The Coming Potential
Crisis: A Somewhat Brief Explanation
by Brandon Powers, BA
Economics, Ohio State University
Let me start by saying
that the following is not a politically charged rant. This isn't just
some bullshit about the minimum wage, Obama, gun laws, etc. This
stuff actually matters a great deal, and I'll bet that most people
who read this have no idea whatsoever that this is even an issue.
A few days ago, the
European Central Bank (ECB), headed by Mario Draghi (Ex-Goldman
Sachs, Harvard) announced that they would now charge member
banks to hold their reserves in their savings accounts, through the
use of a negative deposit rate of -0.10%. In a normal savings
account, the bank pays you interest. Now, the member banks will be
paying the ECB interest.
I will
try my absolute best to refrain from econ jargon and uninterpretable
jibberish from this explanation, since the readers of this are likely
not up to speed on Macroeconomics. However, it is a very complex
issue and will require some thinking. The best way to explain the
situation is through a series of questions and answers:
What
are bank reserves?
How
does borrowing and consuming create price inflation?
Why
is price inflation desired by central banks?
Why
and how does borrowing and consuming create boom and bust cycles?
What
may happen to _____ if the Fed pursues a similar policy?
The
stock market
The
bond market; treasuries, corporate, junk, MBS
The
housing market
Commodities
Interest
rates and the US Dollar
US
government debt
The
average American
What
can be done to hedge against this risk?
The
silver lining... or is it?
Why
should you spread the word?
What
are bank reserves?
Bank reserves are the amount of cash on deposit that banks hold
above the reserve requirement. If you don't know anything about the
American banking system, it goes like this; You deposit $1000 at 1st
American Bank. The bank loans out $900 of your $1000 deposit to a guy
named Barry. They keep $100 in the vault due to the reserve
requirement, in case you come wanting some of your money back.
It works very similarly for big investment banks, too. Think of the
Federal Reserve, Fed, as 'the banks' bank,' where the big banks have
accounts. So, bank reserves are like 'credits' to use as loanable
funds.
Here is where our problem begins. In the US and in Europe, the big
banks have been parking tons and tons of cash at the Fed and ECB,
where it collecting interest at 0.25% APY. They have been stowing the
cash that they have received from the Fed's asset purchase program
known as Quantitative Easing.
Normally, this is where economists will go off into a spiraling
series of explanations of intertwining issues... the joke goes,
“Economists can be both clear and short, but not at the same time.”
So,
the big banks have all these
excess reserves
parked at the Fed earning a tiny
profit. So what? Well, the economy can't pick up speed if there are a
lack of loans being made to businesses, consumers, etc. The banks are
reluctant to lend because they're still nervous from 2008, you know,
their near-death experience, and would rather make 0.25% risk free
over lending at 3.5%. Not to mention, the banks are still on life
support. But both the Fed and the ECB want banks to loan out the
money to create price inflation.
How
does borrowing and consuming cause price inflation?
Back
to our bank story with you, 1st
American Bank, and Barry. Barry has taken out a $900 loan from 1st
American. Barry uses that money to buy a new reclining leather couch
with cup holders so he can get the bitches. He bought the couch from
Jeff, who now deposits that $900 into his account at 1st
National Bank. 1st
National Bank now loans out $810 (remember, 10% reserve requirement)
to Hank, who buys a new exhaust system for his Honda Civic to make it
sound mean and get the bitches. He bought the exhaust system from
Ricky, who deposits the $810.... This is called fractional reserve banking, and it creates new money out of thin air.
This goes on and on and on and on until eventually, $10,000 of new
money is created. The quicker way to find that out is to take the
initial deposit amount, $1000, and divide by the reserve requirement,
0.10.
As
this new money enters the economy, each dollar becomes slightly less
valuable. If there are 1,000,000 apples at the grocery store but only
10 oranges, which one do you think has the higher price, all things
equal? (You're comparing apples to oranges!) The oranges, because
they are more scarce. So, if the money becomes slightly less scarce
with each new dollar entering the economy, costs rise on basic
materials, which works its way around until eventually businesses
raise prices, that way they attain more dollars with less value and
net-net receive the same real
amount of profit.
Why
is price inflation desired by central banks?
Central
banks want low price inflation because they think it 'greases the
gears' of the economy. (Please note: economies are not machines, they
do not have set outputs for set inputs.) What that means is that if
consumers anticipate the price of goods will rise next year, they
will buy them this year, and that spurs Gross Domestic Product (GDP),
of which 70% is made up of consumption. GDP is calculated by this
simple equation:
Y = C + I + G + NX
Output
(GDP) equals consumption spending plus investment spending plus
government spending plus the value of net exports (imports minus
exports). This is the standard measure of economic power in use
today. Therefore, central banks want to keep the economy strong by
encouraging spending, which we know causes price inflation.
How
does borrowing and consuming create boom / bust cycles?
First,
let's start with the definition of a boom and bust. Booms are times
of growth, when GDP annually grows at a rate < 2%. Busts are when
GDP contracts, or has a negative growth rate, for more than two
consecutive quarters. This is also called a recession.
During the boom phase, consumers and businesses take on more debt.
Consumers borrow money to buy cars, houses (eek! 2008!), furniture,
vacations, anything! They will take on more debt if interest rates
are low. As they spend this money, businesses expand in order to keep
up with the consumer demand, which they are able to do with low
interest rates. Prices start to rise as each dollar becomes less
valuable in the economy. Eventually, the creditors will start to
raise interest rates (which if you think about it is also a price;
the price of money).
During the bust phase, interest rates begin to rise. The cost of
borrowing rises. Consumers slow spending and start to pay down their
debts because of the increasing interest payments. Businesses, which
have expanded to meet the consumer demand, must cut back due to the
decrease in consumer spending. This means layoffs, since the first
and highest cost to businesses is labor. As more people become
unemployed, they spend less, and save what they can. This is helped
by rising interest rates: would you rather deposit your money and
earn 2% or 5%? As more and more consumers save their money and pay
down debt, interest rates fall, and before long the economy is back
in the boom phase.
For the sake of simplicity, we will say that this is the natural
state of markets and the economy (it's not). Because this is
“normal,” what's the problem? The central bank!
Think of it like this: the central bank pumps money into the economy
through asset purchases. They buy these assets (treasury bonds) with
reserves from the big banks, who loan out the reserves. Those
reserves collected from the asset purchases by the central bank are
like “fake savings.” They achieve the same result as actual
savings; it lowers interest rates. The difference is that consumers
spend money they don't have, which means that the boom is
'artificial.' The businesses that expand are being duped into
thinking that this spending can continue, when it really can't.
My personal favorite analogy to explain this goes like so: A man
owns a restaurant in a town. One day, the circus comes to town. Every
day from open to close the restaurant is packed with clowns. The man
can't see that they're clowns, though, so he thinks it is real demand
for his food. He opens up a second restaurant on the other side of
town, which also gets packed every day with clowns. Eventually, the
circus leaves town, and sales at the restaurant plummet. The man, not
knowing that this was only temporary demand, has to close down both
restaurants because he can't afford to keep them open due to the loss
in sales and rise in interest payments on his loan for the second
restaurant. As a result, his workers are now unemployed and the bank
that loaned him the money has a default on their books.
What
may happen to _____ if the Fed implements the ECB policy?
Remember, the Fed wants banks to lend their reserves out and create
inflation which (in their minds) will boost the economy. The banks
don't want to lend because they can earn 0.25% risk free on $4
trillion worth of excess reserves. If they Fed were to implement the
ECB policy, and make that 0.25% into -0.10%, the banks would have a
higher incentive to lend the reserves out. So what will happen to...
The Stock Market
Stocks
will likely rise in the short run after the announcement. Higher
prices means higher profits, and investors like profits. In the long
run, the following scenarios would do a lot of damage to stock
prices.
The Bond Market
Yields will rise on bonds. As new money enters the economy, prices
rise, including interest rates. For those of you that don't know how
bonds are priced, I'll simplify. If interest rates rise, bond prices
fall; they have an inverse relationship. If yields (interest rates)
rise on bonds, investors lose money.
Some
of you may have heard in the news recently that the big banks are
more profitable than ever before. And you might think, “Wait, I
thought they were just on the brink and had to be saved with MY tax
money?! And if they aren't making loans, where are the profits coming
from? Dafuq yo!” That's because they have been borrowing at near 0%
interest and buying treasury bonds and other bonds that yield 2.5%-5%
and leveraging that 60 times over, making huge profits. This is
called a carry trade,
and has become the main business of the banks, not lending.
If yields rise on treasuries, corporate bonds, junk bonds, and
mortgage-backed securities (MBS), then this carry trade profit
machine would quickly turn into a loss machine, and banks would be
right back where they were in 2008. I mean, this is the real-life
Walking Dead. Many, many more things could happen if yields rise
significantly on bonds, but to explain them all would take 20 pages.
The Housing Market
So we all know that the housing market collapsed over the course of
2006-2010. That is a topic for a later date. Prices have since begun
to rebound, starting in 2011. In fact, prices are higher than they
were at the peak of the bubble in markets like San Francisco, where
the median home price is $800,000! But, home ownership rates
have only recovered slightly, and 1st time home buyers are
near all time lows. This is due to the very small spread of mortgage
rates. If the prime rate (the best interest rate available, applies
for those with excellent credit, etc) is only 3.5% on a 30yr
mortgage, the bank won't make that much money. It is also due to the
fact that many of those who would be 1st time buyers are
still laden with debt they took on during the bubble years, and many
are chained with heaping student loan debts, rendering them bad
candidates for mortgages. So how have prices risen? As soon as home
prices began to bottom in 2010, a furor of speculation resulted in
homes being bought up left and right in all cash deals. Therefore,
housing prices have not recovered 'naturally.' It's reminiscent of
the bubble days.
Not to mention, many current home owners are still underwater,
meaning they owe more on their mortgage than what the house is
currently worth. Many home owners can barely afford their homes at
current near all time low rates. If interest rates rise, how will
people be able to afford homes at all? The bottom will fall out yet
again in the housing market.
Commodities
Think back to what was said about price inflation. As the new money
enters the economy, the devaluation will affect the price of basic
materials and commodities first. Things like oil, natural gas, food,
etc. As the prices of these rise, the costs on businesses will rise
and they will raise prices. If we do some simple math using the
reserve requirement ratio and the chart of excess reserves shown
before we can make a rough guestimate as to where the price of oil
could be should all that money make its way into the economy.
Reserve Ratio: R = .12
Excess Reserves = $2,544,000,000,000
254000000000/.12 = $2.12e^13, or $21,200,000,000,000
Twenty
one trillion, two hundred billion dollars.
Don't take this too literally, but that could send oil prices to
$600/barrel, all things equal. Gasoline where I live in Ohio is about
$4/gallon. With WTI Crude prices right at about $100/barrel
currently, that makes the price of gas about 4% the price of crude.
Assuming that remains constant, gasoline could be as much as
$24/gallon. You get the picture?
Interest Rates and the US Dollar
If inflation begins to pick up when the banks start lending out the
excess reserves, interest rates will absolutely have to rise. The US
dollar will lose value compared to other currencies, making imported
goods more expensive. Most of the goods we use each day are imported,
so that would affect households greatly.
US Government Debt
The national debt, only including what the US Government owes to its
bondholders and not to future liabilities like Social Security (mega
ponzi scheme by the way), stands at $17,555,437,713,940 as of April
2014. The Government currently pays interest on that debt at very low
rates and on very short term maturities. If interest rates rise, the
burden of paying down that debt becomes much heavier, and a very
large portion, if not all, of revenues will go just to 'servicing the
debt.' You know what that means? MUCH higher taxes, because of how
overextended the Government is. Our creditors, China, Japan, etc.,
will want to see higher taxes so that they will have faith that our
Government will be able yo pay what they promised on the treasury
bonds they hold so much of (trillions worth). It also means drastic
spending cuts will have to be made, but who knows what they'll cut?
Everyone wants their hand in the honey pot; “You can't cut my
Social Security! My Medicare! Welfare! The Military! The EPA!
Nothing!” They through an enormous fit when the Government shut
down for a couple of days, and when the 'sequester' of $85 billion
worth of cuts were made in March of last year.
The Average American
So,
according to what I've just listed, shit looks rough. Higher prices,
higher taxes, you name it. If the Fed cannot contain the inflation
they want so badly, the economy will spiral into a much worse
recession than the fiasco of 2007-2009. And I wouldn't have much
faith in our wise overlords at the Fed to save the day, either.
Here's Ben Bernanke, former chairman of the Federal Reserve, being
absolutely wrong on everything that was coming during the housing
bust:
What
can be done to hedge against this risk?
Unfortunately,
this is not so easy to explain. One could say leave the country, or
put your money in a Swiss bank account, what have you. The most I
could offer is to hold what money you can in physical gold.
Gold throughout history
has always been seen as valuable, no matter what has happened. If
those pieces of paper that we call Dollars (not backed by gold since
1971) lose their value substantially, you make look like this:
In
addition to gold I'd hold physical commodities... anything tangible
that would have value to someone. That's being extremely vague, but
consider a world where dollars are not the preferred medium of
exchange when you think about what has value.
The
silver lining...?
Aside from all the gloom and doom, this is actually not all that
likely to happen. I think (...I hope...) the Fed is not that stupid
to try and let loose 22 trillion dollars. That said though, it could
be unavoidable. The Fed has no 'exit strategy' of how to get out of
the economy, so to speak. They have no solid plan on how to control
all those excess reserves should they start flowing out from the
coffers of the Fed. Hell, the Fed itself could potentially become
insolvent!
While I don't think the Fed will step out into the unknown like the
ECB, I would not put it past them. And even if they don't the
aforementioned scenarios can still very well play out. You don't
create all that money that quickly and expect there to be no
inflation forever!
Why
should you spread the word?
The
American people have had the story all wrong since the fiasco of
2007-2009. It was Bush's fault! Obama's fault! Warren Buffet's fault!
The evil banksters! The 1%! It's all wrong. It's the Fed that
everyone should be worried about. The 12 members of the Federal Open
Market Committee (FOMC) are the most powerful people in the world,
even more so than the President and Congress. They control the
nation's money, and are unelected. Many of them are 'revolving door'
cronies, coming from the likes of Goldman Sachs, Morgan Stanley,
Harvard, and other big evil institutions. If you want to point
fingers, point it at them!
What
this country needs is a return to what made us great. Free markets,
low regulations, low taxes, individual liberty, a much smaller
military presence, and sound money; unaltered by the likes of our
wise overlords at the Fed. That sounds like a Republican ideology,
but it's not. Both political parties are the same. They're bad.
Here's Stefan Molyneux's famous rant on the idiocy that is voting:
I'll
end with this: You have been warned. Don't take this lightly. Read
and research for yourself, and don't believe what the fuck nuts in
Washington say about the economy, it is NOT recovering.
