Printing Currency, Not Money

This sounds like an academic distinction but it is not. Especially at times like these, knowing the difference is key to understanding the behavior of financial systems.

What is Money?
Let's start with a textbook definition of money and proceed from there. Most definitions include two parts, some add a third. According to them, money is:

1. a medium of exchange
2. a store of value
3. a standard of value or unit of account (widely but not universally accepted)

If you look closely at the first two definitions, you will see that money exists in the minds of those who use it. This is partially true for the third definition as well. (note: For all of you monetary theory geeks, please relax. These are deliberate simplifications designed to make the ideas accessible to a general audience, not a detailed exposition of precise financial models.)

1. I can exchange my money for stuff.
2. I can exchange my money for stuff later.
3. I can exchange my money for a predictable amount of stuff later.

Let's think about what is happening here. Money has value because people will give you stuff for it, both now or in the future. But why will they do that? They have to believe that they can trade it onward in turn for stuff they want. So the utility value of money is based on a set of collective beliefs - what Carl Jung referred to as the Collective Unconscious. This is the set of beliefs that are widely held by a group of people at a deep level and upon which they will act without thinking about it. One can think of this as the unstated assumptions of a society. In the US, the dollar has had a stable or relatively stable value for so long that few would ever consider NOT accepting it in exchange for stuff. The dollar as money is a deeply embedded part of our Collective Unconscious, both here and around the world.

Though there are many who are beginning to question the value of the dollar as money, the number is still miniscule as a percentage of society. Even if a person were to cease to believe in the dollar as money in their own mind, they would still accept it as long as they believed that others would accept it from them in exchange for goods. So externally, they would act as if the dollar was still money, even if they no longer held that belief. That is what puts the collective in unconscious. At some point, things deteriorate sufficiently that everyone KNOWS that everyone else is just pretending. That is the point of universal hypocracy just before the belief system breaks down.

The great Adam Smith said it well:

"All money is a matter of belief."

Printing Money?

Now we get back to the title of this entry. It is clear that from a purely physical point of view, a central bank can create as much currency (physical or electronic) as it wishes - subject of course to certain practical constraints such as logistics. But MONEY exists solely in the minds of people. It is essentially a matter of faith and faith is not something a government or central bank can print or conjure from thin air. The value of the dollar is the credibility built up over two centuries of the US Treasury always meeting its obligations. The money, is the widely held belief that the US government will guarantee that dollar holders will always be able to get things of value in return for their dollars, which is backed by generations of positive experience.

Now, please ask yourself "Does creating more currency enhance or damage that belief system?" The answer should be self-evident. The very act of creating more dollars ensures that the purchasing power of every existing dollar is diluted. There is only one scenario under which this will not damage the purchasing power of the dollar - if and only if those created dollars can be used to add a roughly comparable amount of value to the pool of available goods and services available for purchase. That is precisely the role of well-functioning credit system: to allocate capital to useful expansions of capacity and new business ventures in order to create that added value. This is why such a credit system can actually create money through credit. Because the act of printing dollars would have no such offsetting value-added, the arbitrary creation of more dollars undermines the faith which is at the root of money's very existence.

A central bank like the Fed can print currency but it cannot print belief - which is what money really is. A central bank can assist money creation by making the commercial credit system (banks) more credible with a backstop during normal times but that is a supporting role. When it takes the lead by acting unilaterally, it can only destroy money.

Printing dollars destroys money.

The Circle of Lies

Circular Money(TM): at least that's the PG-version of what several correspondents are calling it and we'll explain later. But first a little background. Quite a few folks have expressed concern about the Fed "printing" massive amounts of dollars and putting them into the economy, which will trigger inflation. This is certainly a reasonable fear given the numbers being thrown around and the rhetoric coming out of the Treasury and the Fed. However, we do not believe that the fear is well-founded and our evidence come from the Fed itself. Consider the latest report on reserve balances.

The total balance sheet has expanded by an alarming $1 trillion or 110% in 12 months - very disturbing. But the key question would be is any of this actually printed into existence? To determine this, look at the other side of the balance sheet - the liabilities and capital. Liabilities have expanded by $1,032 billion and capital by $3 billion. Liabilities mean the the assets are funded by borrowing. Real printing would go straight to capital since it creates no offsetting liability. The minuscule increase in capital is easily accounted for by interest on the Fed's bond portfolio so we may safely conclude that little or no actual printing is taking place - much less the monstrous quantities that some would suggest. So the money is being borrowed; now let's look at the liability details to see from where the incremental money is being borrowed.

• $78 billion worth of Federal Reserve Notes has been issued - increasing the amount in circulation by 10%. This is a function of demand for cash, not Fed policy. Increasing distrust of banks naturally leads to an increased preference for cash instead of deposits.
• $32 billion of reverse repos - that is the Fed borrowing from other financial institutions using its Treasury holdings as collateral
• $917 billion of "deposits" - now a deposit is a loan so this is the Fed borrowing once again. Let's break this down further:
• $216 billion is borrowed from the US Treasury - through the general and supplemental accounts
• $699 billion is from "depositary institutions" - i.e. banks.

This last one really should get your attention. You might say "I thought the Fed was lending money to the banks!?!" and you'd be right. Then the banks are turning right around and lending that money back to the Fed. It would be as if George "lent" money to Bob and then Bob turned around and "lent" that money right back to George. If the "loans" were for $1, they each now have an asset (the loan) and a liability (obligation to repay) of $1. But that is a sham transaction, whether for $1 or $1 billion. They have both expanded their balance sheet, but how much actual lending took place there? In reality, nothing changed except a meaningless book entry and the same is true with the Fed and the banks. George and Bob could exchange "loans" of $1 billion dollars and it would be just as ineffective as what the Fed has done. This is what we have dubbed Circular Money(TM).

Keep in mind, this is Circular Money(TM) only to the extent to which the entries offset and that is not a perfect match but very close. TAF loans increased by $388 billion and "other loans" (the rest of the alphabet soup) by $139 billion for a total of $527 billion vs $599 billion the banks lent to the Fed. The remainder comes from assets the banks sold to the Fed to raise cash. Clearly a large portion of the $34 billion in agency bonds and $65 billion in mortgage-backed securities (MBS) also was sold by banks. The money comes from the Fed and goes right back to them. Here again we see the Fed's actions in light of their attempts to maintain the deception. They started to pay interest to the commercial banks on required and excess reserves in October 2008. They are currently paying the banks 25 basis points (0.25%) on all reserves deposited with the Fed. Note that the Effective Fed Funds rate is a nearly identical 22-24 basis points. The ability to pay interest on the reserves was critical to offset the interest cost of borrowing. This way the imaginary accounting entries can be maintained nearly indefinitely with interest paid neatly offsetting interest received as well. The interest differential on huge sums of non-existent money would have unmasked the deception fairly quickly otherwise.

The Big Con
This game has no effect in reality, so what is the purpose of the Circular Money(TM) deception? It is yet another con game by the Fed to convince people that dead banks aren't really dead because Ben Bernanke says so. As long as a critical mass of people continue to buy the party line, the zombie banks will continue to lurch about spastically. We have long contended that the Federal Reserve is a very weak entity in reality and it's greatest power is that people THINK it is powerful. They announce things intended to influence the behavior of those under this illusion. They threaten to "print" in order to stoke fear of inflation and get people to act accordingly - they seem to be hoping to restart financial speculation by scaring people into draining their savings or taking on debt. But if the Fed could actually induce inflation, then we should already have it already as they've been taking radical action now for over 18 months. When the current threats fail to become reality, the already damaged credibility of the Fed will be severely compromised.

The concerns about inflation would be very serious if any actual printing were taking place but that would destroy the banking system - which is the last thing they want. As things stand, the money exists only in theory and cannot be lent outside the banking system since it doesn't really exist. In order for it to exist outside this circle of lies, the Fed would have to find a large funding source beyond the banks themselves to replace any funds the banks lend out to the economy rather than back to the Fed. They would have to compete for that funding with the Treasury who needs to borrow over $1 trillion in short order. Now do you see why the Fed prefers this deception to going to the market and trying to get that funding? If they tried and failed, it would reveal the Great Oz as the helpless little man behind the curtain that he really is.

Smaller Piece of a Smaller Pie

We would just like to summarize the macro picture of the era we are leaving in order to understand the era we are entering. We have been blogging about the credit dangers on Financial Jenga since 2007 and warning about them even longer than that. The global scope of the financial crisis should surprise no one. Didn't we hear all about "globalization" for many years during the synchronized boom? That level of integration virtually guaranteed that any bust would be synchronized as well.

Nearly all other economic ills stem from the mainspring of a deformed and distorted credit system. For many years now, the foundation of the entire world economic system has been the willingness of the average American to spend their entire income - and more besides. This blog described the magnitude of that "more" in its very first entry. That foundation is collapsing and the global system is flying apart as American households suddenly realize that they are in a hole and stop digging. Savings rates have rebounded from negative territory almost back to 3% per the Bureau of Economic Analysis. The fact that Americans are saving again is viewed as a disaster by the Keynesian orthodoxy, which seems oblivious to the need for savings as a source of capital. They are going to have an absolute coronary when US savings rates begin to approach the historical norm of 10% +/- 2%.

The renewed interest in savings certainly will impose short-term pain on a distorted economy based on excessive consumption. The foundation of the economy will have to shift to something more balanced. The simultaneous and related desire to reduce debt is going to accelerate the shift. The pie of funds available to spend is shrinking as income falls in real terms and willingness to take on debt disappears. In addition, the slice of the pie going to consumption is shrinking (it couldn't exactly grow much beyond 100%) as a tiny piece is actually being allocated to savings again. Activities dependent on profligate spending are suffering badly. It was this insight that led us to forecast the consumer spending collapse and the subsequent implosion of the export-dependent economies.

As the cure of a mountain of debt, our government now proposes to borrow in OUR name thus fitting our children and grandchildren for the chains of debt slavery. We must exert ourselves to stop the madness. Though it is financial rather than political, this quote from George Orwell's 1984 seem utterly apt. As Inner Party member O'Brien explains to the protagonist:

If you want a vision of the future, Winston, imagine a boot stamping on a human face forever.

Trade Grinds to a Halt

Over the last 6-9 months, we have seen many indicators of weakening demand and the impact on trade. For example, the collapse of the Baltic Dry Index - down more than 90%. This reflected lease rates for freighters and indirectly demand for bulk cargo capacity. The initial drops in shipping volume were modest but had a severe impact on commodity prices and shipping rates as the global economy swung from a sellers market to a buyers market. Now we are starting to see the full impact of credit withdrawal. Our thesis has long been that excessive and EZ credit (TM) were the root cause of massive false demand that radically distorted the consumer economies, those who manufactured and exported to them and the raw material suppliers to the manufacturers. The chain of causation has proven out and now we will see just how large that distortion was.

Domestic Strife
Our back of the envelope calculation is that first-order effects in the US will be 10% of GDP, with further ripple effects from there. Our assumptions are fairly simple. Net additions to household debt ranged between $800 billion to $1.2 trillion from 2002 to 2007. That number fell to $77 billion in Q2 and negative $117 billion in Q3. All data come from the Fed Z.1 Flow of Funds release. We merely assume that net consumer credit will go to zero, whereas it could go severely negative as defaults and debt repayment have already caused outstanding credit to fall. We further assume that household savings will rebound from approximately zero to halfway back to the historic 10% range. The cumulative impact would be to reduce personal consumption by $1.3-1.6 trillion or between 9% and 12% of GDP.

Granted not all of this will hit US production. Much of the damage will occur in the export economies as we stop buying from them. We have repeatedly argued as much. Outsourcing which destroyed jobs in the US and made the target nations prosperous is now going in reverse and this should provide a partial circuit-breaker to the US economy which MAY prevent a consumption-employment-income-consumption death spiral like the 1930s. On the other hand, business spending is also falling and that swing is far more difficult to estimate. For modeling purposes, the hit to US output from lower capital spending should be roughly equal in size to the reduced demand for imports so US GDP probably declines 9-12% - straddling the 10% line of the textbook definition of depression.

Unless people dig themselves even deeper into a debt hole, households will not take on further debt - either out of prudence or inability. It would have been extraordinarily difficult to stop this a year and virtually impossible now. Once the (misplaced) confidence evaporated, the conclusion became inevitable.


Globo Stop
I'd like to thank Karl Denninger of Ticker Forum for his inimitable description of the current crisis. The PG version of which runs:

We're screwed, but they're screwed worse.

We are indeed seeing just how bad the rest of the world has it right now. The NY Times did an excellent piece over the weekend that described the rapid decline of world trade. Here's the money quote:

Over all, the total reported exports from those 43 countries peaked in July, at $1.03 trillion. By November, the figure was down 26 percent, to $766 billion. Since the figures are seasonally adjusted, the monthly figures should be comparable.

This is not just a problem for Asia but a global one. German exports fell 21%. Over a quarter of all world trade went away in only FOUR MONTHS. I think this is a pretty good example of just how much credit distorted the US and world economy. At some point, credit goes from a useful organ to a cancer. We have often spoken of the Universal Debt bubble and the breathtaking size and scope of it. It was "fun" while it lasted but the bill for the UDB is about to come due. The check is on its way to the table and we're going to spend a lot of time arguing over who gets to pay for it. George Washington spoke of government but it applies to credit as well and the distinction between the government and the banks grows ever smaller:

... a troublesome servant and a fearful master. Never for a moment should it be left to irresponsible action.

Asian Flu

In the past few days we have received confirmation that our thesis regarding Asia is playing out rapidly. The data come from Japan and Korea - both heavily industrialized exporters and relatively open societies. While we have been very bearish on Asian economies here at Financial Jenga, the rapid pace of the implosion even surprises us.

Japan will soon report 4th quarter GDP and the estimates are moving fast - an in a really frightening manner. Bloomberg reports that Barclays now is estimating that Japan's economy contracted at over 12% annualized in Q4. This would be the worst result since the Arab oil embargo of 1974. Korea reported a similarly disastrous result for November industrial production. The YoY decline of 14.1% was the worst on record - with data going back to 1970. Understand that the textbook definition of depression is a 10% fall in GDP - and both Japan and Korea are already on pace to do so in a year or less.

We do not yet have any numbers this bad from China but we should not expect to see them for some time. China's economy possessed tremendous momentum entering the current crisis and that will have to bleed off before the damage becomes apparent on a macro scale. Also, China's government is still rather secretive and probably will attempt to hide the extent of the declines. However, we are getting industrial production numbers showing that December was the fifth straight month of decline.

Once again, Bloomberg reports that industrial output is slowing and the pace of layoff is increasing. The problem is that order also continue to fall so this is not an inventory correction as the head of the People's Bank of China would suggest. This is a collapse of end demand driven by credit. The demand is nearly all external so China has no control over that. Since China's end consumer demand is small and even most of that is tied to export industries in some way, there really isn't any way out for them. The most fascinating quote from that article follows:

China’s economic growth may have slipped to 5.5 percent last quarter, the weakest pace in at least 15 years, according to Shanghai-based Industrial Bank Co.

Once again, numbers that would have seemed shocking a short time ago are now the expected. China will be fortunate indeed if their GDP continues to grow at all in the near future.

Submerging Market Update

note: This post was begun some time ago and the date-time stamp reflects the initial draft. The bulk of the data has been added since then.


China: The Collapse Begins
Chinese exports are collapsing and industrial activity with it. Recent reports suggest that they are experiencing mass factory shutdowns with owners and manager absconding. According to the BBC, migrant workers from rural areas are returning to their homes in the countryside en masse. Those watching the media would think that an shocking collapse came out of nowhere in the last few weeks. Readers of Financial Jenga have known that this was not just possible but virtually inevitable for many months.

China could spend some of their dollars but they need to keep at least $1 trillion so the Yuan doesn't completely crash and burn. The interesting problem is the currency mismatch and "sterilization" issues. China's money supply growth is going to fall quickly as there will be fewer incoming dollars against which to issue new Yuan. Yes they will also be exporting fewer dollars to pay for raw materials but that doesn't matter to the unemployed citizens.

The mismatch issue is more critical. Everybody likes to talk about China's currency reserves. The problem is they've already been used up. Yes, they still have the dollars at the central bank but they've already issued Yuan against them as part of their "sterilization" operations. I.e. they cannot use the reserves to "stimulate" the domestic economy. They can SPEND them abroad, which will enable China to consume but will add production elsewhere, doing nothing for the production side of the Chinese economy. The mismatch problem is that they need more Yuan but what they have are Dollars. Much of the existing base of Yuan supply only exists because of the Dollar reserves. If they spend down the reserves, they either have to reduce their domestic money supply or simply print more money to make up the difference.

People like to point to China's dollar reserves but they've already had as much stimulative impact on China's economy as they ever will. Note that the Yuan is NOT a convertible currency. There is no large pool of Yuan outside of China that could be exchanged for dollars and spent in the domestic economy. Nor can they be lent out with the understanding that the loan be spent on Chinese goods (vendor financing). They have already done that indirectly by purchasing Treasury and Agency debt. Those looking for such an impact don't understand the structure of China's financial system.


Latin Cognates
Despite a vicious snapback, the trend is quite clearly down. Likely driven in part by the Fed's dollar swaps, these markets found support last week but it looks like a dead cat bounce. During that week a rally in their sovereign bonds of 200 basis points +/- 10 bp, left Mexico and Brazil debt trading 8.55% and 7.58% respectively. What this tell us is that the threat of immediate default has been averted by Fed imprudence but no one is willing to lend at anything less than a huge multiple of the 100 bp spreads we saw only a year and a half ago.

Latin economies are heavily dependent on natural resource extration. Thus they have had and continue to have a symbiotic relationship with the resource-eating black hole known as China. With consumption slowing worldwide and the initial feedback effects on the exporting countries, we are starting to see resource demand falling but the excess capacity created is collapsing commodity prices. The storm of demand destruction is roaring up the supply chain and spawning tornados that tear through individual sectors. The latest example comes from Brazil, where giant mining conglomerate Vale do Rio Doce is desperately cutting spending. The big news is the cancellation of 12 giant ore carriers - which would have been built in new Chinese shipyards. At the same time, they are cutting ore production as demand falls.

An intersting question is how much demand for their own ore Vale just destroyed by cancelling the ship order. This is a vicious circle as the feedback loop in the symbiotic relationship turns negative. Rising expectations and optimism feed off themselves - until they don't anymore. Then ugliness always ensues. In this case the fall will be long and ugly - like that of Icarus, who flew too close to the sun. We have dubbed it the Universal Debt bubble as virtually every country and every industry was caught up in it. Countries like Brazil and China were some of the biggest beneficiaries of the UDB, yet those who advocated the Decoupling Theory essentially argued that the biggest beneficiaries of a trend would be hurt little if at all when it ended. The silliness of THAT position is now manifest for all to see.

Containment Breach
We've heard many times how the crisis would be "contained" to a specific industry or geographic region. The authorities making these countless claims were either lying, incompetent or both. We see now that it is and was global and across the board - thus UDB is very accurate. While we expect exporters and raw materials producers to suffer worse than most, the damage goes on elsewhere. German factory orders fell 8%. US durable goods spending fell 14.1% in the 3Q GDP report. Japanese auto sales have hit levels not seen since the 1970s, while US sales are Back to the Future of the 1980s. This is global and ugly friends. Please protect yourselves.

Some Key Questions

The most important question facing us today, both in the US and around the world is just how much of our supposed wealth is real and how much was part of the illusion generated by bubble-mania and the UDB. Most of the actions of various governments and CBs seem aimed at preventing us from answering this question accurately. In The Limits of Optimism we outlined the various elements of the capital structure and it should be immediately apparent why the stock market is the chosen instrument for conjuring chimeras. By coercing a larger and larger percentage of accumulated capital into stocks, Wall Street ensured a large pool of buyers to continue pushing prices higher in complete defiance of fundamentals. By allowing so much of our wealth accumulation to be attached to something so insubstantial, we have collectively ensured the destruction of much of that wealth. Something that falls as soon as anyone wants to sell isn't much of an investment.

Now we see some of the real world impacts of aggressively tying ourselves to the stock market. Once again, the secondary feedback effects may be greater than the primary impact. According to the WSJ:

At the end of 2007, companies in the S&P 500 had a combined pension-plan surplus of about $60 billion, The market selloff in the nine months to late September turned that into a combined deficit of about $75 billion...

Of course that was before October even started and we all know that things didn't go so well during that month either. Double digit declines were the rule for the month - pretty much across the board. The pension obligation and attempt to meet it by speculating in the stock market are yet another example of companies tying their fortunes directly to stock market whims rather than fundamental performance. It worked well for a while - allowing them to report higher profits than justified by actual results as speculative profits allowed them to pay less into the pension funds than a sensible and stable plan would have required. The reverse is now occurring and it's going to be nasty. This is yet ANOTHER headwind for corporate profits as they are forced to pay cash in to make up for speculative losses.

The lesson that should be learned here is "don't gamble with retirement money" but I fear few will choose to learn it until all other avenues have been exhausted. People can usually be counted on to do the right thing after all else fails.


Confirmed Reservations
Occasionally, I will encounter a supercilious restaurant host who will haughtily ask if we have reservations. When the right mood strikes the answer will sometimes be "yes, but we're planning on eating here anyway." In much the same vein, our prior reservations about the export economies and China in particular have been confirmed with a vengeance recently. Reuters reports that China's PMI hit 44.6 in October - indicating clear and serious contraction in factory output. This now makes three of the last four months down. In addition, recent BBC reports suggest that half of the toy factories in China have shut down since the start of the year.

Keep in mind that we expect a crash and burn in China's economy even if exports stagnate, much less roll over. Government action can partially ameliorate this but only to a small extent. We laid out the full case four months ago in China Syndrome. All of the elements preliminary requirements have now been met for this scenario to play out. The US is desperately trying to prevent a meltdown across the submerging markets with swap lines to exchange valuable dollars for garbage currencies like the Mexican Peso and the Brazilian Real. The temporary availability of dollars in those imploding economies has relieved the pressure from capital flight for the moment and perhaps even caused a small short squeeze for those who were looking for reality to catch up to those nations' financial system. But the banking systems overseas cannot sustain their credit expansion in the face of falling external demand and especially the collapse of primary commodity prices on which their economies rely heavily.