Sunday, August 24, 2008

The “Inevitable” Decline of Fiat Currency

Mises wrote that all fiat currencies eventually end in hyperinflationary events, and since this is always going to happen, he concluded that money should be based on a gold standard, which cannot be hyperinflated at policy maker's whims.

If one considers that all things eventually come to an end, that is, all nations eventually fall, and that nothing lasts forever, then I suppose it is true that the dollar will one day collapse in an inflationary spiral. But does it have to be that way? I posit that neither inflation nor hyperinflation is an economic necessity, but rather a choice made by those who regulate the supply of printed currency.

I’d like to reconsider the idea in light of the cash-inventory equivalency, where the worth of all goods for sale in an economic system equals the money supply. Previous posts have supposed that inflation results from (1) an increase of money supply; either that or (2) a decrease of the inventory of goods for sale (in other words, increasing scarcity). Either would tend to cause general price increases, and their reversal would put downward pressure on prices. Now, neither one of those conditions absolutely has to happen. Therefore, inflation need not be considered a given.

The amount of printed currency is under the control of those who print it. The amount of inventory is under the control of those who produce it. Either one could fluctuate over time, such that the cash to inventory ratio could either increase or decrease. Thus there is no inevitability that fiat currency has to eventually become worthless if those who produce cash wish it not to be so. Cash value could simply cycle up and down over time. (I'm leaving credit out here because its effect on money supply is temporary; it increases money supply when lent, decreases money supply when paid back, and its net effect over time is zero.)

Now, the banking industry, who regulates money supply through the Fed, does seem to prefer some inflation. Whatever reason that is would be their own, but I suspect it keeps the credit machine lubricated, and makes people more likely to take out loans because they anticipate rising prices down the road. Taking on credit to avoid higher prices later encourages borrowing, thus banks profit. But even mild inflation if held constant at say 2% will eventually follow a hyperbolic pattern skyward leading to hyperinflation.

The wealth of the banking industry comes from debt payable in U.S. dollars, and so I argue they, in taking the pathway of greatest profitability, would stop the policy of mild inflation before it reaches hyperinflationary proportions.

And so, fiat currency does not have to decline, inflation is not inevitable, nor is it the motive of those who produce currency for it to become worthless. Inflation happens only as long as it serves the interest of those who print the money. So long as the banking industry has control, hyperinflation is never in their interest.

Friday, August 15, 2008

Dollar Days

Since mentioning a small spike in the dollar relative to the Euro when the ECB kept their rates fixed, the dollar has enjoyed a little rally over the last week. It has actually been pretty sharp. It has also rallied against a number of commodities, notably oil and gold. Oil and metals have fallen in price, or put another way, the dollar has risen in value against commodities. For several months now it has been rising in value against assets, namely stocks and real estate.

Even though this blog forecasts the strength of cash as we proceed into the recession, I’m not overly excited by this news. It smells more of panic and markets running wild than an actual trend. If, however, this continues over the coming months, and the prices of commodities stay low or even fall further, and the turmoil now seen in credit markets does not resolve with recent action by the Fed and Treasury Department, it would lend support to a running theme of this blog: that the value of the dollar is decoupled from the health of the credit markets, and even more than that, is inversely proportional.

Saturday, August 9, 2008

Credited Out

Before I sound too much like a broken record posting a litany of pessimistic news from the financial sector, I just want to say there is method to the madness. It does relate to the value of the dollar.

To recap, I have argued the value of the dollar will rise as the amount of credit in the system falls. In support of this, I proposed that the inventory of available goods for sale is exactly equal to the money supply ("the cash-inventory equivalency") except for errors of pricing, which are common but equilibrate over time. I also accept the general notion that money supply is the sum of printed currency plus outstanding credit. So, in short, as credit declines, then total money in the system declines. With less money in the system, prices have to fall to capture the rare cash that is left, else increasing inventory goes unsold. In this way, the value of the dollar increases with the demise of credit.

Now, recent legislation has promised us endless liquidity, in the form of credit, originating from the U.S. tax base—at least as far as houses are concerned—with the bailout of Fannie Mae and Freddie Mac. They buy or insure a sizeable percentage of all mortgages in America and as of July 30, 2008 have an unlimited stream of capital from the Treasury Department to accomplish this. So, would this keep credit high? Would this allow the pattern of borrowing and spending so characteristic of the first half of this decade to continue unabated?

There will come a day where banks are unwilling to lend, and borrowers cannot or will not take on more debt regardless of how favorable are the terms. This is the point where the system is "credited out."

Now, credit expands when it is lent out by banks and contracts when it is paid back or defaulted on. If terms were made so favorable that much of the credit capacity of the system was lent between 2001-2006, then subsequent years will no longer see anywhere near as much credit shoveled in to the economy. Worse, incomes will be consumed by paying off debt. So, where before the economy was flush with easy money, soon it will be starved with debt repayment. Where there was once free-flowing credit to boost incomes and lubricate consumerism, soon payments on interest and principle will squeeze out sales of all but the basic necessities.

The backlash of the credit mania is nigh, and the repercussion will be felt for years. The only solution is not to get into this mess in the first place.

Thursday, August 7, 2008

ECB holds at 4.25%

The European Central Bank held rates steady today at 4.25%, a whopping 2.25% higher than the current rate from the Fed. One can admire their inflation fighting tenacity, however a small rise in the dollar against the Euro suggests markets think Europe is too much on the cusp of a recession to be playing that game. I think I am not alone in believing we can anticipate rate drops in coming meetings.

Bank Shares Continue to Fall

It is no secret the precipitous fall of major financial stocks—investment banks Lehman Brother's and AIG are mentioned in this article—but the growing willingness of banks to abandon the values of their shares (e.g. Washington Mutual and Freddie Mac) in the anticipation of government bailouts can't be helping any.

Citi, Merrill Forced to Pay Delinquent Paper

This article sheds a little light on the collapse of the commercial paper market earlier this year, which caused the Fed to intervene with TAFs, TLSFs, and PDCFs as taxpayer sponsored sources of emergency capital for the banking system.

Apparently, banks simply stopped paying back auction rate securities when they couldn't find new cyclical buyers from the private sector, and since these bonds are regarded as very safe places to store money, naturally the market collapsed.

Regulatory forces have directed Citibank to reimburse small investors $7.3 billion—and there is more with institutional investors not covered—plus a $100 million fine. Under the gun, Merrill Lynch is paying back $10 billion to small investors, again with more due to institutional investors, and Bank of America is being subpoenad.

The article states auction rate securities are a $300 billion market, and indeed, that is about the combined value of TAFs, TLSFs, and PDCFs. This rotating source of low-interest capital has now been subsidized by government so it only makes sense that the private investors be paid back from when they were left holding the bag.

ADDENDUM (8/8/08): Today UBS is similarly on the hook for $19.2 billion, and a $150 million fine. (8/11/08): Add Morgan Stanley to the list for $4.5 billion. (8/15/08): Wachovia agrees to pay $9 billion, and the Attorney General's office of New York has decided Merrill's agreement to pay $10 billion was not enough and needs to pay more. (9/12/08) Fidelity, the seller of asset backed securties, takes a $300 million hit.

Wednesday, August 6, 2008

Freddie Slashes Dividends

So the dark underbelly of the GSE bailout is beginning to take shape. Though the winners haven't fully emerged yet, we are seeing the losers in Freddie Mac, who slashed stock dividends from 25 cents a share to 5 on the report of ongoing and worse loses than expected.

If Freddie Mac were subjected to free market forces, at this point, this would be the death knell. Raising capital would be impossible, which would cause the company to fold. However, now with the Treasury Department willing and able to buy as many shares as it wants to, at taxpayer expense, Freddie Mac is no longer beholden to performance standards. It's throwing the value of the stock out the window. Shareholders in Freddie Mac are screwed.

As with the Fed's bailout of Bear Stearns, stockholders are cast aside. It is the bondholders being rescued here, at stockholder and taxpayer expense.

Despite the stated intention of the legislation to keep house prices unaffordable, my guess is the correction will continue unabated.

ADDENDUM (8/8/08): Over the past couple days Freddie Mac reported an $821 million quarterly loss, and Fannie a $2.3 billion loss for the quarter, both with dividend cuts. Whispers are starting to be heard of reduced mortgage purchases and insurance as the GSEs go defensive with their capital base.

Tuesday, August 5, 2008

Fed Rate Stays at 2%

In a move that seems to have gotten Wall Street excited, the Federal Reserve Bank holds overnight interest rates at 2%.

Judging from recent news stories, inflation fears seem to be subsiding, so pressure to increase rates is low at this point. Prices are already dropping in the asset classes (i.e. stocks and houses) and I predict will continue to fall throughout the general economy under supply and demand forces as we progress further into the current economic downturn. In time I anticipate wholesale deflation across the board.

Our financial industry is now subsidized by hundreds of billions of dollars of taxpayer-sponsored capital for banks and investment banks—in the form of TAFs, TSLFs, and PDCFs—at rock bottom interest rates disconnected, as best I can tell, from the Federal Funds Rate. But the low rate will keep adjustible rate mortgages low such that struggling homeowners can continue to struggle. Consequently, interest on capital supplied to banks (increasingly by government) has to be kept low. A low overnight rate also keeps interest rates on deposits low, so what savings are left in the system receive lower interest payments from banks.

The 2% interest rate no longer exists to entice more borrowing and consuming by the American public. Those days are gone. Interest rates are now suppressed to keep a flailing financial industry on life support. Wall Street's enthusiasm is misplaced.

Saturday, August 2, 2008

The Housing and Economic Recovery Act of 2008

On the heels of Fed's expansion of emergency liquidity for banks and investment banks, the Housing and Economic Recovery Act was signed in to law on July 30. Between the two, taxpayers are insuring at least $700 billion worth of struggling debt, which could easily expand to a trillion depending on the needs of the GSEs. If all goes well, all that debt will be paid back so taxpayers will hardly be liable for anything. However, all things considered, particularly factoring in all the news over the past 6 months, anticipating a worst case scenario is not insensible.

Cost-wise, The Housing and Economic Recovery Act has two major elements: one involves the long-anticipated mortgage bailout; the other the sudden government subsidation of Fannie Mae and Freddie Mac in response to the collapse of their stock values last month on general suspicion of poor capitalization.

The mortgage rescue part of the bill ("The HOPE for Homeowners Act") offers $300 billion of mortgage insurance through the FHA. If the bank servicing the mortgage is willing to refinance it to 90% of the current appraised value as a fixed rate mortgage, the FHA will insure it. Whether either banks or homeowners accept the proposal are "ifs" because they both turned down the conditions of the Bush bailout plan of a few months ago, prefering to foreclose instead. These provisions will be in effect starting October 2008 through September 2011. The ceiling for refinanced loans is $625,500.

The part relating to GSEs ("Treasury Emergency Authority") allows the Treasury Department to purchase common stock and debt securities issued from GSEs. There are no limits to what the treasury department may spend, and seemingly little direction on how it is spent. Essentially, I believe, people who hold securitized bonds in Fannie Mae and Freddie Mac may now consider these bonds federally insured, at least until the authority expires on December 31, 2009. GSEs may continue to purchase mortgages with needed capitalization supplied by the treasury department.

There are numerous other aspects to the bill, but they pale in comparison. One of particular note is raising the U.S. Debt Ceiling to $10.6 trillion. Last I looked the national debt stands at around 9 trillion. I didn't know there was a national debt ceiling, but it also appears easy enough to raise at congresses convenience.

It is not uncommon for expensive legislation to propose an agenda of social justice, while the middle class is taxed and the wealthy and powerful are the beneficiaries. Coming posts will critique the bill in this light.

UPDATE [12/30/08]: While a major piece of legislation back in August, five months later the Hope for Homeowners Act has fallen in to obscurity with all the subsequent bailout legislation. There have been 321 mortgage applications for revision, and not one of them has been approved.