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Most people assume that prices move as a result of changes in the money supply. Instead, let’s look at the effect of changes in interest. To start, consider a hamburger restaurant. Suppose that the average profit in the burger business is ten percent of invested capital. If MacDowell’s is thinking about expanding, it has to consider the interest rate. Why?

Typically, most of the capital to expand a business is borrowed. MacDowell’s has to borrow the cash to build out its new store. If the cost of capital is greater than the return on capital, then it makes no sense to expand. Let that sink in, because it is vitally important. You cannot borrow at 10% to earn 8%.

Of course not all of the capital is borrowed. MacDowell’s also puts up some of its own funds (or at least it would in a normal world without a central bank drowning the markets with liquidity). The company has to consider what else it could do with that cash. If it could earn more on a bond portfolio, why should it take business risk? Let this sink in also. You should not invest in business equity to earn less than the yield on bonds.

We have just looked at two connections between interest and profit margins. It is both impossible and undesirable, to expand a business which earns less than the interest rate. Now let’s look at the connection in the other direction. MacDowell’s profit-seeking behavior actually affects interest.

What happens to the interest rate if MacDowell’s borrows at two percent to build a hamburger stand that makes ten percent? The very act of borrowing pushes up the interest rate slightly (in a normal world). The very act of opening another hamburger store pushes down the rate of profits on hamburger stores.

…click on the above link to read the rest of the article…

Opinion: The banking system faces an existential threat — and it’s not bitcoin

January 5, 2016

Opinion: The banking system faces an existential threat — and it’s not bitcoin

A movement in Europe would require banks to fully back deposits

In 1666, King Charles II put control of the money supply into private hands. The privatization of the money-creation process gave birth to the system we use today.

Christmas did not offer much good cheer to the world’s bankers, who have received a sustained kicking since the financial crisis erupted in 2008.

In the latest blow, Switzerland announced that it would hold a referendum on a radical proposal that would strip commercial banks of the ability to create money, depriving them of a great deal of their profit-making capabilities. If the Swiss proposal catches on around the world, it could shred core business assumptions that have underpinned the banking model over the past three centuries.

From Babylon to central bank

The earliest banks we know of, in ancient Babylon, were temples that doubled as repositories where one could store wealth. At some point, the guardians of the stored treasure realized they could put this accumulated wealth to work, and banks accordingly began to lend capital. Borrowers would pay interest on what they borrowed, and this interest would ultimately find its way back to the lenders after the banks had taken a cut. The banks became trusted intermediaries that brought lender and borrower together and ensured neither would be cheated. Paper money emerged after people found it was easier to buy things using deposit slips from their bank than carrying gold around.

The next evolution happened when bankers realized that since depositors almost never simultaneously withdrew all their funds, banks could lend more capital than had been deposited. This allowed banks to “create” money in the sense that bankers could issue loans not necessarily backed up by hard deposits.

…click on the above link to read the rest of the article…

Central Bank Money Printing—-The Rotten Philosophy Beneath

January 5, 2016

Central Bank Money Printing—-The Rotten Philosophy Beneath

If advocates of freedom were to make up a list of New Year’s resolutions for 2016, one of the most important items should be ending government’s monopoly control over money. In a free society, people in the marketplace should decide what they wish to use as money, not the government.

For more than two hundred years, practically all of even the most free market advocates have assumed that money and banking were different from other types of goods and markets. From Adam Smith to Milton Friedman, the presumption has been that competitive markets and free consumer choice are far better than government control and planning – except in the realm of money and financial intermediation.

This belief has been taken to the extreme over the last one hundred years, during which governments have claimed virtually absolute and unlimited authority over national monetary systems through the institution of paper money.

At least before the First World War (1914-1918) the general consensus among economists, many political leaders, and the vast majority of the citizenry was that governments could not be completely trusted with management of the monetary system. Abuse of the monetary printing press would always be too tempting for demagogues, special interest groups, and shortsighted politicians looking for easy ways to fund their way to power, privilege, and political advantage.

The Gold Standard and the Monetary “Rules of the Game”

Thus, before 1914 the national currencies of practically all the major countries of what used to be called the “civilized world” were anchored to market-based commodities, either gold or silver. This was meant to place money outside the immediate and arbitrary manipulation of governments.

…click on the above link to read the rest of the article…

Who Owns the Federal Reserve Bank and Why is It Shrouded in Myths and Mysteries?

December 19, 2015

Who Owns the Federal Reserve Bank and Why is It Shrouded in Myths and Mysteries?

Federal Reserve

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

— Henry Ford

“Give me control of a Nation’s money supply, and I care not who makes its laws.”

— M. A. Rothschild

The Federal Reserve Bank (or simply the Fed), is shrouded in a number of myths and mysteries. These include its name, its ownership, its purported independence form external influences, and its presumed commitment to market stability, economic growth and public interest.

The first MAJOR MYTH, accepted by most people in and outside of the United States, is that the Fed is owned by the Federal government, as implied by its name: the Federal Reserve Bank. In reality, however, it is a private institution whose shareholders are commercial banks; it is the “bankers’ bank.” Like other corporations, it is guided by and committed to the interests of its shareholders—pro forma supervision of the Congress notwithstanding.

The choice of the word “Federal” in the name of the bank thus seems to be a deliberate misnomer—designed to create the impression that it is a public entity. Indeed, misrepresentation of its ownership is not merely by implication or impression created by its name. More importantly, it is also officially and explicitly stated on its Website: “The Federal Reserve System fulfills its public mission as an independent entity within government. It is not owned by anyone and is not a private, profit-making institution” [1].

To unmask this blatant misrepresentation, the late Congressman Louis McFadden, Chairman of the House Banking and Currency Committee in the 1930s, described the Fed in the following words:

…click on the above link to read the rest of the article…

The Velocity of the American Consumer

December 19, 2015

The Velocity of the American Consumer

I was reading something yesterday by my highly esteemed fellow writer Charles Hugh Smith that had me first puzzled and then thinking ‘I don’t think so’, in the same vein as Mark Twain’s recently over-quoted quote:

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

I was thinking that was the case with Charles’ article. I was sure it just ain’t so. As for Twain, I’m more partial to another quote of his these days (though it has absolutely nothing to do with the topic:

“Eat a live frog first thing in the morning, and nothing worse will happen to you the rest of the day.”

Told you it had nothing to do with anything.

Charles’ article deals with money supply and the velocity of money. Familiar terms for Automatic Earth readers, though we use them in a slightly different context, that of deflation. In our definition, the interaction between the two (with credit added to money supply) is what defines inflation and deflation, which are mostly -erroneously- defined as rising or falling prices.

I don’t want to get into the myriad different definitions of ‘money supply’, and for the subject at hand there is no need. The first FRED graph below uses TMS-2 (True Money Supply 2 consists of currency in circulation + checking accounts + sweeps of checking accounts + savings accounts). The second one uses M2 money stock. Not the same thing, but good enough for the sake of the argument.

In his piece, Charles seems to portray the two, money supply and velocity of money, as somehow being two sides of the same coin, but in a whole different way than we do. He thinks that the money supply can drive velocity up or down. And that’s where I think that just ain’t so. I also think he defeats his own thesis as he goes along.

…click on the above link to read the rest of the article…

Money Velocity Is Crashing–Here’s Why

December 17, 2015

Money Velocity Is Crashing–Here’s Why

The inescapable conclusion is that Fed policies have effectively crashed the velocity of money.

That the velocity of money has been crashing while the money supply has been exploding doesn’t seem to bother the mainstream pundits. There is always a fancy-footwork explanation of why whatever is crashing no longer matters.

Take a look at these two charts and tell me money velocity doesn’t matter.First, here’s money supply: notice how money supply leaped from 2001 to 2008 as the Federal Reserve pumped liquidity and credit into the economy, and then how it exploded higher as the Fed went all in after the Global Financial Meltdown.

Now look at a brief history of the velocity of money. There are various measures of money supply and various interpretations of velocity, but let’s set those quibbles aside and compare money velocity in the “golden era” of the 1950s/1960s and the stagflationary 1970s to the present era from 2008 to 2015–the era of “growth”:

Notice how the velocity of money remained in a mild uptrend during both good times and not so good times. The inflationary peak of 1979-1982 (Treasury yields were 16% and mortgages were 18%) generated a spike, but velocity soon returned to its uptrending channel.

The speculative excesses of the dot-com era pushed velocity to unprecedented heights. Given the extremes in velocity, it is unsurprising that it quickly fell in the dot-com bust.

The Federal Reserve launched an unprecedented expansion of money, credit and liquidity that again pushed velocity up in the speculative frenzy of the housing bubble. But note that despite the vast expansion of money supply, the peak in the velocity of money was considerably lower than the dot-com peak.

…click on the above link to read the rest of the article…

What Deflation Quacks Like

December 8, 2015

What Deflation Quacks Like

As yet another day of headlines shows, see the links and details in today’s Debt Rattle at the Automatic Earth, deflation is visible everywhere, from a 98% drop in EM debt issuance to junk bonds reporting the first loss since 2008 to corporate bonds downgrades to plummeting cattle prices in Kansas to China’s falling demand for iron ore and a whole list of other commodities.

The list is endless. It is absolutely everywhere. And it’s there every single day. But how would we know? After all, we’re being told incessantly that deflation equals falling consumer prices. And since these don’t fall -yet-, other than at the pump (something people seem to think is some freak accident), every Tom and Dick and Harry concludes there is no deflation.

But if you wait for consumer prices to fall to recognize deflationary forces, you’ll be way behind the curve. Always. Consumer prices won’t drop until we’re -very- well into deflation, and they will do so only at the moment when nary a soul can afford them anymore even at their new low levels.

The money supply, however it’s measured, may be soaring (Ambrose Evans-Pritchard makes the point every other day), but that makes no difference when spending falls as much as it does. And it does. The whole shebang is maxed out. And the whole caboodle is maxed out too. All of it except for central banks and other money printers.

Everyone has so much debt that spending can only come from borrowing more. Until it can’t. We read comments that tell us the global markets are reaching the end of the ‘credit cycle’, but can the insanity that has ‘saved’ the economy over the past 7 years truly be seen as a ‘cycle’, or is it perhaps instead just pure insanity? There’s never been so much debt on the planet, so unless we’re starting a whole new kind of cycle, not much about it looks cyclical.

…click on the above link to read the rest of the article…

US Stock Market – An Accident Waiting to Happen

December 1, 2015

US Stock Market – An Accident Waiting to Happen

Monetary Inflation Becomes Less Supportive of Asset Prices

We have recently discussed the sorry state of the junk bond market, as well as the noteworthy decline in the annual growth rate of US money supply aggregates. The latter has finally manifested itself not only in terms of narrow monetary aggregates like M1 (see chart) and AMS (“Austrian money supply”, a.k.a. TMS-1, the narrow true money supply), but also in the broader true money supply aggregate TMS-2.

awh Photo credit: Keith Maniac

As a reminder, here is the most recent chart of the year-on-year growth rate of TMS-2 :

Year-on-year growth in money TMS-2 has declined to its slowest pace since November of 2008, shortly after Ben Bernanke’s money printing orgy had been unleashed – click to enlarge.

Below is a chart of the annual growth rate of narrow money AMS from the transcript of the October advisory board meeting of the Incrementum Fund. US money AMS is calculated by Dr. Frank Shostak. The chart shown below originally appeared in his AAS Economics Weekly Report of October 5, 2015.

As you can see, the growth rate of the narrow true money supply has fallen off the proverbial cliff recently. It is fair to assume that it will continue to be a leading indicator for the growth rate of TMS-2. Steven Saville of the Speculative Investor has recently mentioned that the sharp growth in euro area money supply (a chart of the growth differential between US and euro area AMS can be seen here) could well help to keep asset prices up longer, by offsetting the slowdown in US money supply growth to some extent.

This idea certainly has merit, as there exists empirical evidence to this effect. However, the US stock market will likely continue to be the leading international stock market. Should leveraged positions in the US market run into trouble, it will affect “risk asset” prices nearly everywhere. The danger that this could soon happen is clearly growing:

…click on the above link to read the rest of the article…

Money Supply Versus Money Demand

November 27, 2015

Money Supply Versus Money Demand

According to popular thinking not every increase in the supply of money will have an effect on economic activity. For instance, if an increase in supply is matched by a corresponding increase in the demand for money then there won’t be any effect on the economy. The increase in the supply of money is neutralised so to speak by an increase in the demand for money or the willingness to hold a greater amount of money than before.

What do we mean by demand for money? And how does this demand differ from demand for goods and services?

Now, demand for a good is not a demand for a particular good as such but a demand for the services that the good offers. For instance, individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and well being. Demand here means that people want to consume the food in order to secure the necessary elements that sustain life and well being.

Also, the demand for money arises on account of the services that money provides. However, instead of consuming money people demand money in order to exchange it for goods and services. With the help of money various goods become more marketable – they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.

Demand for money is demand for the medium of exchange

Take for instance a baker, John, who produces ten loaves of bread per day and consumes two loaves. The eight loaves he exchanges for various goods such as fruit and vegetables. Observe that John’s ability to secure fruits and vegetables is on account of the fact that he has produced the means to pay for them, which are eight loaves of bread.

…click on the above link to read the rest of the article…

Can the Fed Print Money?

October 28, 2015

Can the Fed Print Money?

Every morning is the dawn of a new error – Anonymous

It Can and it Does

In light of the upcoming October Fed (non-)decision, we want to briefly revisit a subject that still appears to be causing some confusion. We most recently encountered this confusion again in a quarterly update by the Hoisington Investment Management Company. To be sure, we very often, if not to say almost always, have tended to agree with the economic conclusions of Lacy Hunt and Van Hoisington since we have first come across their work (we may arrive at these conclusions in a somewhat different manner, but the conclusions as such are usually not much different).

2015-10-27_213416 Money from nothing and chicks for free – how the Fed does it.
Image credit: dreamstime

US true money supply TMS-2: this broad aggregate contains all the items that can be properly defined as money – click to enlarge.

In their third quarter update we have come across one sentence that we believe requires comment, as we have seen similar things asserted elsewhere and we believe it is important to be 100% clear on the topic. In addition to the assertion we want to challenge, which is highlighted below, we also quote the preceding paragraph, because it serves to elucidate a few additional conceptual problems.

“Despite the unprecedented increase in the Federal Reserve’s balance sheet, growth in M2 over the first nine months of this year fell below its average rate of growth over the past 115 years, a time when the growth in the monetary base was stable and quite modest. In addition, velocity of money, which is an equal partner to money in determining nominal GDP, has moved even further outside the Fed’s control. The drop in velocity to a six decade low is consistent with a misallocation of capital and an increase in debt used for either unproductive or counterproductive purposes.

…click on the above link to read the rest of the article…

ECB – Going Full Retard

October 23, 2015

ECB – Going Full Retard

Done Deal: We’re Making Europe Richer by Making it Poorer, Comrades!

mario-draghi-ecb Ready, aim, fire! Draghi reminds everybody that there is no limit to how much fiat weaponry and ammunition he can deploy
Photo credit: François Lenoir / Reuters

We were really surprised at the extent to which the lunacy within the ECB council has apparently expanded. Right along with the euro area’s money supply, it is evidently the fastest growing thing in Europe right now.

According to the ECB, there is “not enough inflation” in the euro area just yet. Hence, it will increase the rate of growth of this mountain of money further by monetizing even more debt – click to enlarge.

A summary from a mainstream press report:

“Eurozone stocks could be gearing up for another rally in the coming months following dovish signals from the European Central Bank.

ECB President Mario Draghi on Thursday said policymakers will decide at their December meeting whether the eurozone economy needs further easing measures. The ECB has already been buying roughly US$60 billion in bonds a month since March in an effort to prop up the 19-member eurozone economy, with plans to continue the program until at least September 2016.

The eurozone economy has modestly grown so far this year, but continues to face risks in the form of low inflation and a slowing economy in China — its second largest trading partner. Draghi last month voiced concerns about the impact China will have on eurozone exports.

[…]

The euro notably pulled back Thursday on Draghi’s comments, losing 1.6 per cent against the U.S. dollar to US$1.11. Analysts said the euro could see the kind of sharp decline it experienced prior to the launch of the ECB’s bond-buying program earlier this year.”

…click on the above link to read the rest of the article…

Neither Bull nor Bear

October 22, 2015

Neither Bull nor Bear

“Good Economic Management” vs. Larceny

“Will you shut up?!”

That is what we wanted to say this morning, here in Zurich, Switzerland. At the table next to us, a hedge fund promoter is working hard…

“The value proposition… outside of the box… we’re only talking two points… we can dialogue about it… Goldman… our business model… prioritize our priorities… get the balance right…”

hi-trudeau-04924780-8col New Canadian prime minister Justin Trudeau – who actually has more than just one bad idea.
Photo credit: Andrew Vaughan / Canadian Press

Meanwhile, on the front page of the Financial Times is a good-looking guy with a bad idea. Pierre Trudeau’s son, Justin, is Canada’s new prime minister. (Another political dynasty!) He will “take advantage of low interest rates” to embark on a C$60 billion infrastructure program.

Just for the record, the Canuck feds are not taking advantage of low interest rates. They’re cheating savers… retirees… and responsible citizens whose expenses are lower than their incomes.

In much of the developed world, central banks have pushed interest rates to their lowest level in 5,000 years. This is not “good economic management.” It’s larceny. They’re taking money from savers and giving it to borrowers – especially in the financial sector and in government. But on to other things….

This is not just larceny, it is insanity (not unique to Canada to be sure, as it has gone global) – click to enlarge.

12% a Year in Stocks

“We don’t pay any attention to the stock market. We buy good companies at good prices,” an old friend explained about how his private fund operates. (In the interest of full disclosure, we are one of his investors.)

“We aim for 12% a year,” he continued. “And that’s what we get, more or less.”

…click on the above link to read the rest of the article…

The Economist Rings Out Cognitive Dollar Dissonance

October 11, 2015

**The Economist Rings Out Cognitive Dollar Dissonance**

Two years ago, prior to travelling to Sydney to present at the Annual Precious Metals Symposium, I prepared an article for the Gold Standard Institute Journal titled Cognitive Dollar Dissonance: Why a Global De-Leveraging Requires the De-Rating of the Dollar and the Remonetisation of Gold (see here). This article highlighted the growing inconsistency between those arguing on the one hand that the dollar’s role in international trade and finance was clearly diminishing; yet denying that it was in any danger of losing the near-exclusive monetary reserve status it has enjoyed since the 1940s.

This apparently contradictory yet mainstream thinking about the future of the international monetary system continues to the present day. Indeed, earlier this month the Economist magazine ran a special feature on fading US economic power replete with dollar dissonance. The experts cited note the accelerating trend towards bilateral trade settlement, say between Russia and China, who plan to finance their multiple ‘Silk Road’ infrastructure projects using their own currencies and their own development bank (The Asian Infrastructure Investment Bank or AIIB: See http://www.aiib.org/). They also observe that Russia, China and the other BRICS are no longer accumulating dollar reserves (although curiously overlook that they continue to accumulate gold). They acknowledge that not only the BRICS but many other countries have repeatedly expressed their desire that the current set of global monetary arrangements should be restructured in some way, although they are not always clear as to their specific preferences.

Note the sharp contrast in these two paragraphs, both on the very same page of the Economist feature:

…click on the above link to read the rest of the article…

EU Moloch in a Fresh Bid to Inflate

October 4, 2015

EU Moloch in a Fresh Bid to Inflate

Brussels Alters Capital Requirements to “Spur Lending”

Saints preserve us, the central planners in Brussels are giving birth to new inflationist ideas. Apparently the 2008 crisis wasn’t enough of a wake-up call. It should be clear by now even to the densest observers that a fractionally reserved banking system that flagrantly over-trades its capital is prone to collapse when the tide is going out. 2008 was really nothing but a brief reminder of this fact.

The political and bureaucratic classes will certainly never go back to sound money or free banking. The State’s paws will remain firmly embedded in the business of money, as the modern-day welfare/warfare states and the ever-growing hordes of cronies and zombies they have to keep well-fed have become utterly dependent on fiat money inflation. This will continue until the bitter end. New measures are now being designed to hasten its arrival.

3 EURO FRONT

Before we continue, ask yourself if the euro zone actually needs more monetary inflation – even from the perspective of those who erroneously believe inflation to be an economic panacea:

The euro area’s money supply over time. We are on purpose using the narrow aggregate M1, which is the closest approximation to money TMS. The broader aggregates include items that are actually not money, but credit transactions. This leads to double-counting. Money= the means of final payment for goods and services in the economy, chart via ECB – click to enlarge.

It is fair to say that this expansion of the money supply hasn’t made society at large any more prosperous; quite the contrary in fact. It has however been beneficial to the State and others with first dibs on newly created money, as real wealth has been redistributed to these privileged groups.

…click on the above link to read the rest of the article…

US Credit Growth – the First Cracks?

September 24, 2015

US Credit Growth – the First Cracks?

Inflationary Bank Lending and Money Supply Growth

Given that there is currently no “QE” program underway – with the exception of the reinvestment scheme designed to prevent the Fed’s balance sheet from shrinking (if it were to shrink, the money supply would decline as well) – money supply growth depends primarily on the amount of fiduciary media created ex nihilo by commercial banks.

Putting it differently, it depends on the growth in bank lending, since new uncovered deposit money comes into being by the extension of credit by banks. This deposit money is a money substitute that is only partially covered by standard money, or potential standard money (i.e., bank reserves). However, it has to be regarded as part of the money supply, given that it is used for the final payment of goods and services. From the perspective of its users, it is money.

financial-bubble-credit

Photo credit: .Kai

Since the crisis of 2008 and the collapse of the mortgage credit bubble, the following trends have been in evidence: lending to corporations has quickly reached growth rates usually associated with boom conditions. Consumer lending has by contrast been more subdued, with mortgage credit growth not surprisingly only very slowly moving back into positive territory. Most of the acceleration in bank lending could be observed once “QE” was tapered and ended – as a result, broad US money supply growth has remained brisk, even though it is far below its peak levels of recent years.

…click on the above link to read the rest of the article…

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