Thursday, February 26, 2009

Obama's Bubble Budget

In a time of "hard choices" and a "new age of responsibility," Obama's budget proposal is more excessive spending. A lot more.

Some highlights: it totals $3.55T, and it leaves the country with a record deficit of $1.75T, almost four-times the prior record of $455B under Bush. Shockingly, another $750B is earmarked for bailing out failed financial institutions. Then an additional $75B in war spending... excuse me? Is joining the military the solution for unemployment? It speaks of "medicare savings" while pouring $634B into a universal health care proposal. It proposes tax increases for the wealthy, but it should be obvious our grandchildren will be paying for this. At least the middle class will get a $400/year tax cut.

Republicans, your time for a comeback has arrived.

Tuesday, February 24, 2009


I open Google News today, and the economy is getting top billing all the way around. Housing data from December is coming in deadly, Bernanke continues to testify in favor of aggressive Federal Reserve interventions (it's a good read), and Obama is set to give us a "sober assessment" of the economy tonight.

Obama's Stimulus has just passed, which I suspect will mainly bailout the states; and a third round of mortgage revision attempts is in the works, with the prior two having completely failed—and the DJIA yesterday closed at 50% off peak. Citigroup and Bank of America are talking of being nationalized, and AIG is coming back for more bailouts still.

The problem, and the only reason why any of this is newsworthy, is that the peak of the bubble is regarded by politicians and maybe most Americans as the normal state of affairs. Once we shake that psychology, and regard economic events through 2006 as highly out of equilibrium and driven by the mother of all credit bubbles, we can all adapt to where this economy is going, adjust our expectations, write off what needs to be written off, and look forward again to prosperity once the correction is complete.

Friday, February 20, 2009

Goodbye 8000?

The DJIA seems to have been sitting comfortably in the 7000-range this week. The last time we saw major movement was right after the TARP was signed in October—when it collapsed from the 10,000s to around 7500. It recovered into the 8000s—where it has magically hovered since despite an endless onslaught of economic contraction and pessimistic financial figures. The signing of Obama's stimulus package may have finally broken the 8000 barrier as the DJIA sank deep into the 7000s this week, seemingly without much energy to reverse course.

Thursday, February 19, 2009

Lost Credit

In a follow-up to my commentary posted earlier today on Mish's post regarding the weight of credit on money supply—and building on the concept of "lost money" from before (or why the recent doubling of base money has had little upward pressure on prices)—this post will develop the parallel concept of "lost credit."

Lost money refers to base money that should not be counted toward total money supply because it is not being spent and not participating in the economy. If the Fed printed a trillion dollars and stuffed it in coffee cans, and bury it, then those newly printed dollars have no effect on the economy and shouldn't be counted until the point they are found and spent. Similarly if the Fed generates nearly $1 trillion in base money and distributes it to banks where it just sits in bank reserves, it is "lost" to the economic system.

Now, Mish's article estimates $40 trillion of credit in the private market. That this came about in a fractional reserve system allegedly set at 10%. With less than $1 trillion in base money before last September, there shouldn't really be any more than $9 trillion in outstanding credit.

I have no doubt there is more than that, and I have no reason to doubt the $40 trillion figure. So here I will present an argument that much of it shouldn't be factored in to the active money supply, regardless of its market value.

Say I take out a $1M loan to buy a big yacht. Not knowing how to sail, I sink it a week later. Say I didn't buy insurance, and I declare bankruptcy. $1M has been moved from the bank to the seller; the seller still has the money, but the bank has no chance of getting it back. Luckily, for the bank, they packaged the loan and sold it as a security before the boat sank. They recouped their $1M + fees before the security became worthless. The fiat fractional reserve money supply is completely unchanged: the seller of the yacht is spending away and the bank can still lend freely. I'm just out a yacht but I didn't pay much for it either (assuming no down payment). The person screwed is a buyer of that security whose wealth is now irrevocably gone with the boat sitting at the bottom of the ocean. The person who bought the "security" faced the full burden of the loss of wealth.

So, that toxic security would still be added to the amount of outstanding credit until the bankruptcy hearings are finalized. In this case, it's market value would be $0. But that credit no longer plays a role in the money supply. The person who bought the security became the true owner of the boat and I sank it. Even if I didn't sink it, that credit is no more a part of the money supply than is an unpaid Superbowl bet between friends. It is a loan between private parties disconnected from fractional reserves.

It's "Lost Credit." Regardless of its value, toxic or not, securitized debt should not be added in to the money supply.

A Closer look at Credit

In Fiat World Mathematical Model by Mish published earlier today, which is an engaging article, he takes the well-known equation in Austrian Economics, that money supply (M) is the sum of printed currency (P) and credit (C), that I've repeated over and over here, and expands on it. He evaluated credit with a multiplier (v) to get the market value of the credit, rather than the absolute value of the credit. So, fiat money supply in a fractional reserve system would be the sum of printed money and what the credit is worth, not what is owed. Using my notation for money supply, we have: M = P + v(C), where v(C), is the fraction of outstanding credit that is likely to be paid back or recovered in a foreclosure. If all loans are good then v is 100%.

I think it is a good estimation, but I have two critiques: first, in a world of fuzzy accounting and bailouts, market value is hard to estimate. Also, money brought into reality though fractional reserve lending, does not simply disappear if the buyer forecloses (say he buys a boat and sinks it the next day, then declares bankruptcy), because the seller still has the money and is buying things with it, and the bank's balance sheet would still face the same restrictions in the short run regardless of whether the buyer forecloses the next day or makes gradual payments over 20 years. Bad credit restricts money supply not because its securities are toxic but because the banks are restricted from lending due to poor income.

What the post points out well is there seems an unacceptable lag between money supply, which remains very high with outstanding credit, and the buying power of the economy.

Also in the article is a welcome estimation of the amount of outstanding credit in the private sector. I'm not sure what is backing up this number or how it was calculated, but the graph shows it to be 4 x 10^7 in millions, or 40 million million, or about $40 trillion.

Wednesday, February 18, 2009

Obama's Mortgage and Toxic Asset Rescues

Next on the launching pad is a $75B proposal to assist in a voluntary program by banks and borrowers to modify mortgages (summary of the terms here). Deja vu? This requires no Congressional approval; it will be coming from the TARP money. The Treasury Department will also expand support of Fannie Mae and Freddie Mac to $400B in purchase of preferred shares, up from $200B. I'm presuming this comes from the remaining TARP money. There was $320B available when Obama took office. By my math that is $45B left.

Obama's Stimulus

The $787B stimulus package has been signed in to law, yesterday. It's a diffuse increase in spending on a range of government services that leaves me neither offended nor hopeful. The amounts per program are listed in this link—time will tell how it all plays out. I have a feeling some of its infrastructure development, like renewable energy and electronic medical records, will be shifted to emergency bailouts of the states. Debt servicing would add up to around $330B over 10 years.

The statutory limit on national debt is increased to $12.1 trillion (an increase of $789B from when the TARP was passed). Gross Domestic Product in the United States runs around $14 trillion.

Monday, February 16, 2009

Japan’s Lost... Two Decades?

A flurry of news has been coming out of Japan today, sparked by the announcement of its quarterly decline in GDP. Japan’s GDP contracted 3.3% for a seasonally-adjust annual change of -12.7%. The thinking is, Japan’s recovery from the “lost decade” was heavily reliant on a world-wide spending spree, which stumbled last quarter. Also, the yen is strong, even against the U.S. dollar, attributed to the unwinding of the yen’s use as a carry currency, since more of it is now needed to repay Japanese banks than is lent internationally. So it has become scarcer abroad. A strong yen has exports hurting.

Consistent with the decline in GDP, industrial production is decreasing and unemployment rising at the fastest rates seen in decades. Extensive measures have already been enacted over that "lost decade" to stimulate economic activity—which leaves policymakers, with elections soon, at a loss for further interventions.

Japan’s path to economic recovery is not one we want to follow.

Iceland’s Krona

I’d like to comment on a currency that is said to have collapsed last October (2008), and its political system has been in upheaval since. Against U.S. dollars, Iceland’s Krona typically trades in the 1-2 cent range. When I last checked, it is just under half a cent. Iceland’s economy has suffered wild gyrations on the international stage, but here I will try to pull relevant details as it relates to the printed currency, credit, and sales in Iceland.

Iceland’s economy, at first glance, appears strong. The CIA world factbook reports: “Literacy, longevity, and social cohesion are first-rate by world standards.”… “Iceland's Scandinavian-type social-market economy combines a capitalist structure and free-market principles with an extensive welfare system, including generous housing subsidies. With this system, Iceland has achieved high growth, low unemployment, and a remarkably even distribution of income.”

But: Iceland has been on a credit binge. Its external debt is around 50B euros, compared to its GDP of 8.5B euros (numbers vary, probably due to currency fluctuations, but debt remains steady at 6x GDP). That’s huge! With that kind of borrowing, it should be easy to maintain a prosperous welfare state… at least for a while.

With foreign credit pouring in to Iceland’s economy, prices rose. Blogs from foreign visitors complain of the surprisingly high price of meals there, for example. To fight the rampant inflation, the central bank raised interest rates up to 15%, which isn’t a bad return at all, and so the world flocked to Kronas.

Though it has been suggested Iceland’s central bank was rather loose in currency printing, we aren’t seeing wheelbarrows full of cash—or bank notes in the billions and trillions of Krona. This isn’t hyperinflation. This isn't Zimbabwe. This was a Krona bubble.

Eventually there came a crisis of confidence in the banking system, and the Krona was sold off, quickly, by foreigners. Its markets collapsed, and it has become obvious Iceland will not be able to pay back its debt, bonds, or foreign deposits in its international banking system.

So, then where does this leave the Krona? The huge contraction of defaulted credit would strengthen its buying power—prices would fall—if cash and inventory stay constant. However Iceland’s foreign creditors will not walk away easily and a lot of GDP stands to be sent offshore as repayments. Iceland’s markets will be tight for some time. Iceland's balance sheet shows base money expansion (12/31/07: 168B Krona; 12/31/08: 411B Krona; 1/31/09: 376B Krona) which would put downward pressure on its value—but this is unlikely anywhere near the amount of credit lost to the system. So, if we have declining inventories, declining credit, increased cash, but an overall decline in money supply, then prices in Iceland in Krona can go either way and the Krona is likely to remain weak on world markets but still alive at home. I anticipate that any advantage to Icelanders holding Krona, given the shrinking money supply, will be mitigated by upward price pressures due to scarcity of inventory.

Here, the devil is in the detail, and what I’ve presented is a general schematic. This blog attends to the strength of cash in the face of financial turmoil, so the fall of a world currency through a mechanism other than hyperinflation is of interest. More of Iceland’s story will be reported as it unfolds.

Sunday, February 15, 2009

Keynesians and Dose-Dependent Responses

A repeated argument we hear from the Keynesians for why Keynesian solutions do not work, like say Japanese efforts to revive their economy during the "lost decade"—a policy which Obama is showing signs of embarking upon—is that they weren't Keynesian enough (example).

Say a Keynesian economist recommends a certain sum be infused to jump-start the economy, and have it humming again. But government agencies didn't spend that much. When they had spent a quarter of the recommended amount, almost nothing happened. When they were up to a half, not only did nothing happen, but there was a deterioration in economic activity. But, Keynesians say, if the whole amount had been spent, things would have been fine.

This would be a non-"dose-dependent" response, meaning there is non-linear relationship between the treatment applied, and the response outcome. In other words, small expenses don't lead to small gains, but they suggest large expenses would lead to large gains.

Keynesians need to explain why this is so before it would make any sense to choke on a full dose of Keynesian medicine.

Friday, February 13, 2009

Happy Friday the 13th

Of all days, Obama's stimulus bill passed Congress this night. I'll post details of the bill with commentary next week when Obama signs it in to law.

Wednesday, February 11, 2009

Welcome to Banking Hell

Today, the CEOs of the major banks arrived in Washington, D.C. on Amtrak to testify before Congress they are sorry about past malfeasance and really are trying to lend out money to get the economy rolling—which I doubt anyone believed.

Here's the situation: there is $330B in TARP bailout money left, there is about $850B of newly created base money sitting in bank reserves they could fall back on, an unknowable but estimated $2-3T of toxic assets, and a taxpaying public growing more outraged by further bailout money for the financial industry. So, that's nearly $1-2T or so of vaporized wealth that banks somehow need to wiggle out of. And that's just for mortgages.

I had no doubt the original TARP would breeze through Congress. Now, finally, things may be getting interesting.

Tuesday, February 10, 2009

Geithner reveals... nothing?

News of late has been dragging its feet—being anticipated days and weeks ahead of its actual coming. This is a good thing when it comes to government spending—after all it seems sensible that bailout packages in the hundreds of billions should receive a healthy congressional debate rather than steamrolling it through based on fear tactics. So thumbs up to senate republicans for offering some minority opposition to Obama's stimulus proposal, a luxury democrats rarely saw from their representatives during the Bush administration.

As with the stimulus package, we've been awaiting a statement by new Secretary of the Treasury Timothy Geithner around continued bailouts of the banking industry. So far he has been non-commital around action—but talking trillions of dollars for expenses. Most famously has been proposed the "bad bank," where toxic assets can be taken off bank's balance sheets and backed by a taxpayer driven federal program.

As of his statement today, he remains diffuse, and was explicitly criticized by a Congressional hearing over that, and the DJIA trended down sharply in response. Whatever it is, he still has $320B of TARP money to work with, for now.

The fact he is calling for the use of private capital in all of this, for this "bad bank," which obviously isn't going to happen unless it is fully guaranteed, strikes me as almost a delay tactic.

Saturday, February 7, 2009

Bank Reserves and Inflation

Per Fed data, nearly $1T has been added to base money in the last 4 months. If all of it were lent out by recipient banks, it could expand upwards of $10T (at 10% fractional reserve), nearly doubling the overall money supply. But as we know, banks have hardly been lending their bailout money… thankfully, because it was excessive credit that got us in to this mess.

During the period of base money expansion, starting last September, prices have remained at best the same for most common everyday goods, and have been dropping for things like gas, houses, and most investments. Even retail prices have been dropping with more and more on-sale items to be found. The money added to bank reserves almost exactly matches the base money expansion. So the question becomes, how inflationary would be increasing bank reserves if the reserves are just sitting there?

Let’s start by examining the deflationary forces that prompted recent increases in base money. Say a $500,000 house in the outskirts of Stockton two years ago now goes for $200,000. That’s a decline in wealth by $300,000. Now, as much as people who hold legal title to the house like to believe they are homeowners, the truth is, until the mortgage is paid off, it is owned by the bank—and in this situation, one does well to take full advantage of that and mail the bank their keys if there were little equity in the place. The bank will recover what it can, about $200k at auction, and be stuck with a $300k deficit, minus any equity there might have been.

Now the original $500k loan added to the money supply via fractional reserve credit is still out in circulation (sitting in the sellers bank account unless they spent it, in which case the money is wherever it is in a line of transactions). If the Fed or Treasury department decides to keep the troubled bank afloat and grants them $300k in base money for their loss, is that $300k worth of money expansion? The rescue of the loan can be viewed as a deposit of new currency from the Fed. Which is inflationary.

But what price increases there were during a credit happy environment are now stressed with credit contraction, and not sufficiently compensated by base money expansion. So while inflationists are right that we have a lot of inflation in base money, we have greater contractions in credit, and general price declines.

Whether inflationary forces outweigh deflationary ones, or vice versa, the proof is in the pricing: the dollar now buys more houses, gas, stocks, and a slew of retail items than it once did. There is a broad contraction of investment wealth, and only the banks (and AIG and automakers) are being rescued. Deflationary forces are prevailing over inflationary ones, and I see no reason to anticipate a quick turnaround.

If this deflationary course reverses I’ll be the first to report on it.

Sunday, February 1, 2009

Metrics: Cash, Credit, and Prices

The "cash-inventory equivalency," proposed before, states: money supply (MS)—or the sum of printed cash (P) and outstanding credit (C)—exactly equals the value of the inventory (I) of all things for sale (e.g. MS = I; or P + C = I).

Where there are discrepancies in this equation, where things for sale are overpriced or underpriced, it reflects an error of pricing, relative to the desire society has for a given item. Since errors of pricing reflect inefficiencies for the seller, prices will tend to self-adjust over time to conform to this equivalency. From the cash-inventory equivalency, one can derive a value for cash that reflects its purchasing power at home, independent of how it sizes up against foreign currencies. Also, equilibrium and disequilibrium prices can be conceptualized.

But this equation is an assumption. I have argued that if the sum of all prices is greatly lower than money supply, then sales velocity increases and sellers adjust by increasing prices; or if prices greatly exceed money supply, then sales will slow, and sellers have to cut prices such that sales keep up with productive capacity. In either of these extreme cases the direction of price correction goes toward the cash-inventory equivalency, but does it exactly equal it? That I cannot say for sure.

Even if money supply and inventory were not exactly equal but exactly proportional and related by a constant, then cash value and price disequilibrium would still hold valid, but with the constant factored in. But if money supply and prices are generally proportional and not exactly proportional, then no headway has been made since the quantity theory of money, which has been around for centuries.

Now, the cash-inventory equivalency (P + C = I) could be demonstrated if each variable were measurable and could be followed over time; and especially opportune would be a setting where the relative proportion of credit to printed currency is in flux as it is now. This post will offer some initial thoughts on the measurement of these variables.

1. Cash (P) is the easiest to measure. There are two approaches I have, both of which yield around the same answer: you have M1-currency which is the amount of cash that was run off at the presses; either that you can subtract bank reserves from base money supply—all of these numbers are published regularly by the Fed. Interestingly, while base money and bank reserves have been skyrocketing, M1 has risen slightly. The Fed isn’t really “printing” all that much. Base money expansion is just ineffable eMoney which gives the banks some leeway for making loans in the current credit environment; or more importantly, it will allow them to withstand the implosion of Alt-A (stated income) loans, commercial real estate, and credit cards, particularly as the effect of recent job losses snowballs through the economy. Currently, there is about $800B cash in circulation.

2. As for measuring credit (C), to the degree that the money originated by fractional reserve lending is redeposited by sellers back in to banks, and I think that is a pretty reliable assumption, then deposits are a reasonably good estimate of credit. Until March 2006, we used to have that information when M3 was published by the Fed. Subtract M1-currency from M3 and you have outstanding credit in dollars. So now there is M2 and MZM which do not factor in large CDs or deposits with a maturity date. M3 was becoming increasingly disproportionate to M2 right before the Fed stopped publishing it, so it’s essential data in measuring credit.

So all we have are M2 and MZM, which are around $8-9 trillion dollars. Subtract cash and we have close to $7 trillion outstanding credit in the system (I am using broad approximations with wide error margins for now and will refine over time). While the financial industry is crashing and burning, we don’t see declines in M2. Part of this may be due to bailout efforts delaying the pain, particularly in protecting the balance sheets of the banks. Defaulted credit does not hit personal deposits; it hits the reserves of banks, and that is where the bailout money and base money expansion has been going.

3. As far as prices (I) go, thus far I’ve been following trends. I watch several indices: DJIA for the health of businesses; Case Shiller for house prices; Reuters-CBH commodities index; spot oil; the CPI for everyday expenses; GDP; and gold. Trends in these indices can be eyeballed as indications of general price trends.

So far, I have a decent measurement of cash, a broad and inaccurate underestimation of credit, and broad indices of general price movements, but nothing that could be considered “the sum of all things for sale.” The first step in demonstrating the cash inventory equivalency would be to refine measurements of credit and pricing trends to determine whether money supply and inventory could be regarded as exactly proportionate or not.