Thanks in large part to the handful of ET posters who are actually knowledgeable and helpful, I think I understand money creation through lending, but I do not understand how wealth disappears. It's pretty obvious how a decline in an asset's value affects the owner of that asset during the decline in price, and particularly how banks can be quickly rendered insolvent by defaults or foreclosure of severely devalued assets, since they are conjuring most of the money they lend out of thin air (in other words, if they don't get most of it back, they're screwed). However, the money from the loan went to purchase something, no matter how dubious its valuation at the time of the transaction. Even though the buyer (and ultimately the lender, if it comes to that) realizes a loss, the seller received the money and presumably retains it, or passes it to someone else in another transaction. In any case, it seems there should be some kind of law of conservation of "money". Now, it also seems obvious that there is a distinction between "wealth" (or "value") and "money", and I can see how inflation could wipe out wealth while preserving the amount of money. But if we are experiencing deflation at the moment, not inflation, why do people constantly mention the $11 trillion (or 16 or whatever) of wealth that has evaporated? All that money that people spent on ill-fated CDOs or CDSs, or McMansions in Stockton for that matter, where did it "go"? If there are so many losers, why aren't there an equal number of winners so that spending remains the same. It is self-evident that spending is decreasing, but I would like to understand how and why. Thanks!
What if there was a system of 10 people each holding one $1 bill. And this system uses $1 bills and only $1 bills as money. What if 5 of these people did something stupid and burned their $1 bills forever so that there are only five one dollar bills in the system now. Suddenly the five with one dollar bills remaining are richer. They have something the other five don't. The five without one dollar bills are poorer. Now if any of the five that do have the dollar bill spend theirs, he will become poorer while the one receiving becomes richer. Therefore every party now has a natural tendency not to spend theirs and hide their money under a mattress.
I think the winners are other countries right now that have reserves of dollars. Our heavy importing and light exporting is finally having its effects. It's not really destruction of wealth, it's just a shift. We are all "world citizens" and should feel so "patriotic" that we are spreading our wealth around
As it relates to McMansions and stocks for that matter, keep in mind that it doesn't require very many sellers to diminish the value of an "asset". If 100 people own the same house "worth" $1,000,000 and one of those people sell their home for $950,000, the "value" of all 100 of the homes is now $950,000, not $1,000,000. The reduction in "value" creates a deflationary effect because there's less value to re-mortgage the homes with.
Money "conjured out of thin air" is leverage. The losses are real. Think of it like a margin account. Someone daytrades a security at 4/1 margin. The margin money comes out of thin air. If the security goes up it's all good. If it goes down there's a loss at $4 for each $1 put up. If the trader can't cover the loss, the broker eats it. Same for banks. In the good old days (pre 2002), banks required lots of collateral and ability to cover of the interest payments. Then they didn't and when the underlying asset price went down the banks had to eat the loss.
Good question. On housing wealth evaporation: Lets say you became a homeowner and bought a house. Your house appreciated due to the massive housing bubble. Lets say you then sold you house for a nice profit to someone who bought it using a subprime loan. You have then profited from this mortgage party. Say then the new owner is 200k underwater and cant afford payments so the exercise their contractual right: they default on the loan. Either the MBS holder, or party who is guaranteeing the loan (fannie mae) is the one left holding the bag. If the loan was owned by fannie mae, they might write down their loan portfolio 250k. The +50k is to cover the cost of carry and and selling expenses. The cost of carry is maintenance, utilities, taxes. The selling expenses are real estate agent costs, appraisal costs, etc. So you see what happens here? A single failed mortgage could cause a 250k writedown in the portfolio of fannie mae. Such numbers are added up and put on newspaper headlines that claim the housing crisis has cost 2 trillion or whatever. However, say you profited 150k by selling that appreciated house to someone who took out a subprime loan they couldn't repay. They money was simply transferred to you at the expense of bank of america, goldman sachs, freddie mae or ivy league endowment loaded up with toxic products.
another thing that happens is money dries up. People no longer lend or invest. People who need to sell must sell at a significant loss which deflates an asset. Those who are well capitalize hoard their cash which cause markets to dry up. It's a psychological effect in many ways. If a lender feels borrowers will default why would they lend? Therefore, no interest on capital. Also, spending will dry up because cash is king and people are afraid to spend because they may need access to cash quickly.
This is the key. Remember, money is created three ways: 1) printing of actual paper 2) monetization of government debt. (treasury sells new bond, fed buys it with cash it created. government now has extra cash it needs to pay the bills) 3) fractional reserve banking multiplier. This is the key to the above argument. If the reserve ratio is 10%, then $1B of money created by the fed turns into a total $9B money created by the banking system (ponzi scheme). Think of #1 and #2 as the Fed printing money -- and #3 the banking system's impact. Right now we see #2 fighting #3, and #3 winning for now (multiplier has shrunk). Money is destroyed when any of these three things go opposite. (destruction of currency, demonetization (fed selling bonds to take money out of the system), and decrease in the multiplier) #3 on the surface seems to operate on monetary velocity (money's turnover) as it does money supply. Large multiplier numbers promote increased velocity as long as lending is healthy. If reserve ratio is 1%, the ponzi scheme can lead to exponential money supply growth as well as promote turnover. If reserve ratio is 90%, then you get barely any turnover of lent money through the banking system. So when in #3 the banks are forced to writedown bad loans (which are assets on their books) by 50%, they still are obligated to maintain their reserve ratios. They must raise more money so the assets balance out their liabilities (deposits). ie, bank has 90B in assets that are written down to 40B, and a reserve of 10B. Total bank deposits are 100B. So they have 50B of worth against deposits of 100B. They are entirely insolvent if people want their money. As a result, they stop lending until they recapitalize (and because new regulations come in) sufficiently. This results in the multiplier number going down, thus less money created. Remember multiplier number is inverse to the reserve ratio. 10% reserve ratio = 10 multiplier. 25% reserve ratio = 4 multiplier. Look at: http://en.wikipedia.org/wiki/Image:Fractional-reserve_banking_with_varying_reserve_requirements.gif Imagine our money supply going from the blue to the red line. Thats just what happened. Now the fed is offsetting that. Now the clincher: we can't afford a deflationary depression unlike in 1929 as our debt levels are too high. So we will keep printing money until the recession/depression goes away at any cost. And thus the spiral begins. Either that, or somehow we give up medicare, social security, low taxes, and almost all defense spending in attempt to fix this. I believe they'll take the inflation route.