Wednesday, April 30, 2008

Federal Funds Rate to 2%

Today, the Fed eases the overnight rate to 2%, hopefully ending a striking series of sudden decreases throughout the past 8 months.

A little history: in 2001, following the bust, the Fed dropped rates from 6.5% to just under 2 by the beginning of 2002, and the low rates continued to ebb down to 1% by 2004—and during this time we see the rise of the now infamous housing bubble. Huge amounts of ridiculously easy credit was extended. Beginning mid-2004, there was a steady rise of rates back to 5.25%, which held between June 2006 to September 2007.

In late 2007 the Fed began to ease again, which accelerated as credit markets froze from subprime defaults—among other recessionary forces like costs of oil, and an economy exhausted of borrowing. The rationale for the freeze and the Fed attempts to loosen the economy will be detailed in later posts.

There is some suggestions both within Fed statements and "on the street" of a pause at this point. If so, I forecast the bottom of the dollar is near: in the cash value equation, inventories will rise as less is bought, and credit supply has nowhere to go but down.

Monday, April 28, 2008

Cash Model Synopsis

In prior posts I have constructed a model that accounts for the strength of cash in light of the upcoming recession. Here is synopsis of the “Cash Value Model” with references:

1. The value (V) of the dollar is determined by the value of all the goods dollars can buy (I), divided by the number of dollars in circulation (or money supply). The money supply is the sum of printed money (P) plus outstanding credit (C). Or: V = I/(P+C). Cash is a good investment if the value of the dollar rises (ref. a).

2. In the housing bubble, enormous credit was extended, thus increasing the money supply (ref. b). Now that credit is no longer extended at the same rate, money supply will contract through repayments that exceed lending, and through defaults (ref. c). Through all this, the amount of printed currency has not grown much (ref. d).

3. I anticipate the value of cash will rise as money supply dwindles due to the contraction of credit, while the amount of cash and the inventory value of purchasable goods remains about the same. So, in the above equation, as C declines, V increases.

4. The primary risk of a cash investment is a hyperinflationary event, where financial regulators try to bail out the incipient recession by printing enough currency to make up for the contraction of credit. Though they will almost certainly print some money, it will not be enough to stave off a deflationary recession. So they will have to choose between allowing a deflationary recession or hyperinflation (ref. e). Since many people have much of their wealth stored as debt, or bonds, payable in U.S. dollars, which would become worthless after a hyperinflationary event, the chances of that happening is unlikely—but not to the degree it can be totally dismissed (ref. f).

a. The Value of Money
b. Austrian Economics, Recessions, and the Dollar
c. Monetary Expansion and Fractional Reserves
d. Printing, Cash, and Credit
e. Why not “Muddle Through”?
f. Power, Inflation, and the “Reset Button”

Friday, April 25, 2008

The Value of Money

So far I have discussed money supply, and the sensibility of a deflationary recession in the event of a credit contraction. Posts have focused on the big picture; relevant details and errors of generalization will be handled in due time. Generalities for now will suffice to proceed with the thesis: mainly, the cash investor should keep an eye on printed currency and credit, and of the two, printing is the more worrisome.

In order to decide if cash is worth a lot or a little, it is necessary to determine its value. Modern economics regards the “value” of money in terms of its exchange rates against foreign currencies. I’d like to offer a complimentary definition based on the actual function of cash: buying goods.

I submit the value of money (V) is determined predominantly by two factors:

(1) it is directly correlated with the inventory of goods (I) available (e.g. if more goods can be purchased with less money to go around, that would increase its value; or if nothing can be purchased with a given currency, then it is worthless); and

(2) it is inversely correlated with the supply of money in circulation (if money is readily available it will be less precious, and vice versa). For money supply, as usual, I use the Austrian definition of printed currency (P) + credit (C).

So V = I/(P+C). The unit of value is goods per dollar. Sharp-eyed readers will notice this is the inverse of prices (cost per unit). Only scarce goods factor into the inventory—if someone wants to sell buckets of mud, more of that is available than is desired, so it can be had for free.

Now, the usual definition of inflation is a general increase in prices, and deflation would be the reverse. (Similarly, we could invert this and define inflation and deflation in terms of cash value.) The problem either way is that price changes (and their inverse) are affected by many factors—e.g. availability, cost of production, and changing preferences over time—such that any conclusions one can draw from prices about monetary policy are at best vague. Prices of commodities (i.e. wheat and oil are going up lately) behave differently from assets (e.g. houses and stocks are even or going down), and the prices of services is driven by different forces still.

The Austrian school defines inflation as an increase of the money supply, and deflation is a decrease. This is right; the common definition is wrong. Prices are a function of inflation and deflation—not the reverse, since prices are also a function of inventory, which is unrelated to money supply.

Tuesday, April 22, 2008

Price Fixing

This post is intended to offer a little theoretical basis on the folly of price fixing by the Fed, if it wanted to keep asset prices stable. What would happen if the Fed wanted to use monetary policy to keep houses selling at their bubble peak values?

I’m going to build a model that begins with extreme simplicity and then adds layers of complexity as we go. Say the only thing for sale is McMansions, and the Fed wants to keep them all fixed at a million bucks a pop. For now, in this simple example, the inventory of McMansions stays the same month-to-month.

The cost per McMansion is directly proportional to the money supply, and inversely proportional to the number of McMansions. Money supply is printed currency (P) + credit (C); divide that by inventory (I) to approximate the cost per unit ($).

So: $(McMansion) = (P+C)/I. A shrinkage of money supply puts a downward pressure on prices ($). Alternatively, if the desirability of McMansions falls and puts a downward pressure on prices (with money supply constant), then some go unsold, and inventory tends to increase. To price fix, the ratio of money supply to inventory has to be kept constant.

As credit grew over the past few years, McMansions rose from $500,000 to a million. If nobody is borrowing anymore, the money supply/inventory ratio must be kept constant—so cash (P) has to be printed to make up for diminishing credit (C). This keeps the money supply even, and therefore the ratio of money supply to inventory is fixed.

But some McMansions will be in better locations, or some will have more granite countertops than others, or big screen TVs, or whatever. There will be variances in prices. To keep them all fixed, we can still consider the ratio of money supply to the sum of the variably priced McMansions. Each McMansion in the inventory denominator can be weighted in terms of its bubble peak price divided by that of the average McMansion, and all of those weighted McMansions can be summed, and the ratio of money supply to inventory still holds for each given unit. If the Fed can replace lost credit—either through easier credit than before, or printing cash—it can fix variably priced McMansions similarly to ones that are all priced the same.

Say heating bills increase, and McMansions are seen as a silly purchase to begin with, their desirability drops. People just aren’t buying them like they used to. As the inventory denominator of the ratio grows, so must the numerator. Now, not only must the Fed replace lost credit with printed cash (or really easy credit), it must create more money to keep the numerator proportionate to the expanding inventory denominator. If the inventory doubles, you have to double the money supply to keep prices fixed.

Say McMansions are only half the economy, the other half is oil and wheat, whose prices are rising. Since money supply, at a given moment, is a finite number, what is given to oil and wheat is taken away from the McMansion budget. McMansion money supply shrinks. So to price fix, the Fed must compensate that shrinkage. Say oil and wheat rise so high they now consume 75% of spending, then only 25% of the general budget is left for McMansions. To price fix, the Fed has to double the money supply, and if people are tired of borrowing easy credit, or they’ve borrowed all they can pay back, that means printing.

Bottom line, if the Fed tries to fix prices, invest in oil and wheat.

Monday, April 21, 2008

Lucky Sevens

The Midwestern National City bank will be getting a $7 billion infusion, which seems to be the lucky number when it comes to multi-billion dollar private bailout packages. The name of its rescuer, Corsair Capital, doesn't sound wholly reassuring, but no doubt their money is welcome. Bank of America is projecting a net income decline of 77%. BOA had been weathering financial events so far with aplomb but this latest news seems to have spooked Wall Street a little. Both their credit card and mortgage divisions are under stress, and CEO Kenneth Lewis looks like he's seen better days.

Saturday, April 19, 2008

Financial Sector Layoffs

I don't plan to report every time stock prices fall, or dividends are cut, or there is some shift in policy within otherwise solvent corporations, but cutting 12,400 jobs (this week alone, more in the past, and almost certainly more later) from Citigroup, Merril Lynch, and Wachovia seemed significant enough to mention. The article implies the cuts are directed at highly paid professionals on Wall Street, rather than, say, janitorial staff at local branches, but time will tell. If so, one wonders how long this bear run in Manhattan real estate is going to last.

Friday, April 18, 2008

Why not “Muddle Through”?

Mises said credit bubbles are resolved through deflation (where prices drop) or hyperinflation (where monetary value drops). But can’t there be a middle ground, where asset prices only drop a little, and the dollar is only modestly devalued?

In “muddle through,” growth proceeds until asset prices at the end of a bubble are no longer such poor investments. The economy catches up to where assets again generate reasonable dividends in accord with their cost. (For houses, that means rents would be comparable to mortgage payments. After you factor in property taxes, insurance, maintenance, and the possibility of vacancy—even treasury bonds of late have been a better investment than a house. Given the risk, effort, and extraneous costs involved, houses should outperform treasuries to be a rational purchase; so rents must increase considerably.) Since muddle through requires growth, albeit slow, it is not possible during recessionary times.

Normally, once the peak of a bubble is reached, asset prices deflate. Alternatively, regulators can try to keep prices high by devaluing the dollar, such that (hopefully) wages increase, and spending increases, and rents increase, to the point where it makes sense again to buy instead of rent. This is perhaps a nice compromise—at least for those who do not want to cede the high price of their house. Certainly it may be desirable for some, the question is, is it possible?

Right now, regulators are trying to mitigate the natural course of deflation by increasing liquidity, so people can borrow easier and buy more to stimulate the economy. But this isn’t working; we are in a system now that is “credited out.” People aren’t borrowing, and banks aren’t lending. We are at “zero hour,” where further attempts to inject credit into the economy no longer benefit GDP.

In that case, printing becomes the only option to increase money supply. If you print a little bit of money you get inflation. If you print a lot of money, you get hyperinflation. Will printing a little bit of money be enough to prevent the incipient deflationary event from the credit bubble? This is a judgment call, but I believe the credit bubble is too big to be corrected by a small amount of printed cash. Rather a massive injection of currency would be needed to keep bubble peak prices afloat. If so, the only ways to resolve the bubble would be deflation or hyperinflation.

Almost certainly, regulators will try to split the difference between asset depreciation and dollar devaluation, so whether such would be possible is a hypothesis that will soon be tested. If this fails, regulators will choose deflation over hyperinflation.

Tuesday, April 15, 2008

Government Debt: Endgame

In examining government debt, I will consider again the distant risk of hyperinflation, before (in the next post) presenting a scenario of moderate inflation.

Excessive government spending offers plenty of reason to worry the cash investor. But as it chugs along and treasuries are floated, it has no effect on money supply. Rather, capital is simply shifted from private enterprise to government. If you buy a treasury security, cash is briefly lost from the economy when the bond is purchased, and the same amount is reintroduced when the government spends it to pay interest on the debt and fund its services. If the government were to print a treasury bill as direct payment, the recipient is being paid cash over time rather than getting a lump sum right away. Either way, money creation and fractional reserves are unaffected. That is, up to the point where the government can not afford to borrow any more.

The theoretical upper limit of government borrowing is when interest payments on its debt equal tax revenues. When that limit is reached, some tough decisions will need to be made. When the interest payment on the debt equals tax revenue, the government has the option to: (1) increase taxes, (2) default, (3) print money, or (4) cease to exist.

As much as they can, politicians will raise taxes to expand the amount of interest government can afford and debt it can accrue. After that, the only realistic solutions are to default on debt, or print. Defaulting goes something like this: one evening the president comes on TV and says “We are the U.S. government. We are not going to honor our treasury bonds anymore, and since we used your money to build the most powerful military in the world, you can’t make us.” Alternatively, the government can direct the Fed to crank up the printing presses, and pay off its bonds with quickly devaluating dollars. In a situation where the government is facing default, the printing presses would be a worrisome option.

So this is a scary scenario for anyone invested in the dollar. On the one hand, you have banks and private bond holders invested in a lot of debt who want to keep the dollar strong. On the other hand, you have holders of treasury bonds who want to be paid. Each group is represented by the wealthy and powerful. To the degree this financial elite can influence the favors of politicians, the government could go either way—choosing to default on its debt, or print. But if the government prints, then all money disappears for both Treasury bond holders AND other lenders, and so the only real option would be to default. That means nobody buys U.S. Treasury Securities anymore, and our government has to live within the means of its tax base.

As always the holder of cash has to monitor the amount of money being printed, or any changes of patterns. Overall, I think this scenario is a ways away.

Monday, April 14, 2008

$7 Billion for Wachovia

More capital infusion into the banking system. This time for Wachovia, from selling new issues of common and preferred stock. Today's $7 billion follows another $8 billion from January. This may relate to their questionable $24 billion purchase of Golden West in 2006, an Oakland-based mortgage lender. This sort of news underscores solvency problems, which is bad for banks and bad for lending, but I anticipate is good for cash.

Thursday, April 10, 2008

Power, Inflation, and the “Reset Button”

Proverbs 22:7: "The rich rule over the poor, and the borrower is servant to the lender."

Inflation is the natural enemy of cash. Hyperinflation is a nuclear strike on your bank account; though it is unlikely to happen, those long on cash ought to be wary. In any case, it will be a necessary concept when it comes to discussing the middle ground.

If as Mises says, at the end of a credit bubble, policy makers must choose either deflation or hyperinflation, the latter would be hitting the reset button on the economy. The system would have to start again from scratch by recreating a money supply that has value. All existing debt is effectively erased by hyperinflation. So… who wouldn't want to hit the reset button on the economy?

Those who benefit from the “reset button” would be people heavily in debt, like with large monthly mortgage payments. The government is heavily in debt too, so does it want to hyperinflate? No. The “government” is not a thinking entity with no motivation of its own and so does not care or is even cognizant of the amount of debt it owes. Rather, the “government” is a system of many politicians that decide on laws and how tax dollars are spent. So would the body of politicians want to hit the reset button on the economy ever?

One cannot speak for all politicians, and every politician has complex motives that drive him or her. They need to keep their electorate pleased, as well as keeping their contributors happy. That is just the reality of politics, the game that every one must play. Thus, we live in a mixed democracy/plutocracy (each at odds with the other), where the wealthy and powerful have a disproportionately greater say over political affairs than the common voting citizen.

Say 51% of the electorate has a toxic mortgage, and want to pay it off easily with hyperinflated currency and hold title to their house almost free. Does that mean the government will start printing away since it benefits a democratic majority? Probably not.

In terms of whom our financial regulators see fit to benefit, not everyone is created equal. In a recent example, we see the Fed has overstepped its authority to bail out Bear Stearns bond holders. Conversely, we see no concern they have for Bear Stearns share holders whose stock values plummeted from about $30 to $2 as a result of Fed action (it settled at $10). In essence, we have an example of the Fed using its regulatory power to benefit debt (bond) holders over asset (stock) holders. The key for us outsiders is to guess who or what it is the Fed will be treating preferentially with their regulatory measures, and invest accordingly.

But say the reset button is hit. Say the Fed rev’s up the printing presses full power. Treasuries are zero’d out. Mortgages are zero’d out. Superbowl bets that haven’t been paid up yet—those are zero’d out. Those who owed more money than they possess are happy—they are now richer, having no money, rather than debt. Those who have lent out money would be displeased, since they have lost what was owed to them. For every dollar borrowed—by government, businesses, or individuals—there is a bond holder somewhere expecting to be paid back.

Now, of the two, of borrowers or lenders, who would it be that contributes to politicians campaigns? Who would have the most say over the direction regulators take?

Citigroup's $12 Billion

In an echo of recent news for Washington Mutual, Citigroup just received $12 Billion cash from a sale of loan assets. Sort of.

It sounds like a mortage backed security what they did, except this wasn't for subprime mortgages. It was a rather messy sale: loans were sold at 90 cents on the dollar, then Citigroup agreed to accept the first 20% of loses, should there be loses, AND Citigroup helped to finance the deal. That does not sound like a strong bargaining position. Nor is this the rabid securitized debt market of years past. On the other hand, $12 billion is a lot of money for what may be toxic waste.

Tuesday, April 8, 2008

$7 Billion Cash for Washington Mutual

Though mainly, on this blog, I am developing a model that analyzes the value of cash, and arguing that the upcoming recession will more likely be deflationary than inflationary, there will be times for interjecting significant news stories. This latest one is a $7 billion infusion of capital into Washington Mutual, a Savings and Loan, and a major player in recent subprime mortgages. In part it illustrates concerns around fractional reserve lending (see post below).

Washington Mutual devalued existing shares in order to get the cash it needed to stay afloat. It was losing its capital base from subprime foreclosures. When it lends it can leverage its capital base by a factor of 9 (with 10% fractional reserves), but when a loan defaults, that full amount is deducted from its balance sheet (mitigated by what the bank can get from selling the house).

Though the extra cash is good news for Washington Mutual, and anyone who does business with them—it is good news only in that Washington Mutual is barely staying afloat as opposed to collapsing from bad loans. It is mixed bad news for shareholders—though their shares are declining and dividends evaporating, at least they aren’t becoming worthless. It is good news for those who paid the $7 billion—they are probably getting a good deal on a sizable piece of the bank.

Lately, this is what is considered “good news” in finances: not prosperity, but either hanging on by your fingertips, or buying troubled assets for cheap. This is a deflationary event, and if it recurs enough we face a deflationary recession.

Monetary Expansion and Fractional Reserves

Any increase of money supply is of concern to the cash investor, as it can cause inflation. In prior posts I mentioned the two factors that constitute money supply: cash and credit.

I also argued a recession would be typically deflationary if it corrects a credit expansion, since (1) after the event people would have to pay back what they borrowed, and that leaves less money for them to spend; (2) if loans do not originate as quickly as they are paid off, money supply diminishes through the contraction of credit; and furthermore (3) any defaulting on debt would shrink the capital base of banks, and therefore decrease the money supply created by fractional reserve banking.

Now, if you lend someone cash that you have, it doesn’t increase the money supply because the amount of cash in the system is still the same. But banks are allowed to lend out more than they have in deposits, through fractional reserves. If regulators say they need to have at least 10% in reserves, then with $1000 of your savings, the banking system can issue a series of loans up to $9,000. [Basically, the bank takes your $1000 and lends $900 ($100 must be kept in reserve), and when that is re-deposited in another account in another bank, $810 is lent (with $90 in reserve), then $729 ($81 in reserve), etc. which when all loans originating from the initial deposit are added together approaches 9k; with a thousand in reserves].

Mostly, this works out okay for banks. In effect, it can add up to nine times cash deposits to the money supply, which remits as debt is paid off. But if banks lose their capital through defaults, the fractional reserve credit lost will be nine times the capital write off, and money supply shrinks.

So, for every dollar deposited in a bank, that is $9 added to the availability of credit. For every dollar lost by the bank to defaults, that is $9 removed. Are fractional reserves a bad thing? There is some risk in the event of many defaults, but I don’t lose sleep over it. However, it will be relevant for points I raise later.

Saturday, April 5, 2008

Printing, Cash, and Credit

Cash is going to be worthless because the government is printing money like crazy. Just look at all the inflating prices each time we go to the supermarket, or pump gas.

Not! Such would be a misconception, one not uncommonly espoused in some form or another on the blogs. The rate of printing over the last few years has been less than historical patterns (meet FRED). So what gives? What accounts for huge increases in sales and prices of residential real estate, commercial real estate, and stocks?

That would reflect the monetary expansion from credit, which is distinct from currency. In other words, there can be a huge expansion of credit, without necessarily printing any currency, or the banking system can print a lot of cash without extending any credit. Either way, or in any combination, money is injected in to the system. Credit has greatly expanded over the past few years, while the creation of base money, as the FRED graph shows, has been decelerating.

Credit may feel a lot like money, in the beginning. It’s easy to confuse them. You can spend it like cash, and so people who borrow a lot are probably feeling pretty rich when they first get it. Over time, however, credit reveals itself to be very different. Once it is spent, it becomes a liability that you have to pay back. Very often sensible adults see the acquisition of credit as prosperity, rather than liability. Just look at Japan.

So, just because there has been a recent expansion of the money supply does not mean it came about by printing. It could have, and did, come from credit originated by fractional reserve lending.

So long as base money continues to hold about even, the fallout from the credit bubble will be deflationary as asset prices correct to their fundamentals.

Wednesday, April 2, 2008

Austrian Economics, Recessions, and the Dollar

If you are investing in cash itself, rather than assets or commodities, you are betting that price of the goods and services money can buy will decline in the future. The Austrian School of Economics explains this well.

The Austrian School is an economic theory that arose in Austria around the time of the Weimar Republic. Its best known writer is Ludwig von Mises, most known for his general work on economics, Human Action (1949). It is worth a read if your investments are mainly in dollars, or want a contrarian viewpoint for weathering the upcoming recession. With the rise of the Nazi’s, most Austrian-school economists moved to America, and its hub is now situated in Atlanta, Georgia. Generally, its focus is pro-free market and anti-regulation of any sort. Mises argued that any and all government regulation of the economy benefits one group of citizens at the expense of another, and so is unfair except for necessary government services. Whether necessary or not, it introduces economic inefficiencies into the system, through tax burdens. This is a point I plan to return to over the course of this blog.

The theory is useful for explaining credit bubbles, which have been recurrent in history since at least the beginning of central banking. (Consequently, Austrian economics is highly critical of central banking, advocating for a gold standard instead.) Reading histories on the subject e.g. Extraordinary Popular Delusions and the Madness of Crowds (1841) by Charles Mackay, they all repeat similar patterns.

Here is how it works: during times of easy credit, investors will borrow cheap money (at artificially low interest rates) to invest in higher-paying asset-based investments. Thus asset prices will rise due to demand. Then people borrow more money to buy assets expecting profits through capital gains. In short order, speculation gets carried away, to the point where the speculative cost of assets is far, far higher than its value in generating dividends. Recent examples have been the Internet bubble and the housing bubble.

According to Austrian Economics, there are only two ways to resolve the recession that follows a credit bubble: deflation, or hyperinflation. There is no middle ground-- there is no “muddle through” with moderate inflation, which just delays the price correction that must follow. Deflation of asset prices will occur if the market is left alone. The only way to stop deflation would be to “hyperinflate,” which means printing currency to pay off bad debt and keep asset prices high. History has examples of both deflationary recessions (i.e. The Great Depression, or Japan 1990’s-current) and hyperinflationary recessions (i.e. Weimar Republic, or Zimbabwe).

Since printing money is easy enough, it is the decision of our politicians and regulators which route to take. If they do nothing, deflation will occur. Hyperinflation will occur by printing the amount of money necessary to offset the impending deflationary event. This makes investing in the dollar rather exciting during the collapse of a credit bubble. With deflation, the value of the dollar will increase and cash becomes a good investment. With hyperinflation, the value of cash goes to nothing and it is a horrible investment. Making the right guess as to which way our regulators will choose to go will be critical to making the right investment.

If you invest in the dollar, you are absolutely betting this recession will be deflationary, and not hyperinflationary, and not even inflationary “muddle through.”