Anatomy of Financial and Economic Disaster -Part2

By: Andy_Sutton

Last week we looked at some historical milestones as we compared the events leading up to the Great Depression to what we're seeing now. While apples to apples comparisons are problematic due to vast differences in the way economic statistics are measured and reported, it is a much more simple matter to see the big picture. This week, we take a look at things from a monetary perspective.

Perhaps one of the biggest misconceptions deals with deflation. How exactly is deflation (an actual shrinkage in the money supply, not falling prices) achieved? Conventional wisdom points to falling prices, and debt defaults as a source of deflation. Does the theory really hold up though?

Are defaults deflationary?

In order to understand the situation of a default (and falling asset prices) let's create a microcosm of our economy. Let's say for example that we have 5 people. In the initial phase, we set our money supply at $600 with each person possessing an unequal portion of the total. In the Loan step, Person 5 borrows $150 from Person 3 for the purposes of buying a home. In the Purchase step, Person 5 buys the home from Person 1. Then person 5 defaults after making 2 payments of $5 each to person 3. Notice that the default to this point has not changed the money supply. Then Person 3 forecloses on the house and resells it to person 2 for $100.

Even after the loss of 1/3 the home's value, the total money supply is NOT affected! However, we can see that Person 3, the original lender is worse off by $40. Person 1 has seen a $150 increase as a result of selling the house in the Purchase step. Person 2 is $100 worse off, but now has the house. Person 5 is $10 worse off, but enjoyed the ownership of the house for 2 payment periods. Person 4 was unaffected as he wasn't involved in any of the transactions.

In any case, in the above scenario, we had a sale, some payments, a default/foreclosure, and the resale of the property at 2/3 its original value. Even after all that, the total money supply wasn't affected. We had neither inflation nor deflation. The $600 we started with is still there, able to be spent. Certainly some parties are better off and some are worse off, but in the aggregate, nothing has changed.

Now let's look at what happens when Person 3 is a bank that lends out $2 for every $1 it has in deposits. In our case, the bank lends out $200 to persons 1 and 5 for houses. Persons 1 & 5 each take their $200 and give them to Person 4 who has two houses for sale. So Person 1 and 5 see their cash balance go back to where it was originally while Person 4's balance is up to $500. Persons 1 and 5 each make 2 payments of $5 to the bank before defaulting. The bank then takes the houses back and sells them at a loss to person 2 for $75 each.

In the above scenario, we saw the money supply grow from $600 to $1000 as the bank lent out $2 for every dollar on deposit. Notice, its cash balance didn't change after the loan. In fact, it created more money for itself because the loans it made were made from nothing, and real capital was in fact owed back to the bank. At the end of the exercise, the money supply was still $1000 even with two defaults and the bank selling the houses at a substantial discount. And if you look at the bank's tally, it made out quite well DESPITE the 100% default rate and loss of value of the houses.

The second scenario is a simplified version of how our banking system works. As can obviously be seen, the best way for the bank to make money is if it makes loans because of the multiplier effect. And the multiplier effect in the US banking system is much higher than the 2:1 observed multiplier used in the example. Contrary to the popular belief that the Fed is the only creator of money, the banking system is where most of the heavy lifting is done. For reference, the multiplier in the US is closer to 10:1.

Let's tally the two situations. Without a multiplier, you get no change in money supply, which should be expected, and when we made the multiplier 2:1, we saw a 40% increase in the money stock. If the bank still ‘makes money' despite a 100% default rate, how exactly is it that money can disappear from the system? The multiplier is the first possibility. If the multiplier were lowered (ie: reserve requirements raised), banks would have to readjust their loans, maybe make less loans, call in some loans that were callable, or find ways to increase deposits. Unfortunately, raising the reserve requirements would only slow the rate of money supply growth. Even if reserve requirements were raised to 100% (which is a practical impossibility in our banking system), this would ONLY result in a stable money supply as demonstrated by our first example. Still no true deflation even though we have falling asset prices.

The central bank can drain money from the banking system by cutting off loans to commercial banks or by selling assets off its balance sheet to withdraw cash from the system. Perhaps a more ridiculous and anecdotal way money could be destroyed is if people removed cash from their banks accounts and burned it. Given the current economic realities, the latter is more likely to happen than the former.

Savings and Loan banks insolvent by nature

This is one of the biggest reasons why the banking system cannot afford to have a run on it. By design a commercial bank is insolvent. Its assets are spread out over time while its liabilities (deposits) can have zero time preference. People can demand their deposits in full at any time. Plus, runaway withdrawals from bank accounts in addition to causing the bank to run out of cash also cause the bank to have to curtail loan structures to maintain reserve requirements. While all of these things happen to a certain degree on a daily basis under normal conditions, the system is able to smoothly cope by interbank lending facilitated by the central bank. However, in extreme situations, the system itself can come under extreme stress. We have seen a good bit of this recently with the bank runs on Northern Rock in England and IndyMac Bank here in the US .

Did you know?

•  That the growth of consumer credit and GDP have a .97 correlation since the 1970's? This means that without consumer borrowing, our economy essentially goes nowhere. (Note: consumer credit decreased in August 2008)

•  US total money supply as measured by M3 is over $14 trillion. We have debt over $10 trillion. While it is not due and payable in its entirety at one time, we're either going to have to take money from other parts of the economy to pay it or we're going to have to create more money. It's as simple as that. And the debts moving forward only continue to mount. More and more dollars will be necessary to accommodate both the principal repayments as well as the interest on the debt. While the expectation has always been that foreigners will be willing to lend our exported dollars back to us, we will reach a point where they either refuse to do so or a point of exhaustion. Plus, we need ever-increasing dollars here at home if we are to continue to have ‘growth'.

What does this mean for the US ?

The implication here is that if the money supply cannot be grown to accommodate the payment of this debt that the US government will be forced to default. At this point, it would seem we don't have to worry too much about real deflation unless for some reason it is intentionally created by the central banks or as a byproduct of further misguided policy. The biggest concern for the financial system now is rather the lack of ability to continue to inflate.

As the debt mounts, the lack of ability to create money to both enable the real economy to function and the repayment of the debt would cause deflationary affects such as a shortage of dollars, and therefore falling prices since there would fewer and fewer dollars available for goods and services. This is why the credit and lending function is so important. It is why banks are willing to renegotiate loans. As long as the money keeps coming in, it can be multiplied. A few years back, Ben Bernanke said he'd drop money out of helicopters if needed to keep the spending spree going. Maybe Ben wasn't so dim after all. That he would even make such a comment underscores the fact that he understands exactly what is going on and discredits any supposition that he didn't see this crisis coming.

In summation, it would appear that our position moving forward is very similar to the Field of Dreams byline “If you build it they will come”. However, in our case, the sixty-four thousand dollar question is “If you create it, will they borrow?”

Next week we take a look at what things will be like on Main Street moving forward as these new chapters in our nation's history are written. With the playing field resetting almost daily, up to date analysis will be crucial. Our premium newsletter provides not only monthly installments, but also occasional updates between issues as circumstances warrant. For more information, visit our website www.suttonfinance.net/newsletter.php

By Andy Sutton
http://www.my2centsonline.com

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. His firm, Sutton & Associates, LLC currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar. For more information visit www.suttonfinance.net

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