Dire Warning May 2009 - Don't Allow Bush Tax Cuts to Expire

May 7, 2009

New Paradigm Associates

Don Byrne Ph.D.

Ed Derbin MA, MBA

http://byrned.faculty.udmercy.edu/

 

 

A DIRE WARNING…DO NOT ALLOW THE BUSH TAX CUTS TO EXPIRE

 

The economic consultants of President Obama had better review their macroeconomic theory.  Taxes depress aggregate demand and the entire level of production and employment.  The mad orgy of government spending would be quickly negated by tax increases if the Bush tax cuts were allowed to expire.  Had those tax cuts not occurred, imagine what the last few years would have been like.

 

The Financial Fiasco of Two Thousand and Eight (FFTTE) would have occurred in the midst of an economy in rapid decline.  The Obama administration reads history poorly.   Look what the tax increases of the 1990s did to the U.S. economy in 2000 (not 2001).  Rubinomics was its name and economic disaster was its fame and shame.

 

 

 

Not only will the effects of the massive stimulus be offset by the expiration of the Bush tax cuts, but we will be left with a much larger degree of government intervention in the economy.  Since it was the failure of economic policies by the FED, the existing regulatory agencies such as the SEC, and the anti-trust authorities, why does the Obama administration think more government is the cure?  Increasing the number of hogs in the feed lot will not assure a decline in the number of cases of the swine flu.

 

The current federal administration would do well to re-study the Permanent Income Hypothesis http://en.wikipedia.org/wiki/Permanent_income_hypothesis   and the plethora of research concerning it.  Temporary stimulus spending has only short-term effects.  Letting taxes return to higher levels has lasting effects since it changes the average of future cash flows to households.  Remember that massive spending by the Roosevelt (FDR not Teddy) back in the 1930s may have primed the pump but failed in the renewed collapse of 1937 (enter the Social Security Administration). 

 

 

Henry Morganthau, FDR’s Treasury Secretary…

before the

1939 House Ways

and Means Committee

 

 “We have tried spending money. We are spending more than we have ever spent before and it does not work.”

 

http://blog.heritage.org/2009/01/14/were-spending-more-than-ever-and-it-doesnt-work/

 

 

 

President Obama, stop denying reality and replacing it with political rhetoric. 

 

The election is over, where’s the change?

Posted by byrned ( May 07 2009, 12:17:55 AM EDT ) Permalink

Why 25+ Years of US Trade Deficits?

 

May 1, 2009

New Paradigm Associates

Don Byrne Ph.D.

Ed Derbin MA, MBA

http://byrned.faculty.udmercy.edu/

 

Why 25+ Years of Trade Deficits? A tale of High Real Risk-adjusted Interest Rates and the Appreciating Dollar  

 

If the reader has examined the previous blogs on this issue, we should be pretty much on the same page for the discussion that follows.  A short journey through the history of U.S. monetary policy for the last forty years or so will help.  Recall that the 1970s saw an acceleration of inflation ultimately reaching nearly 20% at an annual rate by late 1079 and early 1980.  In the Spring of 1980, the FED (U.S. Federal Reserve) took a 180 degree turn and went from accommodation of inflation, much of which was due to the two oil supply side shocks of 1973 and 1978, and began a policy of “wringing out” the inflationary overhang and ignoring the consequences of a rising unemployment rate.  Once the inflationary pressures began to subside, nominal interest rates fell abruptly. 

 

 

 

 

 

The Fisher Effect was at work again 

http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%203/Fisher%20Effect.htm

 

However, the fall in inflation was slightly greater than the fall in nominal interest rates.  This caused real interest rates adjusted for risk to be relatively high compared to other nations.  By around 1982, the U.S. began to experience a shift from a long standing surplus in its Trade and Current Account balances to growing deficits.

 

 

 

 

 

 

Even when the Fed funds rate was 1.00% in 2004, the capital flowed in!

THEY HAVE TO INVEST THEIR DOLLARS SOMEWHERE – Foreign Investment in the U.S.

Report on Foreign Portfolio Holdings of U.S. Securities as of June 30, 2006

Department of the Treasury and Federal Reserve Bank of New York

Board of Governors of the Federal Reserve System (May 2007)

 

 

The conventional wisdom was that the U.S. slow rates of productivity growth, with accompanying increases in unit labor costs and credit card crazed consumers hell bent on instant gratification, were driving up imports and rising costs were slowing export growth. 

 

But was this the real reason for the reversal in the Trade and Current Account balances?  We think not. 

 

There are five accounts in the conventional presentation of the BOPA (Balance of Payments Accounts).  That structure does not indicate causality.  Causality between the Current Account (nearly all of which is usually the Trade balance) and the Combined Capital Accounts can run either way. 

 

This author holds and has argued for years, that because of the policy of intolerance to inflation adopted by the FED in the Spring of 1980, real risk-adjusted interest rates in the U.S. were relatively high and were a major factor that caused a surplus in the U.S. Combined Capital Account and caused the growing deficit in the Trade balance.

 

The U. S. was and still is the place to invest financially.  This net inflow of capital results in the demand for the Dollar (to invest in the U.S.) to rise relative to the supply of the Dollar (to invest in the rest of the World), making the Dollar scarcer and causing it to appreciate (causing the “strong Dollar”).  Of course this means that foreign currencies are cheaper and the prices of foreign goods in Dollar terms are cheaper that if the Dollar had not appreciated and had remained weaker.   The price of the Dollar in terms of foreign currencies rose (foreign currencies depreciated on a trade weighted basis versus the Dollar) causing the foreign currency price of American goods and services to rise and be more expensive than if the foreign currencies had not depreciated.  The result was that U.S. imports of goods and services rose sharply relative to the U.S. exports of goods and services and a chronic Trade deficit as well as a chronic Current Account Deficit Balances developed. 

 

It was the Combined Capital Account Surplus that caused the Current Account and Trade Balance Deficits and NOT the other way around. 

 

Of course other nations enjoyed these results as their trade surpluses with the U.S. (the same thing as U.S. Trade deficits) stimulated their economies as Trade Balance surpluses do.  When the Dollar weakened due to the FFTTE, the U.S. Trade deficit shrunk and European Union members shrieked loudly. 

 

(The Financial Fiasco of Two-Thousand Eight (FFTTE))

http://byrned.faculty.udmercy.edu/2009%20Volume,%20Issue%201/2009volumeissue1.htm

 

The so-called strong Dollar and the resulting Trade Deficit was one of the reasons for the collapse of the U.S. economy in 2000 (yes 2000, and not 2001) and the weak performance of the economy during much of the Bush Administration’s period.  The GDP went from a positive 7.3% real annualized growth in the 4^th quarter 1999 to a negative (0.5%) real in the 3^rd quarter 2000!

 

 

(1) Significant rise in federal receipts as a percent of National Income…

(2) …and the FED’s change to a monetary policy of restraint, leading to rising short-term interest rates.

 

 

 

 

 

 

There were other factors causing the U.S. Trade deficits.  For example, the Chinese depreciated their Yuan (Renminbi) (CNY) from 2 CNY/$1.00 in the early 1980s and then pegged the Dollar at 8CNY/$1.00 by the mid-1990s (currently around 6.8CNY/dollar).  In Dollar terms, they flooded exchange markets with Yuan and drove the price of the Yuan from $0.50 or fifty cents to 1CNY to $0.125 for 1CNY.   That is a 75% discount on the Yuan and hence Chinese goods and services.  That is the reason for the huge U.S. Trade deficit with mainland China.

 

 

 

 

 

Obviously, the U.S. has gone along with this Chinese initiative,  since we need a strong and stable China and no more Tiananmen Squares sapping there efforts.   You can connect the dots.  Be sure to re-read the first issue of this blog on the U.S. Trade Deficit topic.

 

I hear ideologues argue that we (U.S.) needs a strong Dollar and must avoid a Trade deficit.   By a “strong” Dollar they must mean an overvalued Dollar which of course is very likely to lead to a Trade deficit.  We have had a “strong Dollar” in respect to the Chinese Yuan.  It was achieved by the Chinese government dumping Yuan in the foreign exchange market where Dollars are traded for Yuan. They continue to do so to maintain a peg that will give them a Trade surplus with the U.S.  Arguing for a strong Dollar and a Trade surplus reminds one of unions in the labor markets.  The Law of Demand holds there as elsewhere.  If you want a high price for labor (high compensation per hour) labor must give up job security.  If labor wants job security, it must give up high compensation rates. Witness the U.S. auto industry and the UAW or “Big Three” portion versus the transplants.  If you want a strong Dollar you must be willing to expect a Trade deficit.  The use of impediments to imports such as tariffs and subsidies to exports would have to be used in large doses and this is no longer acceptable to the international community.  Note that in the chaos of the 1930s, nations depreciated their currencies to increase exports and decrease imports.  They wanted a weak currency to achieve this Trade surplus.  Seeking Trade surpluses is in effect a neo-mercantilist strategy.  The nation with that Trade surplus is operating within its production possibility curve and is accepting a lower level of consumption and capital accumulation possibilities than it would have if it experienced a Trade Balance or a deficit in its Trade Balance.  This was explained in the previous blogs focused on the U.S Trade Deficit. 

 

Remember Trade Deficits are deflationary.  They enable a nation to have consumption and capital accumulation possibilities not achievable with a Trade balance or a surplus in their Trade balance.  But it must be financed and the resulting debt must be serviced and may be converted into domestic market dominance as the U.S. has experienced with Japan and Korea in the U.S automotive markets. 

 

Trade surpluses usually mean a weak or undervalued currency.  But trade surpluses can prove inflationary as the Chinese have recently experienced. 

 

There is no free lunch, anywhere.  Somebody has to pay.  Who will pay for the 2 to 3 trillion dollar stimuli packages occurring in the U.S.?  Better not run a tab or you may have a cardiac arrest when you see the bill.

 

Ciao!  

          

Posted by byrned ( May 01 2009, 02:53:08 PM EDT ) Permalink

Drilling down on the Trade Deficit and the BOPA

May 1, 2009

New Paradigm Associates

Don Byrne Ph.D.

Ed Derbin MA, MBA

http://byrned.faculty.udmercy.edu/

 

 

Drilling down on the Trade Deficit and the BOPA

 

In the first blog on the U.S. Trade Deficit, we examined that specific BOPA (Balance of Payments Accounts) deficit directly.  It was shown that neither a deficit nor a surplus in the Trade balance is all good or all bad.  There are both costs and benefits of each type of imbalance.  In this issue, we will examine related balances in the BOPA and the implications of each.

 

As indicated in the first issue pertaining to the U.S. Trade Deficit, there are a dozen or more balances in the BOPA.  It depends upon what factors are included or “above the line” as the expression goes and which factors are excluded or “below the line”.  The Trade Balance or technically, the Balance on Merchandise and Services Accounts includes only two of the five accounts in the BOPA.  By adding the Balance on Unilateral Transfers Account to the Trade Balance, the new combined balance is called the Current Account Balance.  It receives nearly as much notoriety as does the Trade balance.  Verbally, it is equal to the sum of the U.S. exports of merchandise and services and unilateral transfers (gifts by the rest of the World, both official or governmental and private remittances) to the U.S., less the sum of U.S. imports merchandise and services from the rest of the World and U.S. unilateral transfers (gifts by the U.S., both official or governmental and private remittances) to the rest of the world.

 

U.S. Department of Commerce

Bureau of Economic Analysis

U.S. International Transactions Accounts Data

http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=1&area_id=3

 

 

 

 

 

Of course we have such a balance with each nation such as China, and with groupings of nations such as the rest of the OECD members.  To maintain continuity with previous blogs on the Trade Deficit, we will focus on China and the rest of the World including China.

 

 

 

 

 

 

Once the first three accounts, Merchandise or Goods, Services, and Unilateral Transfers are aggregated into the Current Account Balance of the BOPA, what remains are the two Capital Accounts: long-term and short-term.  Since the inclusion of all five accounts must balance or equal zero arithmetically, the Current Account Balance must equal the combined Capital Account Balance, with an opposite sign.  This means that a -$500 billion deficit in the U.S. Current Account balance must be accompanied by a combined Capital Account surplus of +$500 billion during the same period of time.

 

When the U.S. experiences a combined Capital Account Surplus, it means that the Rest of the World is “lending” that amount on a net basis to the U.S.  Remember that “lending or borrowing” in this context include both debt and equity flows.  The U.S. has had such a Current Account Deficit with the rest of the world most of the time since the early 1980s and with mainland China for nearly the past 15 years.  The cause of this chronic position will be examined in the next issue of this blog.

 

There are other balances in the BOPA that are useful for certain purposes.  Over the years some balances become very popular and then seem to wane in importance. 

 

For economic growth purposes, the Basic Balance is often stressed.  This balance adds to the Current Account Balance, the Balance on Long-Term Capital Account, leaving out only short-term capital flows.  A deficit in a developing nation’s Basic Balance is considered much more serious than a similar deficit in that nation’s Current Account Balance.  It is similar to a household financing a home on a thirty year mortgage versus financing the same home on a 30-day note payable.

 

In the days of the IMF fixed exchange rate system which started shortly after WW II and collapsed in the early 1970s, the Official Settlements Balance was closely scrutinized.  It measured the degree to which nations intervened into foreign exchange markets to maintain the official pegged rate of their currency vis-à-vis the U.S. Dollar.  Experts were looking for chronic imbalances that might indicate an official devaluation or revaluation of the exchange rate in question. The Official Settlements Balance was the Basic Balance plus the private short-term capital flows, leaving “below the line” only official or governmental capital flows.

 

Speculation about exchange rate changes hounded the British Pound, the French Franc and other currencies considered weak and ripe for a change in the official pegged levels.  A measure of hot money flows moving due to speculation against a currency was the Net Liquidity Balance.  This balance added to the Basic Balance, the non-liquid short-term capital flows.  This left only the liquid short-term capital flows below the line.  These were the hot money flows not related to fundamental international trade and finance activities.

 

Other balances also gained import such as the balance that drew the line above factors that influenced the Monetary Base.  This was very important to Monetarists who became increasingly dominant in influencing monetary policy decisions in the last third of the 20^th Century but has fallen in popularity as the velocity of the monetary aggregates became increasingly unstable and difficult to reliably predict.

 

In the next issue, we will examine the causes of what has become a chronic Trade Deficit in the U.S. BOPA.

 

iBuenos Dias!

Posted by byrned ( May 01 2009, 01:15:27 AM EDT ) Permalink

Trade Deficits: Good? Bad? Not Necessarily...

April 30, 2009

New Paradigm Associates

Don Byrne Ph.D.

Ed Derbin MA, MBA

http://byrned.faculty.udmercy.edu/

 

Trade Deficits – Good?  Bad?  Not Necessarily

 

Interested in econ – check out our program

ECONONLINE

http://liberalarts.udmercy.edu/programs/depts/econ/econonline/index.htm

 

 

Trade deficits and trade surpluses are neither all good nor all bad, as some so-called experts argue. 

 

To understand this, a production possibility curve or frontier is shown below.  All goods and services produced in the domestic economy are represented as either consumer goods or capital goods.  If a nation is at war, guns and butter are the alternative, where guns represent war goods (capital) and butter represents civilian goods (consumer).  If the economy’s resources are fully and efficiently employed, that economy can produce any combination of consumer and capital goods along the production possibility curve (PPC) or production possibility frontier (PPF). 

 

 

 

 

The presence of unemployed resources or resources that are inefficiently used causes production to fall inside the PPC and the cost to the economy is the horizontal distance to the PPC, the vertical distance to the PPC or any combination between the two intersections of the vertical and horizontal lines and the PPC.  When either or both of these conditions occur, the per capita production of goods and services of the economy is less than the maximum possible.  Becoming efficient and employing the idle resources will bring the economy to the PPC and will maximize the per capita production and income of the economy. 

 

If two nations or more, specialize in that which each has a comparative advantage and produce a surplus of that good or service and trade it with other economies for the surpluses they have produced based upon their comparative advantage, each nation’s production possibility curve or frontier is shifter outward from the origin.   Inhabitants of all nations so trading will have higher per capital production and incomes.  They will be better off materially.

 

The subtleties and nuances of comparative advantage will be examined in a later blog.  Good economic policies require knowledge of these qualifications to the basic principle.  The rest of this blog will consider the cases when imbalances in the combined merchandise and services accounts (Trade Balance) occur and the costs and benefits become more complicated.  To analyze the costs and benefits of international trade when exports of merchandise and services do not equal the imports of merchandise and services, PP Curves (PPCs) will be used again.

 

For nearly all years since the early 1980’s, the U.S. has experienced deficits in their Trade Balance, i.e. U.S. imports of Merchandise and Services exceeded U.S. exports of Merchandise and Services.  For nearly one century before that, the U.S. had experienced Trade Balance surpluses for most years, i.e. U.S. exports of merchandise and services exceeded U.S. imports of merchandise and services.  The causes of these imbalances are often complicated and will be examined in the next blog.  The remainder of this blog will focus upon the effects of such imbalances in the combined Merchandise and Services or Trade Balance accounts.

 

 

 

 

 

 

 

 

 

Compare the PPCs of the U.S. that represent most years for about the last fifteen years or so, reflecting the U.S. trade deficit with the Peoples’ Republic of China (mainland exclusive of Taiwan).  Note that the U.S. PPC including the trade deficit is shifted outward from the origin and enables the U.S. to consume and accumulate capital beyond their ability based upon the PPC reflecting a Trade Balance between the two nations.

The opposite is true for China.  With a trade surplus, their consumption and capital accumulation possibilities are less than if that experienced a Trade balance.  

 

 

 

Since imports reduce aggregate demand and exports increase aggregate demand, this Trade deficit for the U.S. is depressing and tends to reduce the level of aggregate production and income.  Of course if inflation is the key problem and unemployment is not a problem, this is a good macroeconomic outcome since the depressing effects of the Trade deficit are disinflationary, if inflation is occurring.  If inflation is not occurring, then deflationary effects would most likely occur this may require some microeconomic restructuring.  If little competition exists in the economy, price rigidity downward results and deflationary effects do not cause deflation, but rather cause rising unemployment.  To the extent that markets are competitive, deflation will occur without significant harmful macroeconomic side effects. 

 

This was the lesson that Keynes learned after he had proposed returning England to a gold standard at pre war parity prices requiring persistent deflationary policies for a number of years.  He reversed his position and then called gold a “Barbarous Relic”.  The significant rise of competition in the U.S. since the Second World War has eliminated to a large extent in most markets, the downward price rigidity and hence has eliminated much of the negative effects on production and employment levels that deflationary pressures used to cause.

 

What is the downside for the U.S.?  Think of exports as paying for imports.  A trade deficit means that some of the imports must be financed by the nation with the trade surplus, in our case China.  They receive financial claims in the form of checkable deposit claims, most of which will be  used to buy other short term financial claims or even long term financial claims and real assets, eventually.  This has been the pattern of nations such as Japan and Korea.  Our net creditor position as of about 1982 was nearly the largest in the World.  After that, it shrunk with persistent Trade deficits (actually current Account deficits as will be explained in following blogs) until the U.S. is now one of the World’s largest net debtor nations.  That debt must be serviced. 

 

There are also political considerations.  A strong and stable China is in the best interest of the U.S.  Both Pakistan and India have nuclear weapons and North Korea say they have them.  They are neighbors of China.  You connect the dots.  

 

Bonjour

Posted by byrned ( Apr 30 2009, 10:28:05 AM EDT ) Permalink

The Trade Deficit & Balance of Payments

April 29, 2009

New Paradigm Associates

http://byrned.faculty.udmercy.edu/

The Trade Deficit & Balance of Payments Accounts (BOPA) and the Performance of the U.S. Economy

The meaning of the U.S. trade deficit is that U.S. imports of merchandise and services are greater than the U.S. exports of merchandise and services.  It is only one of a dozen balances in the Balance of Payments Accounts (BOPA) calculated by the U.S. Department of Commerce.  It is measured on a quarterly basis or every three months.

U.S. Department of Commerce
(BEA) Bureau of Economic Analysis

U.S. International Transactions Accounts Data

http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=1&area_id=1

The Balance of Payments Accounts (BOPA) measures the international flows between any two areas; usually between two sovereign nations, between a nation and a grouping of nations such as the European Union, between a nation and a geographical groupings such as North America, of one nation vis-à-vis the Rest of the World.  By convention, these flows are grouped into five categories, called accounts, which are all inclusive and mutually exclusive.  The BOPA is a double entry bookkeeping system, and as in garden variety accounting, each account has debits and credits.  This fact can be and will be safely ignored throughout this and succeeding blogs on this topic.

The five accounts in the BOPA are the (1) Merchandise (or Goods) Account; the (2) Services Account; the (3) Unilateral Transfers Account; the (4) Long-Term Capital Account; and the (5) Short-Term Capital Account. 

(1) Merchandise (or Goods) Account

http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=20&area_id=3

(2) Services Account

http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=22&area_id=3

(3) Unilateral Transfers Account

http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=1&area_id=3

Capital Accounts (Financial)

(4) Long-Term Capital Account

http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=17&area_id=1

(5) Short-Term Capital Account

http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=1&area_id=1

Each account on one side reflects the demand for dollars and thus a supply of foreign exchange as do U.S. exports of merchandise in the Merchandise account.  On the other side of the account is reflected the supply of dollars and thus the demand for foreign exchange as would be the case for U.S. imports of merchandise in the Merchandise account.

In the services accounts, U.S. Exports would result in a demand for dollars and a supply of foreign exchange whereas U.S Imports of services would result in a supply of dollars and a demand for foreign exchange.  Before we move on to the other three accounts and balances in the BOPA, let us utilize what we have just examined and briefly discuss the U.S. Trade deficit.   

The Trade Balance includes both the Merchandise and Services Accounts.  Verbally it is equal to the sum of U.S. Exports of Merchandise and Services minus the sum of U.S. Imports of merchandise and Services.  If the combined value of imports of merchandise and services are greater than the combined value of exports or merchandise and services, it is called a deficit.   Another way of looking at it is that the sum of the merchandise and the services balances is negative where in each account, imports are subtracted from exports.  It is critical to see that this deficit in the Trade balance means an excess supply of dollars and an excess demand for foreign exchange.  In a later blog we will finish our examination of the other accounts and balances in the BOPA and we will relate this trade balance to the determination of the dollar price of other currencies such as the Euro or Chinese Yen. 

In the next blog we will examine the ongoing situation of the U.S. Trade deficits with China and other nations. 

Auf Wiedersehen

 

Posted by byrned ( Apr 29 2009, 10:52:30 PM EDT ) Permalink

Money Supply and Those Overworked Printing Presses

Christopher’s question…

What is the linkage between the money supply and the monetary base?  I have heard repeatedly that the money supply is expanding and the printing presses are running overtime.  If this is the case, how can that not be inflationary moving forward? 

The Money Supply and those (supposedly) Overworked Printing Presses

M1 Money…

1. M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions. Seasonally adjusted M1 is constructed by summing currency, traveler's checks, demand deposits, and OCDs, each seasonally adjusted separately.

Currency takes care of the underground and the rest of the world’s needs.

The overwhelming majority of transactions in the aboveground (legitimate) economy (not evading taxes, not trying to escape indictments, etc.) takes place in the checkable deposit of M1

Note:

From the NY Fed http://www.newyorkfed.org/aboutthefed/fedpoint/fed01.html

As of December 2006, currency in circulation—that is, U.S. coins and paper currency in the hands of the public—totaled about $820 billion dollars. The amount of cash in circulation has risen rapidly in recent decades and much of the increase has been caused by demand from abroad. The Federal Reserve estimates that the majority of the cash in circulation today is outside the United States.

By some estimates, up to two-thirds of the currency in circulation is outside of the US

FYI – While currency in circulation is certainly higher than it was a year ago, it has not grown all that much (M1 has increased a bit more)

http://federalreserve.gov/releases/h6/current/h6.htm

If we are not running the printing presses, then what is going on?

Let’s take a walk through the credit creation process…

Checkable deposits

1 – Borrow request a loan from a depository institution (e.g. commercial bank)

2 – If the loan is approved, the borrower is asked to sign a note payable, which details how the principal and interest is to be repaid to the bank. 

This is a liability or a note payable to the borrower

Asset or a note receivable to the bank

What does the borrower get in return?

3 – Bank issues a deposit slip to the borrower.

This increases the borrower’s checkable deposit equal to the amount of the loan.

This checkable deposit is an asset to the borrower, but a liability to the bank. 

4 – Credit is thus created by the bank in favor of the borrower – the M1 increases because checkable deposits are part of the M1 Monetary Aggregate (Money Stock). 

 

 

It is clear that the bank has created both credit (the loan) and money (M1 – checkable deposit).  We could also say that the bank has also created M1 money in checkable deposit form and lent it to the borrower.  We could also say that the bank has monetized the borrower’s debt.  The borrower’s debt, or note payable, is not M1 money.  The bank’s liability – the checkable deposit, is M1 money.  Therefore in this process of creating credit for the borrower, it has also created NEW M1 money.  Yet another way of looking at this, is that the borrower and the bank swap debt or liabilities with each other and new money and credit are created.  Note that the bank need not have the M1 money to lend it out: it simply creates a liability on itself.    

Rarely does the bank lend currency money out.  In almost all cases, the bank simply creates a checkable deposit liability on itself and gives title to that to the borrower.  The borrower can ‘spend’ that money by means of check, debit card, or wire transfer.  Spending this money really means conveying title of this checkable deposit to someone else. 

Confusion often arises in the minds of most people because most of the time they go to a bank (depository in general…bank, credit union, etc.) and deposit currency or checks in their account.  Obviously, that currency or check already existed – and we can think of it as ‘old money’.  This type of deposit has been called ‘primary deposit’ in the past.  When banks create new deposits (as explained in the loan transaction above), these newly created deposits are referred to as secondary deposits. These secondary deposits are the result of the borrower signing a note payable in favor of the bank.  Since the vast majority of ‘new money’ is created by depositories, in the process of creating credit, NO PRINTING PRESSES ARE REQUIRED!

Where does the expression, RUNNING THE PRINTING PRESSES, come from?

In the 1860s, in order to partially finance the Civil War, the US government (the North – Union), actually printed United States Notes, often called ‘greenbacks’ and spent them.  Up until the Civil War, state chartered banks also had paper money (currency) printed and would lend that paper money out when making a loan.  By placing a heavy tax on this bank note (or paper money) issue, the Federal government ended this practice by state chartered banks. 

In order to maintain their ability to maintain loans or credit, state-chartered banks aggressively promoted checking accounts.  Federally-chartered national banks were given the power in the 1860s to issue bank notes or paper money.  This power was eliminated in the 1930s.  This left only the federal government with the legal ability to print paper money.  At various times in the past, the US government would purchases silver and gold and on the basis of those purchases, would print silver and gold certificates.  Such purchases were eventually eliminated and the silver and gold certificates were withdrawn from circulation. 

With the passage of the Federal Reserve Act, the Federal Reserve System was empowered to issue paper money, called Federal Reserve Notes.  At the present time, with very minor exceptions, the only paper money in circulation in the US are Federal Reserve Notes.  All other forms of paper money no longer legally circulate with the exception of the United States Notes.  They are so scarce that those remaining are in the hands of collectors. 

The Fed does not issue paper money in the form of Federal Reserve Notes as part of the credit creation process.  Rather, it stands ready to supply paper money in the form of Federal Reserve Notes to the public when they demand it.  This issuance of Federal Reserve Notes to the public is channeled through the depository institutions.  It is part of the depository institutions ‘cash in the vault’.  As a practical matter, nearly 90% of all legitimate transactions in the US economy are facilitated by means of checkable deposits – NOT CURRENCY.  In the illegitimate, or underground economy (estimated to be in the 10-20% range of the total economy), currency – or paper money, does virtually the facilitation of transactions.  Much of that paper money stock (Federal Reserve Notes) serves as the currency of other nations whose citizens do not trust the currency of their respective countries.

It is, therefore a bad characterization to say that inflation is caused by RUNNING THE PRINTING PRESSES!  On occasion, it could be said that hyperactivity by loan officers at depository institutions might cause acceleration in inflation. 

How does the Fed controls this activity?  http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%205/newsletter%20fiveA.htm

Again, more to follow…

(Opinions expressed on this web page are those of a faculty member or employee and do not necessarily reflect the position of University of Detroit Mercy)

Posted by byrned ( Apr 02 2009, 12:51:48 PM EDT ) Permalink

Will the Fed’s actions be inflationary?

Will the Fed’s actions be inflationary?

The recent swapping of assets by the Fed (Federal Reserve http://www.federalreserve.gov/) should have minimal effects on the monetary base.  If the ‘so-called’ toxic assets that they have purchased such as MBS, will not recover lost market values, then the $30 billion of profits that they have managed to achieve in recent years, will be considerably less into the foreseeable future.  Keep in mind that 90% of those profits are sent directly to the US Treasury.  This can be seen in the NIPA under Federal Reserve Banks (line 8) http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=85&Freq=Qtr&FirstYear=2006&LastYear=2008 . 

The Fed’s announced acquisition of over a $1 trillion in long-term US government securities is an entirely different matter altogether.  Such acquisitions increase the monetary base (Federal Reserve Board H.3 Aggregate Reserves of Depository Institutions and the Monetary Base http://www.federalreserve.gov/releases/h3/current/h3.htm).  The monetary base is equal to legal reserves of depository institution, plus the currency in circulation.  So as the Fed acquires these securities, which increase the monetary base, the legal reserves of depository institutions will increase.  This increases the capacity of the depository institutions (commercial banks, credit unions, savings banks and savings and loan associations).  For each dollar of additional legal reserves in the depository system, a multiple of checkable deposits (M1 money) can be created (Federal Reserve Board H.6 Money Stock Measures http://www.federalreserve.gov/releases/h6/current/h6.htm).  At the present time, with a 10% legal reserve ratio, an increase in legal reserves of one dollar can result in a maximum increase of ten dollars of the checkable deposits portion of M1 money.  Since one of those ten dollars resulted from the Fed’s acquisition of securities, nine additional dollars of credit can be created if the depository institutions choose to create checkable deposit money and actually lend it.  This is what is meant by the fractional reserve system

US Code of Federal Regulations

TITLE 12--Banks and Banking

CHAPTER II--FEDERAL RESERVE SYSTEM

SUBCHAPTER A--BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

PART 204—RESERVE REQUIREMENTS OF DEPOSITORY INSTITUTIONS (REGULATION D) http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=635f26c4af3e2fe4327fd25ef4cb5638&tpl=/ecfrbrowse/Title12/12cfr204_main_02.tpl . 

In the actual case, just described, the new money creation is ten times the increase in the additional reserves resulting from the Fed’s purchase of government securities, and a multiple of nine new dollars of credit. 

The ambiguous outcome here as a result of the banks’ desire to use this additional capacity to create new money and credit only if it is profitable, will the banks use this capacity.  The additional revenue from interest and fees, resulting from the new loans being made, will have to exceed all of the cost of the money and credit creation process.  If this is not the case, i.e., if the loans are not profitable, the depositories will not use this capacity to create money and credit and the result will be excess reserves.  At the present time, the depository system has a large amount of excess capacity to create money and credit.  This is measured by excess reserves as shown in the Federal Reserve’s H.3 Release AGGREGATE RESERVES OF DEPOSITORY INSTITUTIONS AND THE MONETARY BASE http://www.federalreserve.gov/releases/h3/current/h3.htm

March 11, 2009

$(billions)

Total Reserves    $678,689

Nonborrowed          48,513

Required                57,171

Excess Reserves    621,518

Monetary Base    1,535,273

Total Borrowing from Federal Reserve $630,177

This huge amount of excess reserves indicates the already huge excess capacity of the depositories.  Even without further Fed action, the depositories could create a huge amount of checkable-deposit-portion of M1 money and credit...why aren’t they doing so?  It’s not profitable.  

The Fed cannot coerce the depositories to do so.  It is the Fed attempting to push a limp string and not a steel rod.  Most likely, a goodly portion of the Fed’s acquisition of the Fed’s long-term US Government securities over the coming year or so will be used to retire the bank loans from the Fed’s discount window mechanism. In any event, it will simply result in more excess capacity until the time that bank lending once again becomes profitable.  This illustrates the asymmetry of the Fed’s monetary power.  It is awesomely powerful in crunching the economy with monetary constraint, but is 98 pound weakling in stimulating growth in money and credit.  (The Federal Reserve System: Sausage making and its relation to monetary policy http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%205/newsletter%20fiveA.htm) 

So what about the inflation?

We’ve already pointed out to you in the above that the Fed cannot force any significant increase in money and credit until profitability returns to the depository institutions.  But even if profitability returns and the depositories increase the supply of money and credit significantly, it will not necessarily lead to inflation.  To argue it will, means that monetarism is still a valid (link to monetarism).  It’s been very clear over the last 15-20 years that the velocity of the monetary aggregates (especially M1, M2 and M3) has not been related enough in a stable/consistent manner to nominal GDP.  For monetarism to be a valid explanation of inflation, requires if not a stable velocity or linkage, it must have a statistically predictable linkage to GDP.  This has not been the case in recent years.  (Economic schools of thought…of long dead economists and other items of interest

http://byrned.faculty.udmercy.edu/2004%20Volume,%20Issue%201/Newsletter%20Vol%202004%20Issue%201.htm)

There is no assurance then that a rapid increase in the growth of money and credit – even growing more rapidly than GDP, will necessarily result in accelerating inflation. 

The economy in the last 25 years or so has shown that a decrease in the velocity of any of the monetary aggregates has offset the expansive effects of increases in those same monetary aggregates.

To further support the warning that increases in the creation of money and credit will not cause significant inflationary pressures one must understand the altered behavior of the PPI and CPI. 

(The FED: CONUNDRUM, CONSTERNATION, OR CONFUSION?

http://byrned.faculty.udmercy.edu/2005%20Volume,%20Issue%201/2005%20Volume%20Issue%201.htm)

“As another indicator of those evolutionary, but dramatic changes in the increasingly competitive U.S. markets, note the changes that have also been occurring on the international front.  Increasing competition in the world, as well as domestically in the U.S. has brought together the behavior of commodity prices facing both the developing and advanced countries. 

For the past five years, as contrasted with previous data, the Consumer Price Index CPI no longer reflects the Producer Price Index pressures.  The CPI has been rising less than the PPI in three of the last five years.  Remember also, that the CPI includes services at the retail level have in previous years, been the main source of inflation.  Even with these included, the CPI is reflecting less inflation than the PPI.  This is in stark contrast to what has typically been the case in the past.”

 

As always…more to follow

(Opinions expressed on this web page are those of a faculty member or employee and do not necessarily reflect the position of University of Detroit Mercy)

Posted by byrned ( Mar 24 2009, 02:35:10 PM EDT ) Permalink Comments [1]