Getting Pithy About Money

This diary series explores what I call the Montana Index - the rich are leaving the US in record numbers or heading for the hills of places like Montana .  Why?  They saw the credit bubble popping long ago.  Now the little guy - the ultimate bag-holders in a lot of foul play - are but beginning to feel the impact.

(For anyone who is entirely new to reading financial media, likewise anyone who feels confused by the very term "credit bubble."  I have written a previous diary about the credit bubble which I recommend reading before proceeding further with this diary.)

Beginner's Luck?
For the past few months I have been immersing myself in a study of the credit/assets bubble.  Pinning words on it has been the most difficult portrait subject I’ve ever faced in my life as an artist.  But there comes a point where it gets easier.  If you're only beginning to read financial media, maybe I can speed the learning process up for you with what I've gained.  All this time I've been frustrating myself to tears reading the dissembling blur of financialese, I would spare you.

And of course anything you learn about art here is also free.  I must say I’m up for studying money after a lifetime of employing illusionism in visual art.  The value of currency too is an illusion.

Why  learn this?  Doug Noland:

I’ll plead once again that the issues of "money", Credit, and inflation are much too vital to the long-term health of free-market democracies to be left to a select group of policymakers and "ivory tower" dogma. I would instead argue that it is imperative that citizens become sufficiently educated on the perils of Credit inflation, financial excess, and unsound "money." This would provide our only hope against the inflationary tendencies of politicians, the Fed, and the Financial Sphere – tendencies that turn highly toxic when mixed with high octane contemporary "money."

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It is imperative that the layman became familiar with our national problem known as the credit/assets bubble - which, in a word, is what Noland calls unsound money.  Another way to say it is that our particular currency is being weakened on the international  market by the problems discussed in this diary.  

What is a Dollar?
After scrubbing the parlance off of what we understood to be wealth, we find we are polishing the proverbial heap - that many things we were taught as children to believe about money are not true any more.  When we say "wealth" we might reasonably draw upon a mental picture like the industrial propaganda films we saw in grade school during the 60’s with those glistening mountains gold bars pictured in the US Treasury.

Now we handle paper currency notes which are essentially IOU’s from the US Treasury.  What gives any paper money value, or any other monetary instrument (say stocks, or bonds) is of course not the paper itself, but that which backs up the value, such as gold.  

At various times during US history a gold standard was used where each dollar was backed up by a certain amount of gold.  If you were nervous about the national state of affairs, and were afraid your paper money might not be honored, you could go to the bank and demand gold for your paper dollars.  The gold standard was most recently revoked by Richard Nixon in 1971.

Yet anything agreed to be of value can back up an IOU - gold, shells, goats, whatever the issuer and the creditor (who buys those dollar bills) agree is of value can back up cash dollars.  This is where our relationship with a bank kicks in, including the whole world’s relationship with our Federal Reserve (American Central Bank).

Wildcat Banking or "Free Banks"
Banks have not always been able to back up the value of their currency.  The FED Bank of Atlanta has recently published a paper about wildcat banking (also known as "free banks") of pre-civil war times before any regulation governed banks at all.  Their conclusions hint at comparison to contemporary times and the effect of computerized electronic finance.  

During the era of free banks what backed up your money might become an unpleasant surprise:

Free banks did not always redeem their notes as promised, and there are fabulous stories of fraudulent activities, stories that appear frequently in histories of free banking and general histories of banking.  For example, in an examination report for Jackson County Bank in Michigan in 1938, the state bank commissioners report that they found the account books had accountholders' names written in pencil and their balances written in pen.  In addition, they examined the banks's specie.

Beneath the counter of the bank, nine boxes were pointed out by the teller, as containing one thousand dollars each.  The teller selected one of the boxes and opened it; this was examined and appeared to be a full box of American half dollars.  One of the commissioners then selected a box, which he opened, and found the same to contain a superficies only of silver, while the remaining portion consisted of lead and ten penny nails.  The commissioner then proceeded to open the remaining seven boxes; they presented the same contents precisely, with a single exception, in which the substratum was window glass broken into small pieces.

How Cash Money Ideally Works
To simplify, suppose a bank has a million dollars out in notes.  Here would be the ideal:  in times of a gold standard (not the best idea, but that’s another diary), you would have a million dollars’ worth of gold to back up the paper notes.  In our ideal world, should political unrest or an earthquake (for instance) make the public nervous about the value of their paper notes, they could go to the bank and demand gold... and get it.  This is where the idea of trust comes in - that paper "debt" instruments (which is what paper money really is - an IOU from whoever printed it) are backed up by something universally trustworthy, like gold.

What frightens all people everywhere in the banking realm, especially now, is that there will be a "run" on currency - that everyone will become afraid of market dynamics and cash in things like stocks and bonds for hard money.  You can see where if there had been a run on cash at the bank described above, people would have been in for a shock.

So if Gold Doesn’t Back up a Dollar, Then What?
The US dollar is a fiat currency.  Simply told, agreements between the premiere economic powers in the world allow the dollar's value to "float" in comparison to certain of the more powerful currencies depending on balance of trade and other complex issues.  The US Dollar Index (USDX) is a system employed by the world’s premiere economic powers whereby the US dollar is compared with a "basket" of other currencies to determine the dollar's value.

In the US We Trust?
Most currencies in the world are not backed up by gold, but by reserves of other currencies, the most common being US dollars.  Many governments are unstable, and what they feared was a run on their own currency due to their domestic problems.  

Because once upon a time the US was perceived as the most stable government and economy in the world, in recent history US dollar was considered the best thing to back up other currencies worldwide.  Therefore their own currencies have been backed up by collections of US dollars (rather than gold, shells, livestock, whatever is agreed as having valued in a given society) in case of a run on their currency.

The term for this unique role of the US dollar is the international reserve currency.  Most of the world’s governments have agreed to back up their OWN currency with the US dollar.  In fact most US dollar notes are actually kept outside the US, in foreign central banks (FCB’s) worldwide.  The reserves of US dollars held abroad are becoming unbelievably huge.  These are called sovereign wealth funds (SWF’s).  

This is how it came about that countries like China began to build up the huge cash dollar reserves which they are now threatening to dump.

No Such Thing As Too Much US Debt?
But for now, understand that the dollar's role as international reserve currency allows for a unique situation whereby the US government can ostensibly keep creating debt and printing money to cover debt.  Many economists have held to the idea that technically there can not be too much debt because the US itself prints up the international reserve currency which covers US debts.  The article linked to the term "international reserve currency" holds to a philosophy which justifies unlimited deficit spending, yet is valuable in citing the various ways the US dollar is different than other currencies.

At the present time, the U.S. dollar remains the world's foremost reserve currency, primarily held in $100 denominations. The majority of U.S. notes are actually held outside the United States, known as eurodollars (not to be confused with the euro) regardless of the location. Economist Paul Samuelson and others maintain that the overseas demand for dollars allows the United States to maintain persistent trade deficits without causing the value of the currency to depreciate and the flow of trade to readjust. Milton Friedman at his death believed this to be the case but, more recently, Paul Samuelson has said he now believes that at some stage in the future these pressures will precipitate a run on the U.S. dollar with serious global financial consequences.  source

No other currency in the world plays the same role in international economic relations that the US dollar does.   Some would say the US dollar is effectually a de facto world economic government unto itself.  As to this idea that the US can not have too much debt:

the American current account deficits and external liabilities are very different from those of a country like Brazil and even from those of the other rich countries. This is due to the fact that the dollar is nowadays the international currency of the world economy. The world economy works in practice, at least since 1980, in what we have been calling the 'floating dollar standard'[2], where the dollar has a very different role from all other currencies (including the convertible currencies of the other rich countries). This gives extraordinarily asymmetric power to the US economy, which simply does not have any kind of balance of payments constraint. source

Supposedly everything the US creates as debts are good.  When we say the dollar is a fiat currency, we mean that what backs it up, basically, is trust in our government‘s word that the paper IOU which is the US dollar will be backed up with some kind of payment.

Frankenstein Finance
But with the nature of contemporary finance and electronic banking, international trust of the US dollar has been abused beyond all reason.  To those who would buy US debt (re:  the recent credit crunch, whereby FCBs are refusing to buy US debt such as securities, CDOs, etc.), they are concerned that our currency is too watered down with debt.

In recent times this capacity to create infinite debt has been abused by our towering national debt.  The truth is, there are more "debt instruments" out there (i.e. stocks, bonds, T-notes etc.) than any kind of asset or official promissory instrument to back them up.

Which is why the US currency is now in so much trouble.  

Suppose there is a run on all that debt.  Suppose everyone goes simultaneously to the bank, wanting to cash in all these new "assets" (stocks, bonds, etc.) for hard currency.  The problem now is that infinite debt is attached to those dollars.  The FED could hardly print money to ever cover it.  The FED, because of their lack of regulation of such things as hedge funds and private equity groups who create dollar-denominated debt instruments OFFSHORE, no longer have any idea how much debt is even attached to the dollar.  We have therefore overspent US trust.

Here is an online article from 2004 which describes our ungainly moment well, and the incredible hubris with which the finance realm has carried on during the last decade:

Plain and simple: the value of the dollar has been held up by Asian currency policy. Asian central banks, in particular Japan and China, have been willing to endlessly buy dollars. So in effect, interest rates and the value of the greenback rest on the whims of Asian central bankers.

What will happen to interest rates here in the U.S.? What will happen to mortgage rates, to the value of real estate and to our stock market, which now rest in the hands of Japan and China more than it does the U.S. Fed? If foreign central banks stop buying or—even worse—start selling, our currency falls and interest rates rise. It is now a question of not "if" but "when" the dollar nexus unravels. No nation—not even the U.S.—can run $500-$600 billion twin budget and trade deficits into perpetuity. At some point foreigners will say "No more!"

Wildcat Finance
The term "wildcat finance" (referring to the era of free banks) is what some critics are calling the nature of contemporary "finance."  This blogger quotes from the Atlanta FED article:

From 1837-1865 banks in the United States issued currency with no oversight of any kind by the federal government. Many of these banks were part of the "free banking" system in which there was no discretionary approval of entry into banking. A note received in a transaction might indicate that it was issued by, say, the Atlanta Bank.

If a bank issues notes with no prospect that they can be redeemed, the issue becomes prevention of fraud, or what is "essentially counterfeiting".

Because of the internet and computerized finance (electronic "money" instruments), the world of debt can be infinitely abused.  In fact the situation has been abused to the point where debt becomes listed as assets by those who own such notes, then used as collateral for assuming more debt, which become assets... ad infinitum.  This has to do with what is known as the derivatives market, which will be covered in a subsequent diary.

The nature of finance (money-lending) has become very strange.  Would you, for instance, go to a bank for a loan and present your previous debt as collateral to take on more debt?  No, of course not.

But that is how it now goes for the rich.  The derivatives market involves a very complex series of maneuvers called "structured finance" which can "shuffle the deck" on bundles of debt (say, 100,000 mortgages), changing their understood identity, and allow all those old debts to be used anew as collateral for new debt.  While a simplified explanation, this is what is going on.  Much of what we call "wealth" is actually "debt" because of these techniques.  

But Why Buy Debt?
Here’s the rub:  most people in the US don’t realize what the national debt "means" in international terms or what happens in this lending process.  Maybe we imagine someone just keeps numbers in a book.  But our national debt is a very dynamic player in the world economy.  It gets pimped out everywhere in piggy-back schemes such as hedge funds.

People keep asking, why would the foreign central banks (FCBs) keep on buying US debt?  The easy answer is because it pays soooooo much interest.  People are getting extremely rich because the US keeps going further and further into debt.  The Chinese, among others, might laugh out loud that the US public pays them all this interest on our "war" debt.  In a complex way, that whooshing sound at the core of everyone’s 401K is our tax dollars paying interest to foreign governments for the debt Congress assigns to us.

The other problem goes back to the role of the dollar as international reserve currency.  Basically, most nations are forced to trade in dollars, and anything abroad denominated in dollars stays that way.  In a vicious cycle, the more debt there is attached to the dollar, the more dollar instruments other FCBs are forced to buy to keep the value of their own holdings.  One critic puts it as follows:

World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. The world's interlinked economies no longer trade to capture a comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies. To prevent speculative and manipulative attacks on their currencies, the world's central banks must acquire and hold dollar reserves in corresponding amounts to their currencies in circulation. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. This creates a built-in support for a strong dollar that in turn forces the world's central banks to acquire and hold more dollar reserves, making it stronger.   source

He also says:

The Quantity Theory of Money is clearly at work. US assets are not growing at a pace on par with the growth of the quantity of dollars. US companies still respresent 56 percent of global market capitalization despite recent retrenchment in which entire sectors suffered some 80 percent a fall in value  source

Moreover, any asset, regardless of location, that is denominated in dollars is a US asset in essence. When oil is denominated in dollars through US state action and the dollar is a fiat currency, the US essentially owns the world's oil for free. And the more the US prints greenbacks, the higher the price of US assets will rise. Thus a strong-dollar policy gives the US a double win.source

This is where we see how the US currency has the potential to be infinitely exploited as a "credit card" by the FED and reckless administrations.  This is why we, as a people, have been successfully shielded - until very recently - from feeling the effects of the size (nearly 9 trillion!!!) of our national debt.  It also has been the means whereby  - again, until lately - the public fails to realize the fallacy by which the limitless war could be "financed."

Wealth is Debt
When you supposedly have a million dollars but three quarters of it is notes you hold from first-time credit customers in Mexico who owe debts on new trucks, should you describe yourself as worth a million before you’re actually paid off?  But because debt is considered an asset and is bought and sold every day on Wall Street in myriad forms, a lot of assumptions can be made about the nature of anyone’s wealth in paper instruments.  This again is an elementary example, but sufficient for our purposes here.

Debts are Assets are Debts are Assets...
To mention another subject to be covered in a subsequent diary, hedge funds have, above all, abused electronic banking in this way.  Because most of them are offshore and unregulated by the FED, when they electronically create dollar-denominated assets, there actually is no way that anyone can keep track of these.  

On Wednesday, May 2nd, 2007 the New York Federal Reserve Bank issued an unprecedented public warning regarding the hedge fund industry, wherein they made note of a variety of what I thought were interesting statistics. This was issued as a warning that the $17-trillion hedge fund industry, 93% of which is debt financed, or in other words, based principally on borrowed money derived from the yen carry trade, has created so many global credit and other speculative asset class bubbles that the principal driver of the global economic collapse scenario is and will be the hedge fund industry.

   The yen carry trade is continuously flooding the world with cheap money. It works by borrowing money at a half a point from the Bank of Japan and re-lending that money at a higher rate through some other instrument. Or by using it to purchase other assets whose perceived values are rising at a greater rate than the .5% that is your cost to carry the money.

   As the Fed points out, referring to the total "assets" of the hedge fund industry is a misnomer. It should be really called the total "debt" of the hedge fund industry, since 93% of their assets are debt, even though they carry it as "assets" on the books.

   However, if 93% of the $17 trillion is borrowed money, through leveraged credit instruments, then you can’t really say it’s an "asset." I think it’s more correct to say, the hedge fund industry is a $17-trillion "debt" industry -- not "assets."

   What the Fed points out is that aggregate hedge fund debt is now approximately twice the average daily ‘free money supply’ of the entire planet. Free money supply – they use the word "free" meaning "net," i.e. the unencumbered money supply of the planet. source

This is why our currency is in worldwide disrepute - people are figuring out that what supposedly backed up all that debt - the value of houses in the US mortgage market - is not worth the value which was assigned by those who rate debt.  

I argue that rather than being the fault of the US homeowner, who is being scapegoated in the US media for our recent "credit crisis" - the nature of money itself (electronic now) and its abuse thereof through contemporary finance (i.e. money-lending industry), together with the FEd's and Congress' failure to regulate, it is at the core of our troubles.

The reason the mortgage debt was wrongly rated in quality was because the derivatives market was insured, and the "packaging" of the debt was subject to being misunderstood.  This too is best undertaken in a subsequent diary.

One of the best people to whom I can refer readers concerning the nature of contemporary "money" or "liquidity" (the same idea, for the beginner) is Doug Noland, in particular the column linked here.  (Note to the beginning reader of finance media:  the first ¾ or so of Noland’s column is numerical indices which will only confuse you.  Search down for the phrase "checks and balances" to get to the meat of his excellent essay on the nature of contemporary "money.")

Some years back (1999) I proposed the concept of an "Infinite Multiplier Effect." Having been unleashed from traditional bank reserve and capital requirements (not to mention a gold standard!), contemporary (electronic) finance (certainly including non-banks) had evolved to the point of attaining the potential for unfettered expansion. This potential is now being fulfilled.
Let’s recall the standard Econ 101 example of fractional reserve banking: In the process of loaning money, Bank A creates $100 deposit money when it "Credits" the borrower’s account in the process of extending a new $100 loan. This new deposit/finance is then spent, and this $100 flow ends up as a new deposit in Bank B. Here, in the case of a 10% reserve requirement, $90 is then available to lend to a new borrower. When this $90 loan is made, the new deposit/purchasing power flows to Bank C where an additional $81 is available to be lent. And so on...

Today, when, for example, a foreign central bank "recycles" dollar liquidity through the purchase of Treasuries, this finance is immediately available to be "multiplied" infinitum in the modern day securities finance arena. Let’s say the Bank of Japan buys $100 million of Treasuries from a hedge fund, a ("carry-trade") speculator using this short-sale as a source of finance for the purchase of higher-yielding securities. Here, a $100 million of dollar liquidity that the Bank of Japan initially acquired by exchanging yen finance with, say, Toyota then flows to the hedge fund. For the hedge fund, this liquidity becomes buying- power for the purchase of ABS from, let’s say, Merrill Lynch. Merrill would then have liquidity for its investment banking clients to finance a jumbo mortgage or perhaps an acquisition. This entire $100 million of finance can then follow various paths as it flows back out to the world financial system whereby it can again be recycled in its entirety right back to our securities markets.

Today, (unrestricted) securities market finance/liquidity circulates through an expansive and increasingly non-transparent Credit system (certainly including Wall Street, "repos", securities and derivatives markets, and off-balance sheet "special purpose vehicles," along with foreign central banks). From securities transaction to securities transaction, this process creates myriad new debt instrument IOUs through a multitude of lending processes (some financing the real economy but most financing the securities and asset markets). This unchecked expansion of a broad range of sophisticated securities market-based liabilities, intermediated globally through various types of institutions and vehicles, now comprises the vast majority of system "liquidity."
(...)
This finance cannot be readily accounted for or monitored, let alone regulated by monetary authorities.

This is almost like minting your own money.  

Even analysts that I respect too frequently point blame for the current state of affairs on the government "printing press." If I could convince readers of one aspect of my less-than-conventional analysis it would be to appreciate that the vast majority of contemporary (electronic) "money" and Credit is created outside of the domain of the Federal Reserve and resides largely beyond its control.source

Because hedge funds and private equity groups trade in US dollar assets yet are unregulated by the FED or Congress in any meaningful capacity.  It weakens our currency in the eyes of the world.  Because no one has any way of knowing how much debt is even out there... how much debt is attached to the dollar.

To end with more excellent words by Doug Noland:

Today, "money" or "liquidity" cannot even be adequately defined, let alone monitored and regulated. Worse yet, in this Credit-induced boom-time euphoria, rabid ideologues (ok, think Kudlow and Laffer) equate free markets in goods and services (the Economic Sphere) with a "free" marketplace in unrestricted finance (the Financial Sphere). Checks and Balances and the Separation of Powers are recognized as absolutely paramount to a healthy democracy, yet these principles are somehow viewed with intense disdain when it comes to modern finance-based Capitalism. To be sure, when exuberance in the private-sector’s capacity to create wealth (and expand finance!) reaches its most fanatical extremes, there will be general antipathy toward any effective governmental monetary control. A great amount of historical precedent has me convinced that unchecked money and Credit pose the greatest risk to free market Capitalism.  link

If we glean nothing more from all this, understand:  finance and economics are different things.  Everyone all the earth over faces economics questions.  Finance, on the other hand, is the money-lending industry.  What is destroying people's understanding of money in the US is the wanton conflation of the ideas of finance with economics in the MSM media.

Our Founding Fathers were incredibly wise and masterful statesmen. When it came to the scourge of the abuse of power, unsound money ranked right up there with tyranny. They were hard money men who would be appalled by the current state of monetary affairs, the power concentrated in the hands of the Wall Street "money"-men, and the untenable debt load we owe to foreign governments and financiers.