maybe foreign investors who have pulled some money out of the weak US stock market the last couple of years have been finding alternative investments. Some went to gold, and some converted to a different currency. I'm not positive if that's the case, but the evidence I have seen points to that as a possibility. In addition to that, commodities have been seeing some action as well. I wonder if some speculators have simply given up on playing the US stock market for a while. It has been pretty dull at times, that's for sure. Another ET member pointed out that Spring Wheat had a nice run lately. Since that was brought up I looked into other areas like oil, heating oil, gasoline, cocoa, cotton, sugar, live cattle, lean hogs, and soybeans. There has been action to the upside. Perhaps money is shifting out of equities in general to find "better" places to call home. Good luck to you, Banker