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Generational Dynamics Web Log for 10-Sep-07
Understanding deflation: Why there's less money in the world today than a month ago.

Web Log - September, 2007

Understanding deflation: Why there's less money in the world today than a month ago.

As the markets continue to fall, the Fed is increasingly in a big bind.

I've received several recent inquiries from web site readers about how there could be less money in the world today than there was a few weeks ago.

Here's how one web site reader put it:

"The only part of your theory that I do not understand is this: I sell my stock in company ABC. I have to put that money in some instrument. The stock is valued at the sell price. Everyone else follows suit in a panic. They all put the money under the mattress or somewhere, The stock continues to decline. The wealth is not disappearing. It is simpling changing hands."

The reader has a point. If you sell your stock, it just means that money goes from one person to another. It doesn't mean that there's less money in the world. So why is there less money in the world?

What we're going to show is how use of credit CREATES new money. What's happening today is a "credit crunch," and the withdrawal of credit actually DESTROYS money.

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First, you have to realize that money doesn't actually exist much any more, at least in physical form. When you put a coin into a vending machine, you're buying something with an actual coin; but it's more likely that you're paying by credit card or by check, and then there's no physical value at all.

Let's start with a silly example. Suppose your bank's computer software has a bug, and it mistakenly adds $10,000 to the balance in your checking account. Well, suddenly you're $10,000 richer, and there $10,000 more money in the world. That's how easy it is. And when the mistake is discovered, you'll be $10,000 poorer and there will be $10,000 less money in the world.

That was a silly example, but let's look at some more realistic examples:

Suppose I have $100 and you have nothing. I lend you the $100, and get an IOU from you for $100. All of a sudden, $100 has turned into $200. How? You have $100 in your pocket. I have a $100 IOU that I can use as collateral for $100 worth of more investments. So we have $200 between the two of us.

Let's look at something more complicated. I buy a share of certain hedge fund for $100. Frank does the same. I sell my share to you for $200. Now I have $200, and you have a hedge fund share worth $200, so we have $400 between us. But what about Frank? His share is now worth $200, even though he's just been sitting there, doing nothing. So Frank has also made $100, and there's a lot more money in the world.

Last year I provided a lengthy explanation of how hedge fund managers "make money" -- and I mean that literally -- they actually create new money. Briefly, they start up a new hedge fund, based on underlying assets of any kind whatsoever, and then bid up the price of the hedge fund shares so that they're worth many times more than the value of the underlying assets. In essence, the hedge fund manager is "making money" -- literally, as if he had a printing press. The hedge fund shares can now be traded at their inflated values, so in some circles they're as good as money.

All of these examples have been occurring with increasing frequency, ever since the dot-com bubble began in the mid-1990s.

In fact, each of the above kinds of things have happened trillions of times in the last few years, and really took off in 2003. Those trillions of times created huge amounts of new money, and that new money created the real estate bubble and various other bubbles.

And now, all of the above processes are going in reverse. Where huge amounts of money were being created, huge amounts of money are now being destroyed.

The destruction of the credit bubble is occurring very rapidly right now. One form of credit is "asset backed commercial paper," or ABCP. This is like the IOU that I described in the example above. One business loans money to another business, and receives ABCP back as collateral. If the ABCP was backed by a AAA-rated corporation, then the ABCP itself can be used for other investments.

However, let's go back to the IOU example that I gave above. Suppose the IOU expires after 90 days. Then two things can happen. After 90 days, you will have to pay me back my $100 (with interest), and I'll return the IOU to you; or you'll simply issue a new IOU for another 90 days and keep the $100. (This last is called "rolling over.")

That's how commercial paper works. It can be issued for 30, 60 or 90 days, and when that period is up, the issuer either has to pay up, or else roll the commercial paper debt over into new commercial paper. Usually the rollover option is pretty much automatic.

But that stopped happening a few weeks ago. The commercial paper market has almost been frozen to a standstill. The amount of commercial paper is falling so rapidly that the phrase "crash" applies to it.

Take a look at the following chart, which appeared on Michael ("Mish") Shedlock's blog, and pay particular attention to the thick white line which started skyrocketing in 2004:

Chart showing the evaporation of commercial paper in the last four weeks. <font size=-2>(Source: Bloomberg via Bennet Sedacca)</font>

Chart showing the evaporation of commercial paper in the last four weeks. (Source: Bloomberg via Bennet Sedacca)

If you look at the thick white line, you see that it reached a peak very close to $1.2 trillion a few weeks ago. Since then it's been falling like a stone, and on September 5 it had fallen 20%, to $959 billion.

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That thick white line represents the amount of commercial paper in circulation. And since commercial paper represents money, it shows that the amount of money in the world due to commercial paper has fallen by some $200 billion in the last few weeks.

Is that the end of the commercial paper crunch? Hardly.

According to an analysis in the Sunday Telegraph,

"Britain's biggest banks could be forced to cough up as much as �70bn ($140 billion) over the next 10 days, as the credit crisis that has seized the global financial system sparks a fresh wave of chaos.

Almost 20 per cent of the short-term money market loans issued by European banks are due to mature between September 11 and September 19. Senior bankers fear that they will have to refinance almost all of these debts with funds from their own coffers, putting a further strain on bank balance sheets.

Tens of billions of pounds of these commercial paper loans have already built up in the financial system, because fear-ridden investors no longer want to buy them. Roughly �23bn ($46 billion) of these loans expire on September 17 alone.

Fears of this impending call on bank credit lines are the true reason that lending between banks has ground to a halt, according to senior money market sources.

Banks have been stockpiling cash in preparation for this "double rollover" week, which sees quarterly loans expire alongside shorter term debts - exacerbating a problem that lies at the heart of the credit crisis."

According to a commentary article,

"As we reveal today, an estimated �70bn worth of European commercial paper that has not yet been caught up in the crisis is due to expire between September 11 and 19. Ordinarily, this would present little problem. Companies borrowing money by issuing commercial paper normally expect to "roll over" the loan from one period the next. Just in case the lenders decide not to play ball, most borrowers arrange a backstop funding facility with a major bank.

Except, now, everyone is getting cold feet at the same time. Lenders are worried that some of the borrowers could be contaminated by the subprime mortgage crisis in the US. Until they can find out which ones, they don't want to lend to anyone at all. So the banks who offered backstop lending lines will soon discover just where the buck really stops."

For those web site readers who wrote to me, and to others who have wondered how money could be disappearing from the world, I hope this clears things up.

Money doesn't really exist any more, in the sense of coins or currency. Money today exists only in the form of bits and bytes in computer databases. And those bits and bytes can be changed in a nanosecond to be larger or smaller, creating or destroying money. And today, they're mostly destroying money.

So now you can see the bind that the Fed is in. I recently posted two articles on Bernanke's philosophy for avoiding a new 1930s style Great Depression: "Ben Bernanke's Great Historic Experiment" and "Bernanke's historic experiment takes center stage."

These articles tell of Bernanke's belief that the 1930s Great Depression could have been prevented, and that a new Great Depression can be avoided, by injecting money into the economy.

This is the "deflation" problem. As the amount of money in the world contracts, there's less money available to buy things, and so prices come down. As I've been saying since 2003, my expectation is that the Consumer Price Index will fall 30% by 2010.

Alan Greenspan and Ben Bernanke used to believe that deflation was impossible. After a decade of deflation in Japan, they finally decided that it was possible, but only if the central bank made mistakes. This is why I keep saying that mainstream macroeconomics has been a total failure.

Now we're beginning to see the real reason why deflation occurs, and why it can't be stopped: The problem is that the Fed and other central banks don't have anything like enough money to compensate for the huge contraction in credit that's going on right now.

Above we showed just what's happening with one form of credit, commercial paper, representing about one trillion dollars of debt. There are hundreds of trillions of dollars in derivative instruments of all types out there in the world, and these are going to contract just like commercial paper.

Frequently on this web site I use the analogy of a tsunami: You can't stop a crisis war from coming any more than you can stop a tsunami; all you can do is prepare for it.

The collapse of credit, and the destruction of money, are the tsunami currently on the horizon.

Bernanke had thought he could stop the tsunami by putting up a small barricade on the beach. But the tsunami will wash over that barricade as if it weren't there.

The stock market is another form of credit. You purchase shares in the company with money that the company uses for its expenses. If the commercial paper market can crash, then so can the stock market.

At some point in the not too distant future, this is going to trigger a major panic. If other forms of credit are crashing as quickly as commercial paper is crashing, then it may yet happen by September 21, or shortly after that otherwise. (10-Sep-07) Permanent Link
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Generational Dynamics Web Log for 10-Sep-07 Understanding deflation: Why there's less money in the world today than a month ago.

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Understanding deflation: Why there's less money in the world today than a month ago.