Monday, December 6, 2010

Economics: Bubbles pt 2 - Pure Credit Expansion

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How extremely fortuitous that last night Federal Reserve President Ben Bernanke was on 60 Minutes, because today we're talking about how pure credit expansion creates booms and busts. In his interview he said a few interesting things, "One myth that's out there is that what we're doing is printing money, we're not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way. What we're doing is lowering interest rates by buying Treasury securities, and by lowering interest rates we hope to stimulate the economy to grow faster. So the trick is to find the appropriate moment when to begin to unwind this policy. And that's what we're gonna do."

I'll unpack that statement in a moment, but let's jump ahead to another profound statement that pretty much sums up everything you need to know about Central Banking and Central Economic Planning:

In response to being asked if he had any regrets, he said: "Well, I wish I'd been omniscient and seen the crisis coming....I didn't."

And there you have it, if you really want to sum up why planned economies fail it's because the people running it are not God, they aren't omniscient, in fact they're only people, well not people like us, they're dumber people. Sure they've got degrees and have studied lots of economic theory, but that's as useful as me gaining a degree on why the moon is made of cheese, *if it's wrong then I'm well-studied in something that's WRONG*, and no matter how many degrees you get in bad economics the theories are still _fundamentally_ wrong. Let's address the fundamentals while dispelling why his first statement I quoted is either a lie or a semantic game (or both).

Imagine I own a grocery store, let's call it Wes-E-B. Here at Wes-E-B the sales have only been okay, but I'm ready for some serious growth, so I decide to let all my customers open an account for $1,000 so they can buy as much as they desire. It works! Everyone is buying everything off the shelves and business is amazing!! My numbers are looking massive! Well, the next day I go to re-supply and it turns out that my suppliers don't take Wes-E-B credit and I can't pay to re-stock my shelves, my business goes belly-up and what looked like great gain turned out to be a short lived "bubble". My credit meant nothing to the rest of the world, so I actually gained nothing, in fact the things that I had were gone as well, I actually gave them away!

That's a very non-systemic bubble. "Systemic" is when everything is intertwined with each other, kind of like the planks in a ship, if one of those planks pops a hole then it dooms the rest, they're linked. So let's expand the scenario a bit further to make it more systemic.

Wes-E-B's line of credit was a success, and to help their sales all my suppliers decide to let me have their goods on credit as well, because once I get paid by my customers (who now owe me $1,000 plus interest) then they'll reap a tidy extra profit too. That game has to work alllll the way down to the farmers and the manufacturers and even to their raw suppliers, miners and whatnot. If the farmers decide they don't want our credit since that won't pay their electricity then the fuse is lit for the entire chain to go up in smoke, because the manufacturer of cereal can't get any corn, Lays can't get potatoes, which means Wes-E-B can't get any inventory and now there's several businesses that are in trouble instead of only mine. My suppliers can't get supplies, I can't put anything in my store, we all fold because we created *new* money through expanding credit.

The turnaround isn't normally that fast, if it only took a few months for the resources to be called upon (and not found) then we'd likely already have abandoned this flawed thinking. Instead, it takes years to find out that the resources aren't there, because the process is far more convoluted and complex, but results are the same.

Here you should note: nearly the entire globe is systemically involved in Wes-E-B's line of credit, it's called the dollar and it's the reserve currency of the world. No one wants to see it go up in flames, because the fallout will be massive if it does.

You see, money is supposed to represent a product or a service rendered. When people see money they believe that they can buy something with it, if you looked at money and said "That won't buy anything because that particular dollar was never earned!" then you'd be insane, because you can't differentiate the two. Money is merely a placeholder for a transaction, $2 I earned by selling shoes is a placeholder for the milk I bought for $2. I traded shoes for milk, that's what currency is for, to allow complex forms of exchange.

However, when you initiate the creation of money by loaning it into existence (which sounds EXACTLY LIKE PRINTING MONEY OUT OF NOWHERE YOU SON OF A B---, ahem) then people suddenly have the ability to purchase items, OR invest it into projects. This is why the rate of interest is so important, a lower interest rate means you can take out a lot of money for longer term projects. If you had a 15% interest rate, would you want to have that rate for 10 years? Probably not, so you're projects would be shorter term so that you could pay back the loan faster and focus only on the most immediately profitable projects. However, if you had access to a loan at 3% interest then you can focus on Research & Development and work on projects that take years to develop and find that next new invention/product that the 'kids' are wild about. Interest rates are VITAL to a healthy economy, it sends all the signals to business about whether it should be producing for now or researching for later.

The market, if left alone, will set these rates automatically. When times are tight then the interest rates should be sky high, because there's so little money to loan out that it can only be allocated to the most profitable projects! Think of it this way, if you only had $100 in your account to last you for the next 45 days, would you loan $90 of it out to someone starting a business? Not if you want to live semi-comfortably! So, the only way you'd lend that $90 out is if you KNEW that 1.) you could get $150 in repayment (which means this person you're lending it to has A++ credibility) and that 2.) you'll get it back before you starve.

If, however, you had $10,000 in your account then you'd be much more willing to loan it out at lower rates of return and be riskier as well in the hopes that you hit a home-run rather than a base-hit.

Where "Helicopter Ben" comes in, is that though he has verbally acknowledged that he's not omniscient, he somehow still thinks he can manipulate the market by setting the interest rates, which leads to an *expansion of credit* that the market never, in reality, ever had. It signals the market to take out loans and create new projects, build houses (financial bubble), build businesses (Dot Com bubble), INVEST (1929 bubble that led to the Great Depression).

If you simply hand out money that nobody ever earned/produced, then it'll be spent on things leading to a boom, but when those things look to get "re-stocked" then it will crash, because those extra 'things' were never there to begin with. If Wes-E-B simply had extra inventory then I'd lower the prices in order to sell more, leading to more real world sales, aka a bigger share of the money that's already out there that I can now use to re-stock, using the excess to fund a new store down the street leading to actual economic growth.

When money grows while the number of products don't, then prices increase, this isn't growth! Growth is when there are products created. You can't replicate growth by increasing the amount of currency! It only leads to the depletion of goods through the boom and bust cycle.

In a post from March, I noted how it's "tricky" for the Fed to "unwind" their inflation. Ben admits it isn't easy, oddly he also simultaneously says that the money supply doesn't increase and that it DOES increase but not in any significant way. Eh? Can up also be down? It's semantics, he's saying the "currency in circulation" doesn't change even though he does increase the money supply. "Currency in circulation" = what we use when we shop; "money supply" = what the banks have access to, essentially. So, if the banks begin loaning out the money he wants to raise rates to keep all of the money from flowing out too quickly, Goldilocks' "just right". However, knowing where that "just right" spot requires some otherworldly knowledge (if it were in fact a good idea anyway, which it isn't).

Bernanke is either "Lord, liar or lunatic", and he admits he isn't Lord.
A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive


Unknown said...

"Sure they've got degrees and have studied lots of economic theory, but that's as useful as me gaining a degree on why the moon is made of cheese"...I agree to a certain extent. In other words I see what you're trying to say. We can prove the moon is not cheese. The substance of the moon is not going to change based on people's attitudes and circumstances. Economics (the study of) is pretty much theory and speculation. Because it's so contingent on peoples' reactions and behaviors,it is dang near impossible to predict what will happen (unless you're the Big Guy of course)It is very hard to say a "theory" is flat out wrong until after said circumstances have taken place... which is why of course, hindsight is always 20/20.

It does seem like Bernanke is splitting hairs. He says they are not technically printing new money. You saying (in the Wes-E-B scenario) the creation of an account to boost sales may not be technically printing money but it's the same thing. (right?)

I have to read up but I think there is a an economic major, you are waaaay more up on this than me but you got me interested and reinvigorated.

I'm like a born again economist.

Wes Hemings said...

lol! Go forth and re-economate!

I 100% agree, the economy is extremely contingent on peoples' reactions and behaviors, a guy named F.A. Hayek actually devoted an entire book to this economic behavior titled "Human Action". It's 900 pages so I'm saving that one for last, but I think the overriding principle is still there, that trying to act like we know what an entire nation wants before they've said it is a bit extreme. I'll freely admit these concepts aren't mine (though I did invent the Wes-E-B analogy, please, please, hold the applause), so it's not necessarily "me" who is saying these ideas are wrong, but Hayek, Mises, Rothbard and a slew of other Austrian Economists have done the homework for why these concepts are wrong, these are the same people who were able to predict why and how these ideas would fail, and in that way I believe it's easy to say a theory is flat out wrong.

Exactly, Bernanke on the one hand is splitting hairs, a word game. He can say he doesn't "print" money, because that's the job of the US Mint, wokka wokka. How he mentally doesn't collapse is beyond me, he recently showed who he loaned out $3.3 Trillion dollars to, and somehow that isn't creating new money? "Intellectually dishonest" at best.

But again, you nailed it, economics is merely the study of, theory and speculation of how people allocate resources.

Regina Anaejionu said...

I don't know if it's your ability to break it down for people like me or if reading the Manifesto book you mentioned is helping me to understand the way some people view things ... but I'm getting more and more interested in all this "theory and speculation ... contingent on peoples' reactions and behaviors."

I'll make sure to comment one day after I learn enough to have an opinion ...

Wes Hemings said...

Wait what? You're actually reading the Manifesto??
"He gon' cry in the car."

Regina Anaejionu said...

kindle = in love with buying books

This guy has me rolling (and thinking):

"...a campaign based on liberty and the Constitution rather than on special-interest pandering and the distribution of loot."

Say what!? You better tell those republicrats. Nice.

Wes Hemings said...

lol, alllllready. Maybe the Kindle isn't so evil after all.

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