Friday, October 3, 2008

Monetary levels are the link

News flow is thick and full of furry meaning nothing right now. Nature publishes research warning us that the brain is trained to kick pattern detection when under stress, usually resulting in astrology taking over analysis in the absence of rational meaning. I understand it as evolution, since a new threat pushes you to start learning again.

So I stick to basics, money levels. That basic, my brother Carlos explained it to me about a year ago, it was the notion of "money" as in M3 and that all debt was money. I had never actually thought about money, but now I did, all paper (fiat) money was ultimately debt, private or public. Quelle surprise! In retrospect I feel very silly.

For those looking for an in-depth explaining of the debt mechanism, if somewhat cynical and off the wall, I recommend this. Careful with it. Look at the Mandrake mechanism, whereby $1 deposit is turned into $10 in circulation. (Spoiler: you lend 9/10 of capital so 1 dol is lent 90c, which comes back as a deposit to the bank, which it lends 81 and so on until the sum of it all asymptotically reaches 10).

This is how the system regulates fractional lending by setting regulatory levels of debt to capital ratios. This number of 10 is then fixed by law, was established during the Great Depression as a safety and applies to regular banks, but importantly not the old iBanks and adjacent shadow banking systems who levered up to the thirties, fifties.

They were creating their own money essentially outside the control of the authorities and essentially where creating their own money levels. This has proved dangerous if left unregulated. It has come back to bite them, actually just plain destroy them in one big blow. The TARP is aimed right at the heart of that problem.

Debt is a creative force. By investing today you help create a positive economic value by summing the discounted future cash flows. The FED can and does heavily use monetary tools as it controls the source of such debt, the US Treasury debt paper.

So when it became clear that some of the promised cash flows were never actually there, what with the real estate bubble exploding, the system started choking on its own bad debt with the dramatic consequences of the last weeks. And since the bad debt has been securitized with rubber-stamped "made in wall street" AAA ratings, the rest of the world is kind of watching the spectacle of this in horror in shock.

Monetary movement is what is happening.

The Shadow Banking System (SBS) is eating its own children with a full blown run on Hedge-funds. Money markets are hit and flight to the security of Treasuries and certain bonds (EU, US Muni). The unregulated banking system was the most levered up and is disappearing quickly and dramatically.

Just like we have monetary inflation, we have monetary deflation. If we are witnessing monetary deflation by destruction of outstanding debt in the SBS. Then the good news is that governments have plenty of leeway to start running the money presses. It will take out unregulated debts in the shadowy private sector and start managing it out in the open. Replacing opaque debt by transparent one will be, in and on itself, a stabilizing factor on this crisis. The "Mark to Paulson/Bernanke" reset button on the system may very well deliver the catalysis to go through the crisis.

Price stability is the mandate of the public entities. On the way down, servicing existing debt becomes a real burden, further choking the economy. You want to use all means necessary to prevent that spiral from taking hold. Price Stability will take priority and as debt deflates in the SBS, the FED can re-inflate on the monetary in the public eye, via programs like the TARP.

Of course this scenario is threatened by the inflationary pressure of commodities which sparked a very real price increase 6 month ago. But with Oil back down to 90's, from a high of 140, are we witnessing deflationary pressures from commodities this year as well? Some are talking about a $50 barrel, further adding to the deflationary pressure.

We will see, it is very hard to make any sense of what is going on, besides the basic monetary analysis of monetary deflation.

8 comments:

Barry Kelly said...
This comment has been removed by the author.
Barry Kelly said...

Marc, fractional reserve banking doesn't create any extra money beyond a static multiplier. If the reserve requirement is 10%, there is at most 10x currency in play. This creation of money is explicitly acknowledged, regulated and permitted by the reserve requirement. Only nutters and oddballs, who would have us revert to the middle ages or prior, object to it.

Ultimately, money is whatever people in a market agree it is. Moneyness a psychological attribute of tangible (hard cash) and intangible (bank balance) things.

However, in order to play the role we have come to expect of money, it needs to have certain attributes:

be a medium of exchange (the x in a->x->b transformation of one person's output to another's input; this implies mutual confidence);

a unit of account (so we know how much we have, and how much things cost, relative to one another; this implies divisibility);

and a store of value.

Most debt doesn't have all these things. Most debt isn't particularly liquid, because of risk of default and the difficulty for third parties measuring that risk at quite a remove; thus there is a lack of confidence, lack of divisibility (the transaction cost of chopping up the bond etc. is going to be rough), and, if the debt goes bad, it won't be a store of value either.

You can't make a logical jump from "reserve requirement" to "leverage", because the two phrases mean different things.

Another point, unrelated to the above: running the money presses won't necessarily fix deflation, because the extra money injected into the system will turn currency itself into a decent and safe investment asset. Basically, banks will keep money in the vault, because the money press's extra money will accrue to it via interest (buy bonds from government, sell them back later).

Japan (BOJ) tried this in 2001, and it didn't work. They expanded the money base by 38%, to little effect.

Marcf said...

Barry,

On fractional reserve banking, that is kind of my point. Regular banks were regulated at the level of 10, investment banks weren't. They levered up to 30/50 were not regulated.

I believe this means the end of the deregulation on monetary levels. iBanks could kind of print their own money when you think about it. Goldman Sachs, the lone survivor of the SBS run, is delevering from 30 to 20 and will have to go to 10 soon.

I do make the jump between reserve requirement and leverage. They are kind of the same thing, no? feel free to correct me here if I am missing something.

On the liquidity being the problem. I have been reading commentary that liquidity was not the solution and my brother talked to me about the "short circuit" in the market this afternoon. The fact that the money pressed goes right back to T-bonds is a short circuit.

The TARP however is a real reset, it is not just about liquidity it is about setting a floor and providing a price, right or wrong, so that markets can start trading with confidence.

I hope it works, thanks for the thoughtful post.

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