Derivatives game players grab for dollars when the music stops.
To kick things off on the Stockhouse moderated macroeconomics group (see background article here), SH writer/editor and group moderator Robert Arber (known on Stockhouse as SH_Arber) put out a call to the participants to define inflation – what it is, what it means, and how it is manifested in the economy.
For the final installment of the “Inflation and money supply” series, Paul van Eeden’s analysis once more formed the basis of discussion – and the one-and-only Alan Greenspan is thrown into the mix.
For a refresher on how the discussion has been proceeding to date, check out the following links:
Investor groups launch with macroeconomics discussion
Inflation and money supply, part I: Treasuries crowd bonds
Inflation and money supply, part II: Buyer’s remorse
Inflation and money supply, part III: Indeflationists unite
Inflation and money supply, part IV: Measuring money
Inflation debate stirs investors
Please add your comments at the bottom of the page, and enjoy!
[Editor’s note: Posts have been edited for punctuation, spelling, grammar and length.]
gabrielgray: I want to refer back to Paul van Eeden's discussion of TMS vs. M3 because there's something bizarre in there that needs to be examined. [Editor’s note: See van Eeden’s original article on Kitco here: http://www.kitco.com/ind/VanEeden/jun022008.html]
Van Eeden mentioned something that I've puzzled over, and I think it's extremely significant even though no one has much to say about it. He quoted Greenspan as saying that it was becoming increasingly difficult to define money, and to say what was money and what was not.
That statement should make people sit up wide awake, because it holds out a clue as to why inflation has been hard to track and predict in recent years. Greenspan is of course well aware of the approaches economists have conventionally applied to pin down and delineate the functions of money. I'm pretty certain that what he was saying is that we have created financial entities that fulfill some of the functions of money, but not others. Put another way, if an asset can be used as specie to make a purchase, does that make it money? Is a commercial letter of credit actually money, and if so, does its issuance expand the money supply?
By now, you can probably see where this is going. I have maintained in the past that the fractional reserve Fed system is no longer the main culprit in monetary inflation that we face. The downline lending of Fed credit has an undeniable expansionary dynamic as the money inflates asset bases through the 10% capital reserve ratio. A whole string of banks are claiming essentially the same money as loan assets on their balance sheets, and each is using the money (or 90% of it) as lending capital in successive transactions.
But what about the creation of structured credit derivatives? No one has ever included collateralized debt obligations, credit default swaps or interest rate swaps in any conventional definition of money supply at any level, because it's assumed that they are capital assets and not currency. While they are certainly not currency, does that mean they have no effect on aggregate monetary base?
For the sake of argument, let's back off a notch on the complexity of the instrument. Is a Treasury bond or T-bill money? Most people would say no. But let's think about that: Various Wall Street banks and brokers are being supplied with Treasury securities in the place of defunct credit derivatives every week. To what end? To recapitalize the banks. How is it that banks can be recapitalized with something that is not money? The answer is that Treasury securities are fungible assets, with a very easily determined value at any point in time.
Now, let’s return to conventional definitions of money. To function as money, an item must serve as:
A medium of exchange
A claim on goods and services
A measure of value
A store of value
It seems simple enough. That is, until you start to think about it. People don't buy cheeseburgers or Chevrolets with Treasury bonds. But Wall Street trading houses do things with Treasury debt that normal people don't do. They borrow yen, sell yen to buy dollars, and use the dollars to buy Treasury bills. They then use the T-bills as collateral to borrow more yen from BoJ (Bank of Japan), and repeat the process to buy more T-bills. The T-bills may be sold, traded or used as collateral for other shady and highly suspect financial manipulations. In other words, certain persons who regularly make large financial transactions regularly use T-bills as a measure of value, a store of value and even a medium of exchange.
Someone is already objecting, "But T-bills aren't used as a claim on goods and services, so they don't fulfill all the functions of money." Okay, so far so good. But have you thought about this: Does a United States Federal Reserve Note fulfill all the functions of money? Let's see, medium of exchange - Yup, claim on goods - Yup, measure of value - Yup, yup, and store of value… Uh oh. The USD/Gold five-year chart says that dollars just don't cut it as a store of value. "Gold's a volatile commodity, you idiot!" someone shouts. Very well, then. How about the USD/EUR chart? That looks nearly as bad as the dollar/gold comparison. There's a reason all those danged furriners are clogging up my national parks and monuments - it's because the EUR has pounded the daylights out of the USD as a store of value over the last five years. I think the real truth is that gold is not a volatile commodity so much as a very revealing inverse indicator on the volatile dollar.
It has to be acknowledged that the USD is today a very poor way to store value, unless you just need to store it overnight.
Do you see my point? Neither dollars nor derivatives fulfill all the functions of money these days, but both of them fulfill some of those functions. I suspect that, just as an overabundance of dollars is distorting the prices of commodities these days, a couple of years back an overabundance of structured credit derivatives was working to distort the prices or values of other financial assets such as stocks and bonds. Bonds remain overvalued but are beginning to correct. Stocks peaked last October and have seen substantial correction already, with (I believe) more to come.
Is it possible to deny that the ongoing collapse in stock valuations is very substantially a result of the implosion of value in structured credit? Vast amounts of money (in the sense of marked value on balance sheets) were created in the explosion of financial derivatives. But it wasn't real money, with value created in goods or services behind it. It was bogus money, like the "wealth" that miraculously appeared in people's home equity from 2002 to 2007. And as such, it is now evaporating. The bad news is that, as it collapses inward upon itself, it is creating a debt implosion that is not bogus, and is genuinely deflationary.
Here's a simple parallel. Ben bought his house three years ago for $300k. Last year, he sold it to Al for $600k. Wachovia Bank took $600k of real money and loaned it to Al to buy Ben's house. Ben took the $600k and split for Grand Cayman.
This year, Al has realized that he cannot keep up the payments, and furthermore, the house is no longer worth anything like $600k. Al walks away after mailing the house keys to Wachovia. Wachovia takes possession of the house and auctions it, bringing in $400k. The net result of this unfortunate exercise in fantasy values it the destruction of $200k of real money.
The $600k valuation of the house was fantasy, driven by speculative delusions. But the $200k was real money, and it's really, really gone.
And that's all I'm going to talk about this, because it's giving me the heebie-jeebies to think how much real money is being vaporized by Wall Street's Derivative Death Star. I feel a great disturbance in the Force.
littleguy123: I should have probably attempted to speak/think theoretically like this earlier in the day - when the synapses were firing a little more smoothly, but I'll see if I can follow up on what you said.
It's basic economics that if you can increase the velocity of money that you can increase total wealth - simply through having the same dollar bill pass through one extra set of hands over a set period of time (without increasing the money supply - in ANY conventional sense). When you arm a bunch of greedy bankers with this basic knowledge, then undoubtedly they would begin to hatch various schemes for either 'juicing' the velocity in a particular economy, or simulating greater velocity.
If you can't actually speed up the velocity, you can accomplish the same thing by essentially 'sharing title' of that dollar with other business associates/accomplices - so that instead of a dollar passing through (for example) five sets of hands, if you can simply be creative with your accounting and/or your transactions, then you can accomplish the same thing by having the same dollar 'exist' on five different sets of books simultaneously (as an asset).
Ultimately, that's what derivatives do, isn't it? There is no actual money created, there are no new assets to add to the mix. You're simply 'stretching' the same number of dollars over more sets of books to artificially increase money velocity - and let bankers reap obscene profits just by manipulating an (originally) fixed amount of capital.
This is why it's ESSENTIAL that these "financial products" be as opaque as possible, so it's impossible to unravel the webs of manipulations - because if that was actually done, then you would (visibly) have multiple parties simultaneously asserting ownership/possession of the same dollar, and the scam/scheme would fall apart.
So isn't this implosion/contraction simply one huge, financial game of "musical chairs"? But when the music stops, instead of the players each scrambling to grab their own chair, they are each trying to grab 'their own' dollar - except (of course) there aren't enough to go around. This is why Wall St.'s game plan consists of various stalling tactics and NEW accounting gimmicks - to try to create new shams and 'stretch' more dollars faster than those old shams are evaporating.
frontline_jason: Alright littleguy, I think you're onto something with the derivatives game. What we need is a field test, so I propose the following: On Saturday, after [my CFA test], my friends and I will get drunk and play musical chairs with one chair. We will iterate the process a few times just so that the results are robust and I will report back to everyone on Monday LOL. Sounds good? May the force be with us… I have my light saber handy just in case.
This group discussion was conducted with members of the Stockhouse community.
Next: The group turned to a discussion of oil and commodities and assessed whether we’re in an energy bubble or not. Answers may surprise. Tune in for the next series of articles from the Stockhouse macroeconomics group, “Oil supply, oil demand.”
Archive
Investor groups launch with macroeconomics discussion
Inflation and money supply, part I: Treasuries crowd bonds
Inflation and money supply, part II: Buyer’s remorse
Inflation and money supply, part III: Indeflationists unite
Inflation and money supply, part IV: Measuring money
Spin-offs
Inflation debate stirs investors
