Why your savings and pensions are at risk

The fractional reserve way of creating money means a lot of people are at risk of losing all or part of their savings and pensions.

If there is too much money supply in the economy then we have inflation and people with savings or pensions lose some of their purchasing power and those who owe money benefit because they repay their loans with less purchasing power.  Now you know why governments and the people who speak on their behalf promote mild inflation.  This is at least unauthorized taxation if not theft.

pexels-photo-2105902If you have deflation, then people who are owed money win because they are repaid with more purchasing power than they loaned.  The borrowers lose because they have to repay with more purchasing power.

To be fair to everyone we need to manage the economy so that just the right amount of money is available at all times.  At a time when the economy is on a down trend, this is very important as too much money puts us in danger of hyperinflation.

Getting this amount right has long been a challenge to central banks although the common sense answer is fairly simple.  The money supply should vary with the quantity of goods and services we want to exchange and it should be flexible up and down.

The wrench in the simplicity is the fractional reserve way of creating money.  When banks make loans they must (or should) keep a fraction of the amount on reserve for when the depositor wants his/her money returned.  As the amount is only a fraction banks are at risk of a “run” if depositors lose faith.  And because of the fractional reserve there is a multiplier effect involved.  Does not this sound like a set up for a crisis?  The mechanics of this process are a little complex although I have always found it easy to understand. To figure it out I suggest you Google “fractional reserve” or look at my free e book Funny Money: Adapting to a Down Economy or look at the essay Going to Market on this weblog.

The other end of the wrench is  that interest is charged on the loans made by the banks.  Mainstream economists have given little or no thought to the consequences of this. Because all of our money is created by the making of loans, if all the outstanding debt were to be paid off at one time there would not be enough money to repay it all because of the interest.  The charging of interest on the debt/money means there is never enough money available to repay all outstanding debt. Inflation is built into the fractional reserve way of creating money.

The system works only so long as the economy and the money supply continues to grow.  An upset in either means crisis of which we have had many.

The relationship between money supply and economic output is expressed in a formula, MV=PQ, some times known as the quantity theory of money.  Money times the velocity at which it circulates in the economy is equal to a price index times the quantity of goods and services produced.

I get ticked off because this is frequently taken to mean there is a direct, proportional relationship between the money supply and the inflation rate or price level.   Can’t people see there are four variables in this formula?  Total output is an important part of this formula.  If it should happen to go down something needs to happen to another variable.

Our society has a strong commitment to economic growth and a need to keep it growing so that people will not suffer from unemployment.   Some desperate people are trying to stimulate growth by increasing the money supply. This may increase inflation but it will not lead to growth unless we can find inexpensive energy and mineral resources to support it.  I suspect the new American president has  his eye on parks and reserve lands to encourage more economic activity.  He will probably succeed in the short term to be followed by a major economic collapse.

This blogger thinks we need some major economic reforms, not only in our financial system but in our commitment to economic growth.  We need to minimize our production and exchange of goods and services so we are using fewer energy and mineral resources.

A lot  of people operate on faith in our financial system and ignore suggestions we need reform.  I think the risk is so great that prudent people will at least give some thought to these issues.  It is your savings and your pensions and your future that is at risk.

 

 

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The future of money: inflation, deflation or disappearance into thin air

The future of money has been getting a little attention lately.  It could go one of three ways – inflation, deflation or part of it could disappear into thin air.  Concerns about money probably reflect concerns and uncertainty about where the economy is going.  Frequently behind these concerns lurk people who want a fixed money supply such as gold or bit coin.

This blogger figures money should be defined as a tool to facilitate the exchange of goods and services.  I do not like definitions that make it a store of wealth or a measure of value because these give money an intrinsic value which it does or should not have.  Money should only have value as a tool. 

One of the most important features of money should be the amount available  in the economy needs to be flexible.  It should be able go to up or down  with changes in the quantity of goods and services we want to exchange.  If the money supply is not flexible then as we change the quantity of goods and services then either prices must go up or down or the velocity, the rate at which money changes hands will change.  It is dangerous to assume there will be only growth.

Inflation happens when the money supply increases faster than the rate of economic growth and deflation happens when the money supply goes not keep up with the rate of growth.    Inflation is good for borrowers as the can repay their loans with money which has less real value.  This is one reason governments and their agents want to see mild inflation.  Deflation is good for lenders as they will be repaid with money which has more value.  The ideal should be price stability so nobody loses.

Our understanding of inflation and deflation has been distorted by the long period of economic growth we have just experienced. Most inflation has happened along with growth and most deflation has resulted from banking authorities trying to restrict the amount of money available.  This happened in the 1930s and todays central bankers have sworn to never again let that happen.

There is some evidence that our time of economic growth has terminated.  It is unclear how this will affect prices.  Quantitative easing which is an attempt to increase the money supply has not led to high inflation.  Past hyperinflations have occurred when governments have increased to money supply faster than the economy was capable of growing.  It appears the money created by quantitative easing has led to inflation in the financial markets rather than consumer markets.

Economists generally understand how fractional reserve banking works to increase the money supply but I am not aware of anyone who has thought out the opposite process.  Money that can be created out of thin air can just as easily disappear into thin air.

In fractional reserve banking banks are required to keep a portion of their deposits as reserves for protection against runs. The rest is loaned out and redeposited with the new deposits subject to the same fractional reserve.  The result is that a large proportion of our money supply is  somewhat precarious.  This blogger and many other people on the internet have explained the process.  Just search “fractional reserve banking.”

Central banks can add money to the system by purchasing financial instruments or by changing the reserve requirements.  The could also reduce the money supply by selling financial instruments or by changing the money supply although it is unlikely they will do either under current conditions.

Another way the money supply could be reduced is if the banks suffer large losses.  Any loans the banks have to write off will directly decrease their available reserves.  (The technical term is high powered money.)  This means they will have to decrease their outstanding loans with the same multiplier effect as the money supply was increased.  We will hear about it as a contraction of credit.

So if the banks experience unusually large losses there could be a drastic decrease in the money supply which could have dire consequences.  ( I have read that a number of Canadian and British banks are highly exposed to the energy industry with unsecured loans.)

If a large part of the money supply were to disappear into thin air in the short term a lot of economic activity would come to a screeching halt.  People have in the past used playing cards or candies as a substitute for money.  In the long term the level of activity would depend upon the physical resources available.

People who talk up monetary reform often want a return to a gold standard or facsimile (bit coin).  It is not clear that either of these would correct the problems inherent in the fractional reserve way of creating money.  Nor would they provide the flexibility that is needed in the total amount of money available.

We all think we know everything there is to know about money.  That is a part of what our parents teach us. However, it is a complex subject which few people understand and there are a lot of unknowns, especially if we have to deal with an extended period of low or negative growth.

The downside of falling oil prices

One would expect lower oil prices to be great economic news.  However there are a couple of problems which could make them the worst possible news  –  our economy does not cope well with deflation and this could indicate the start of a major economic decline.

Oil is such an important part of our economy that lower prices should stimulate economic activity to the point we would easily achieve full employment and all our economic problems would be solved.  Life may be a little more complicated. Most news reports suggest the problem is increased supply from U.S. fracking but there could also a decreased demand for oil.

The first complication is that our economy does  not cope well with deflation.  We can probably cope with falling prices but falling wages are a different matter.  Very few people would willingly take a cut in income.  A further and more serious complication is that most of our money supply is based on debt and it is likely the owners of this debt would want  to be repaid in full in deflated money.  Instead of having economic utopia we could have economic chaos.

The second concern about falling oil prices is with what is happening in the real side of the economy.  Too often we evaluate economics only in financial  terms.  Sometimes this hides problems.

Probably the most serious economic problem is that we have used up the most easily accessible energy and mineral resources.  There are lots of these left on the earth’s surface but they are so difficult  and expensive to extract that it is no longer viable to do so.  This is bound  to have a profound effect on our economy, reduce the potential for economic growth and maybe force us into negative growth.  It could be that high prices for energy and mineral resources have messed up the economy so that we can no longer produce as many goods and services as we  were.   It may be the recent high costs of oil has contributed to its own reduced demand.

If this scenario is correct or even nearly correct then we are in for some serious economic problems.  It could be that falling oil prices are a leading indicator of a crisis.

This has been a difficult post to write because one does not want to witness the human suffering that will come with a prolonged economic downturn.

One further observation: Although headlines show the price of oil has been falling the news has been slow to reach the owner of our local gas bar.

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

Which is more likely – deflation or inflation?

Conventional economic wisdom, as illustrated by the cover of last week’s The Economist, says deflation is a major threat.  However, this blogger, ever the contrarian,  figures inflation, perhaps even hyperinflation, is a more likely threat.

 The idea that deflation is a threat appears to be  based on the concept of inflationary expectations and the desire by those who make decisions on behalf of he government to maintain mild inflation to help deal with government debt.

That high inflation is a threat is based on the formula MV=PQ, known as the quantity theory of money although I prefer to call it the connectivity formula as it connects the financial and real sides of the economy.

 The case for deflation is made in the November 9, 2013 issue of The Economist. (http://www.economist.com/printedition/2013-11-09)

The above formula tells us that the money supply times the velocity at which it changes hands is equal to prices, or a price index, times the quantity of goods and services produced.  It is not clear everybody accepts this formula but I think it contains a lot of truth.  If one of the four variables changes then to maintain the equality one or more of the others also has to change.  For example if the quantity of goods and services goes up then the money supply also needs to go up.  If the increase in money supply exceeds the increase goods and services, then velocity must go down or prices must go up.  Through recent decades prices have gone up and we have had inflation.

 The  current economic crisis is probably mostly a crisis in Q.  While there are still a lot of mineral and energy resources in the earth’s crust we have extracted the most easily accessible.  What is left is difficult to extract and requires a lot of energy.  In the past economic growth has covered a multitude of economic sins.  It is not clear that the economy will be able to return to the type of growth we have experienced since the start of the industrial revolution.

 During the depression of the 1930s the monetary authorities deliberately restricted the money supply (a reduction in M) and this led to a reduction in Q, a recession and a number of financial institutions failed.  This time they are not going to make the same mistake and have been trying to increase the money supply calling it quantitative easing. Large amounts of money have been pumped into the economy.  Consumer prices have not increased and it is tempting to say the formula is not valid.   It could be that velocity has fallen (there are complaints that corporations are sitting on piles of cash) and that price increases have been in paper financial instruments.

 We should note that Wikipedia gives four major examples of deflation in American history and all of them involve contractions in the money supply.  Maybe the formula holds.

 If the formula is correct and with all the excess money floating around the economy, then there is quite a bit of  potential for something unpleasant to happen.   If not high inflation, then a financial crisis in which the money supply is reduced.  In either case the paper used for those financial instruments might have been more useful as firewood.

 Inflation is complicated by the fractional reserve creation of money.  As can be seen from the formula the money supply needs to flexible up or down according to variations in the quantity of goods and services produced.  But our money supply is created when banks make loans upon which interest is charged. Rather than flexibility there is pressure for the money supply to increase continuously.  The result is a Ponzi scheme which collapses from time to time.  Oops, here comes another financial crisis.

 The goal should be price stability or a zero inflation rate.  As loans are in nominal terms when prices go up people who have borrowed benefit at the expense of those who have loaned the money.  If you are a lender, the higher the inflation rate, the more purchasing power you lose.  Deflation works the opposite way, in that a borrower has to repay more purchasing power.  As governments are major borrowers it is hardly surprising that those who set economic policy are anxious for moderate inflation.  Inflation is a tax if not theft.

 Those  charged with setting government economic policy fear that low inflation could easily slip into deflation.  That would  make repaying government debt more difficult and in the past deflation has been associated severe recession.  The difference this time is that there is lots of money available to facilitate the exchange of goods and services.  Hyperinflation would wipe out a lot of savings, fortunes and pensions.

 Whatever happens it looks as if there is a lot of potential for increasing economic chaos.

The inflation conflict

It could be that inflation is at the core of the political divisions on the economy in some industrial countries.

This is because people or organizations that owe money, including governments, benefit from inflation and those who have made loans stand to lose.  It might be useful to make a distinction between money and purchasing power.  Inflation increases  the purchasing power of borrowers and decreases the purchasing power of lenders.

As this is at the core of our well-being we want government economic policies that promote or discourage inflation.  Those who would benefit from inflation want stimulus and an increasing money supply.  Those who stand to lose their savings want austerity and smaller government.

Inflation may be a way of dealing with the one percent but it also catches a lot of people who have worked hard to build up some savings.  It should probably be considered a form of theft.  It is no wonder the victims of inflation have such strong feelings.

It probably doesn’t help for them to hear economists call for inflation to solve debt or economic problems.

It is interesting that when  the representatives of those hurt by inflation get into government they appear unable to get debt under control and frequently increase it.   This may be because they enjoy spending, have friends who need to be rewarded for past support and because they now have to deal with the debt problem.  This may explain the rise of the tea party with its strong feelings of frustration.

The way to deal with the inflation conflict is to aim for price stability. This is probably easier said than done because I figure inflation is built into the way we create money.  For more on this please look at my essay “LETS go to market: Dealing with the economic crisis.”

It may be that inflation is becoming a moot point as it has been going down in spite if attempts to stimulate the economy and increase the money supply via quantitative easing.   Does this indicate some other things we don’t understand are happening in the economy?

This analysis is probably an over simplification as some people may be standing on both sides of the inflation issue and others may change from one side to the other during their lifetime but may not change their politics.

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

Investing during deflation or inflation

This was posted as a comment on an article in The Economist of December 3, 2011 on hedge funds.

http://www.economist.com/node/21541026

 

For an investor I think this is a key sentence in this article:

“Some fund managers privately confess that they wish they could move entirely into cash and sit out the market turmoil.”

During a time of deflation the best investment strategy is to hold assets in cash.

However, with the kind of uncertainty we are currently experiencing one should not rule out the possibility of a sharp switch to inflation.

Probably the best investment at this time would be a market garden – then regardless of what happens one should be able to eat.  And check the quality of the soil.  Some people fear a lot agricultural land has been degraded beyond repair.

(The author of this comment has a web log on economics at https://economics102.wordpress.com/)

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