From Karl Denninger at http://market-ticker.denninger.net/
Monday, December 3, 2007
The Money/Credit Cycle....
I'm going to "spend" my ticker today talking about something that you're not taught in school, yet is critical to understanding where we are - and where we're headed in the markets.
That is the money and credit cycle.
Let us think for a moment about what money really is. Gold is often called "real money", with the implication that other things used as money aren't "real".
Yet money, in the simplest (and most correct) definition is simply "a medium of exchange."
Through the years feathers, bones, foodstuffs and jewels have been used as money.
But - how is money created? Clearly, money must be controlled somehow, right? Otherwise you could walk over to your closest copier and run some off for yourself..... as much as you'd like. That would anger people, don't you think?
The first thing to get your mind around is that money, credit and debt are all interchangeable. In the world of economists these are known as "fungible" - that is, interchangeable without limit.
Today, when you go to the store and swipe your debit card, you are actually spending credit.
Let's say you walk into a restaurant and eat lunch. At the instant you order, you are in debt for $10 - the cost of the lunch. When you pay with your debit card, you settle that debt by moving $10 worth of credit from your account at the bank to the account at the restaurant.
So far so good.
But - where did the $10 you spent come from?
It was created through credit - that is, debt!
Let's start with a world where there is no money but some people own land. With land I can grow a crop to feed my family, but I first must acquire some seeds. Joe down the street has seeds, but he does not have land. We would both like to eat.
Therefore, I issue a debt to Joe in exchange for some seeds; I create money! I give him a promise to pay him part of my crop if he will give me some seed. He does; what he holds in his hands is, in fact, money. I have created it out of thin air by putting myself in debt.
Now what's the problem with that? Well, what happens to Joe if there is a drought? He has given up his seeds, but there is no crop! He loses. That's called risk.
Because of this risk, he will charge me "interest". That is, he wants somewhat more than the value of his seeds to cover the chance that I will in fact produce nothing with them.
And from this - risk - we sow the seeds of what ultimately causes headaches for the monetary system.
Let's say that today you wish to buy a car. You go into a bank and get them to agree to issue you a loan to buy that car. Let's say the loan is for $20,000. You sign a contract promising to pay back the $20,000 plus a rate of interest, which is charged so that the bank is covered for the risk that you won't pay them, and the value of the car at that time might not be as much as you owe. The car is the "security" for the loan - if you fail to pay, they will come and repossess it.
You now have $20,000 in your pocket, and you purchase the car. (We'll get back to how the $20,000 came to be in a minute.)
If these were the only two transactions in the world, you would soon recognize a serious problem - there is only $20,000 in money in the world, but you owe more than $20,000! The interest you must pay means that you somehow must acquire more money than exists in the world over the life of that loan in order to pay it back.
There is only one solution to this problem - the amount of money in the world must increase.
So the government will just print some more, right? After all, the can do anything they want.
Uh, no. If the government were to do that then the value of all the money currently in existence would go down by the exact amount that they printed. You could pay your debt but the bank would be in serious trouble because the money they got paid back with would not be worth as much as the money they gave you!
So where did the money come from?
It was created by the bank because some people trusted THEIR wealth to the bank to "hold" it for them - that is, they deposited some funds with the bank, and through the system of fractional reserve banking, the bank was thus able to "create" a certain amount of credit for each dollar on deposit.
If that system was short-circuited by a "raw printing" of money by the government, this would result in everyone "upstream" of you being hosed!
This of course is not acceptable to anyone (except you!) - the bank and auto manufacturer, along with the bank's depositors, specifically, would shortly say "no way!" and remove their funds from that system, choosing instead to do something else with it.
While many people believe that raw printing of currency is how governments respond to the need for "more money" or "more liquidity", with the exception of dictatorships this simply doesn't happen.
Instead, more money is created not through direct inflation, but rather through the pledging of more assets - that is, the creation of more credit/debt!
If the government wants to spend more it issues more debt (Treasury Bills/Bonds) which are then sold into the market - with interest attached. Due to fractional reserve banking once those bonds are purchased the funds can then be lent out at a multiple of the money received.
But wait a minute........
Isn't there a limit to this?
Ah, now there's the rub.
THERE IS!
See, there are only so many assets available to pledge. While human industry creates more over time - that is, we get better productivity through innovation and technology - there is a natural limit to the pledging of assets.
What's worse, the growth of money required to be able to meet interest and principal demand is an ever-increasing function. The "power" of compound rates of return is the damnation of compound interest, and in this case, its working against the system as a whole.
When the limit is reached - that is, there are insufficient remaining owners of credit-worthy assets who will (or can!) pledge them in return for more credit (money) being issued to them the system will fail and reset.
This is what happened in the 1930s.
It should have happened after the Tech Wreck in 2000.
But it did not, because when the velocity of money slowed precipitously in the tech wreck and Greenspan followed that velocity down by cutting Fed Funds to 1%, he managed to entice homeowners into pledging their HOUSES as collateral for yet another round of "reflation" in credit!
So the "reset" was avoided - for a while.
But - you saw what happened.
House prices exploded upwards as credit standards were thrown out and anyone who had a pulse qualified for a huge mortgage. The house was thought of as "security", making the loan cheap.
Or was it?
What did the mortgage companies and banks that made these loans know?
Well, what do you think they knew? They sold those loans off into the marketplace, keeping only a little - or none - of the risk for themselves.
Why?
Continued in Part II
Monday, December 3, 2007
The Money/Credit Cycle....
I'm going to "spend" my ticker today talking about something that you're not taught in school, yet is critical to understanding where we are - and where we're headed in the markets.
That is the money and credit cycle.
Let us think for a moment about what money really is. Gold is often called "real money", with the implication that other things used as money aren't "real".
Yet money, in the simplest (and most correct) definition is simply "a medium of exchange."
Through the years feathers, bones, foodstuffs and jewels have been used as money.
But - how is money created? Clearly, money must be controlled somehow, right? Otherwise you could walk over to your closest copier and run some off for yourself..... as much as you'd like. That would anger people, don't you think?
The first thing to get your mind around is that money, credit and debt are all interchangeable. In the world of economists these are known as "fungible" - that is, interchangeable without limit.
Today, when you go to the store and swipe your debit card, you are actually spending credit.
Let's say you walk into a restaurant and eat lunch. At the instant you order, you are in debt for $10 - the cost of the lunch. When you pay with your debit card, you settle that debt by moving $10 worth of credit from your account at the bank to the account at the restaurant.
So far so good.
But - where did the $10 you spent come from?
It was created through credit - that is, debt!
Let's start with a world where there is no money but some people own land. With land I can grow a crop to feed my family, but I first must acquire some seeds. Joe down the street has seeds, but he does not have land. We would both like to eat.
Therefore, I issue a debt to Joe in exchange for some seeds; I create money! I give him a promise to pay him part of my crop if he will give me some seed. He does; what he holds in his hands is, in fact, money. I have created it out of thin air by putting myself in debt.
Now what's the problem with that? Well, what happens to Joe if there is a drought? He has given up his seeds, but there is no crop! He loses. That's called risk.
Because of this risk, he will charge me "interest". That is, he wants somewhat more than the value of his seeds to cover the chance that I will in fact produce nothing with them.
And from this - risk - we sow the seeds of what ultimately causes headaches for the monetary system.
Let's say that today you wish to buy a car. You go into a bank and get them to agree to issue you a loan to buy that car. Let's say the loan is for $20,000. You sign a contract promising to pay back the $20,000 plus a rate of interest, which is charged so that the bank is covered for the risk that you won't pay them, and the value of the car at that time might not be as much as you owe. The car is the "security" for the loan - if you fail to pay, they will come and repossess it.
You now have $20,000 in your pocket, and you purchase the car. (We'll get back to how the $20,000 came to be in a minute.)
If these were the only two transactions in the world, you would soon recognize a serious problem - there is only $20,000 in money in the world, but you owe more than $20,000! The interest you must pay means that you somehow must acquire more money than exists in the world over the life of that loan in order to pay it back.
There is only one solution to this problem - the amount of money in the world must increase.
So the government will just print some more, right? After all, the can do anything they want.
Uh, no. If the government were to do that then the value of all the money currently in existence would go down by the exact amount that they printed. You could pay your debt but the bank would be in serious trouble because the money they got paid back with would not be worth as much as the money they gave you!
So where did the money come from?
It was created by the bank because some people trusted THEIR wealth to the bank to "hold" it for them - that is, they deposited some funds with the bank, and through the system of fractional reserve banking, the bank was thus able to "create" a certain amount of credit for each dollar on deposit.
If that system was short-circuited by a "raw printing" of money by the government, this would result in everyone "upstream" of you being hosed!
This of course is not acceptable to anyone (except you!) - the bank and auto manufacturer, along with the bank's depositors, specifically, would shortly say "no way!" and remove their funds from that system, choosing instead to do something else with it.
While many people believe that raw printing of currency is how governments respond to the need for "more money" or "more liquidity", with the exception of dictatorships this simply doesn't happen.
Instead, more money is created not through direct inflation, but rather through the pledging of more assets - that is, the creation of more credit/debt!
If the government wants to spend more it issues more debt (Treasury Bills/Bonds) which are then sold into the market - with interest attached. Due to fractional reserve banking once those bonds are purchased the funds can then be lent out at a multiple of the money received.
But wait a minute........
Isn't there a limit to this?
Ah, now there's the rub.
THERE IS!
See, there are only so many assets available to pledge. While human industry creates more over time - that is, we get better productivity through innovation and technology - there is a natural limit to the pledging of assets.
What's worse, the growth of money required to be able to meet interest and principal demand is an ever-increasing function. The "power" of compound rates of return is the damnation of compound interest, and in this case, its working against the system as a whole.
When the limit is reached - that is, there are insufficient remaining owners of credit-worthy assets who will (or can!) pledge them in return for more credit (money) being issued to them the system will fail and reset.
This is what happened in the 1930s.
It should have happened after the Tech Wreck in 2000.
But it did not, because when the velocity of money slowed precipitously in the tech wreck and Greenspan followed that velocity down by cutting Fed Funds to 1%, he managed to entice homeowners into pledging their HOUSES as collateral for yet another round of "reflation" in credit!
So the "reset" was avoided - for a while.
But - you saw what happened.
House prices exploded upwards as credit standards were thrown out and anyone who had a pulse qualified for a huge mortgage. The house was thought of as "security", making the loan cheap.
Or was it?
What did the mortgage companies and banks that made these loans know?
Well, what do you think they knew? They sold those loans off into the marketplace, keeping only a little - or none - of the risk for themselves.
Why?
Continued in Part II