Saturday, March 26, 2011

How money is created

For background watch this video: Money as Debt. I am expounding on some ideas raised by it.

Anyone can create money, with the assistance of a bank. The act of signing a loan document creates money. Now the bank has a new asset, the note receivable, and a new liability, the demand deposit. The bank will quickly sell the note for cash but this just changes one asset class into another one. The total amount of money in existence has increased by the amount of the loan. With credit cards, the debtor is literally creating money every time the card is used.

When you write (draw) a check on this newly created money, you are creating an asset to the banks; however, this does not in itself create money (unless there is overdraft protection). The recipient deposits it in his bank. Now his bank has a new asset, the check, and a new liability, the increase in the recipient's bank account. They will "sell" the check to a clearing house. Now the clearing house has the asset, the check, and will credit the recipient's bank account. They will then "sell" the check back to the originating bank. The originating bank then "sells" it back to the drawer by debiting his account. Once a check has cleared, it is no longer an asset.

So once this model is understood some more discussion points emerge.

1. What happens if a check is made out to Cash and circulates as money for a while, say one month, before being deposited. In this situation, you are creating sort of your own private money out of then air. Furthermore, this private money exists in the "shadow" economy, outside the formal banking system. Imagine a club where people do this and write a number of $100 bills all post-dated for one month which they use to trade amongst themselves. And then at the end of the month, the holder of the note then would redeem it, or possibly reissue a new check in perpetuity. Now if people actually tried to do this they would be committing the crime of "check kiting". The banks who run everything hate this type of behavior. Yes there are valid concerns about fraud, but they are probably more worried about the competition. I think this is the main reason why banks are concerned about third-party endorsements - not because they are worried about whether the check will clear but because they don't want people using endorsed checks as private money.

But big corporations do this all the time. It is called "commercial paper" and since it is negotiable, it can be used as cash. In the 1800s, bank would print their own bank notes as money. They can no longer do this since the Federal Reserve has a monopoly, but commercial paper is a form of money. Some banks also issue commercial paper; however, the minimum denomination is usually at least $100,000.

2. Since anyone can create money, why not create an unlimited amount? The only constraint seems to be interest, which is necessary to pay for bank operations. What would happen if there were no banking costs? The Bank of North Dakota is a state-owned bank. Although I'm sure it is self-supporting, what would happen if its operating costs were just paid by the state? Could it create its own "commercial paper" at 0% interest in $100 denominations in whatever amount it wanted which would function literally as cash? I think it could but I'm sure there is some law against doing that.

3. This model of money creation, which our whole economy is based upon, has a fatal flaw. Although money is created out of thin air, no money is created to pay back the interest. It is mathematically impossible for all loans in existence to be paid back with interest. A certain amount of defaults and bankruptcies are necessary for the system to work.

4. Money is destroyed by people when they default on their loans. The process of money destruction is much more painful than the process of money creation. When money is created, the bank doesn't make any money except for the loan origination fee. When the loan defaults, the bank loses the entire amount of the loan - it is a bad debt expense. And since banks are so thinly capitalized, it doesn't take many of these defaults to totally wipe out their capital.

5. Right now we are in the process of money destruction, which is actually very healthy for the economy in the long run. Private money is being destroyed at an enormous rate. The Federal Reserve is creating money, but as long as the private money is being destroyed faster than the Federal Reserve creates new money, then there is no danger of hyperinflation. However, at some point in the next few years, the destruction will slow down, and then there is a huge danger of hyperinflation.

6. The flip side of this is although anyone can create money, it is idiotic to do so. Why would banks ever issue unsecured loans when default is so painful to them? And the borrower literally becomes a debt slave. Having a negative net worth is a lot worse than being poor. And this process of money creation is also destructive to the economy as a whole because it makes it unstable. And the more debt money that is created the more unstable the system becomes because the risk of default increases over time.

Anyways, enough rambling for now.

Sunday, March 20, 2011

The US is in worse shape than Japan

Japan has a total national debt (excluding local gov. debt) of 668 trillion yen. It has revenues of 92 trillion yen and annual interest of 21.5 trillion, with an annual deficit of 22.7 trillion. (Source: http://www.mof.go.jp/english/budget/e20101224b.pdf). Assuming an exchange rate of 80 yen/$ this is the equivalent of a national debt of $8.3 trillion, with an annual deficit of $284 billion, almost all of which is interest.

The US has a total national debt of $14.2 trillion, with an annual deficit of $1.48 trillion, of which $214 billion is interest.

The US's national debt is 1.7 times that of Japan (granted the population of the US is more than double of that of Japan). The US's annual deficit is more than 5 times that of Japan.

So while Japan's national debt is larger than that of the US on a per capita or GDP basis, its debt is growing slowly. Another way of putting this is while the US is not in as bad as shape as Japan yet, on an annual basis it is in much worse shape and at some point soon will be in worse financial shape overall. When this will occur is the subject of another future post.

Friday, March 11, 2011

Is this the end of Japan?

http://theeconomiccollapseblog.com/archives/has-the-tsunami-in-japan-destroyed-the-japanese-economy

The tsunami has caused trillions of dollars in damage, and the Japanese are already enormously in debt, which they are able to maintain only because the interest rates are extremely low. Could the tsunami be the event that completely pushes Japan over the edge? Ironically, this may make the dollar seem like a safe haven.

Thursday, March 10, 2011

Oil prices up 13% in one month

From: http://www.economagic.com/em-cgi/data.exe/var/west-texas-crude-long

On 2/1/11 the price was $89.58. On 3/1/11 the price was $101.07. That's an increase of 12.8% in one month. Sounds like hyperinflation to me.

Tuesday, March 8, 2011

Treasury cash

Here is something else to look at: http://www.fms.treas.gov/dts/index.html

On Jan 31 2011, the Treasury had 349,138 million in cash
On Mar 1 2011, they had 156,975 million in cash.
So they spent $192 billion in slightly over a month.

British Constitution Group

See http://www.thebcgroup.org.uk/

I just thought this was interesting:
"As a direct consequence of the betrayal of the British people by the collective political establishment, and others, the British Constitution Group is calling for Lawful Rebellion, as is our right under article 61 Magna Carta 1215."

Monday, March 7, 2011

Monetary base expansion and inflation

Here is something to keep an eye on: http://research.stlouisfed.org/fred2/series/BASE . The monetary base is exploding.

2008-01-02 847.948
2008-09-10 874.796
2008-12-31 1690.796
2009-12-30 1994.399
2010-12-29 1982.741
2011-02-23 2275.053

Monetary base is basically made up of 3 components: currency in circulation, demand deposits, and reserves at the central bank. If you define inflation as expansion of the money supply, then this is as pure as it gets. The alternative definition of inflation is the price you pay at the store, i.e. the consumer price index, CPI. To make this clear, I will call the first "money supply inflation" and the second "consumer price inflation". There is a correlation between the two although it may be a delayed reaction. Anyways it is the first that I am concerned about.

Thus far, the money supply has inflated an average of 7% per month! CPI is increasing only about 1.5% per year. Anyways, this is worth keeping an eye on to see if it keeps rapidly increasing.

Saturday, March 5, 2011

UK squatter horror story

See http://www.dailymail.co.uk/news/article-1363157/Squatters-Inc-As-professional-agencies-MARKET-vacant-family-homes-break-beware-going-holiday.html

Excerpt:

It would be difficult to imagine a more cynical and co-ordinated assault on the property owning class, a campaign spearheaded by the wretched Advisory Service for Squatters.

.. in January ... 36-year-old Mr Hamilton-Brown bought the £1 million property with the intention of turning it into a home for his wife Rebecca and their two daughters, aged four and two. He is still waiting to get back in.

‘It breaks my heart to walk past the house with the kids and be asked by our oldest “When can we move in?” and “Why can’t we go inside and have a look?” explained a weary, quietly furious Mr Hamilton-Brown.

About a dozen squatters from France, Spain, Poland and England forced a window in the early hours to get in. There were no witnesses, so he couldn’t call the police because it was a civil matter. His only option was to go to court.

Mr Hamilton-Brown was not eligible for Legal Aid, so he represented himself to save money. The squatters, on the other hand, did have a solicitor. Because they were EU citizens and unemployed, they qualified for free legal advice.

‘It’s just wrong,’ said Mr Hamilton-Brown.