Wednesday, January 7, 2015
The Money Game (Big Picture)
While we are discussing the nature of money, take a few moments to consider the nature of the money game. Currently our entire monetary system is a castle of debt built on a foundation of thin air. Look at a Federal Reserve Note. It says “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.” Money is usually first created when instruments of debt are sold by the Federal Reserve Bank or the U.S. Treasury. It works like this (a very simplistic explanation): The Treasury issues bonds to dealers who sell them by means of an auction. The Federal Reserve Bank buys the bonds from the dealers using credits created out of nothing. These credits are deposited in the sellers’ bank accounts. The banks holding these accounts are now free to lend this new money to their customers. Some of these customers will be other banks. The second tier of banks can then lend to other banks. This process is called fractional reserve banking. For each new dollar created by the Federal Reserve and the U.S. Treasury ten new dollars can be added to the general economy by banks lending to banks if the reserve requirement is held at10%. The Federal Open Market Committee of the Federal Reserve Bank selects a reserve requirement that they hope will increase or decrease the money supply in a manner that will prevent deflation or control inflation. They hope that you, the American consumer, will borrow this money, get a job, and work the rest of your life to pay back the debt you owe to the bank that owes the money to another bank and taxes to the Government which created the debt in the first place. Here is the problem. If all that debt is going to be repaid in a continuous ongoing cycle, the actual wealth created by our nation must continue to increase—forever. Remember the Rule of 72. If you borrow $1,000 at 6% for 12 years, you must generate $2,000 in after tax income to pay off that debt. 72 divided by the interest rate gives the number of years required to double an investment Let’s look at a couple of simple examples. In 1987 I bought a house valued at $98,000 with a 10% down payment. I had what I hoped would be a secure job. I knew I could pay the mortgage with current salary. I was pretty certain my salary would increase in a predictable manner over time. I guessed right. If a couple bought a similar house in 2006, they would still owe more on that house than it is currently worth. They can’t sell it unless they come up with the money. The other options are a short sale or foreclosure. If they still have their jobs after the crash of 2008-2009, their income has remained stagnant. A student takes out $50,000 in student loans in order to obtain a liberal arts degree. Not having done his research the student discovers that approximately 40% of students graduating with this major are working in low paying retail jobs that do not require a college degree. The 60% that will find a job requiring a degree will earn a median starting pay of $35,000. This will allow them to pay off their student loans at a rate somewhere in the neighborhood of $3,500 a year. If They Are Lucky! In the 1950s and 1960s a married man with a high school diploma could reasonably expect to provide his family with one car and a 1,200 square foot house in a reasonably good neighborhood. Through the 1970s, 1980s, and 1990s my generation upped the ante. The women of America joined the labor force. Two incomes provided two cars, a 1,800 square foot house for a smaller family and more toys sooner for more Americans. Personal debt increased but so did the salaries necessary to service that debt. After 2000 American households maintained more and more of their middle class life style with debt. However, median household income has not increased at a rate that can keep pace with the increasing debt load carried by American families. Over the last 14 years total debt (both pubic and private) has increased significantly but Americans are no longer increasing their wealth at the rate necessary to pay off these debts. The Fed is creating money but the velocity of this money has dropped precipitously over the last six or seven years. That means banks aren’t able to lend money at the rate the Government desires. For a loan to occur the bank must have the money to lend (tax payer bailouts took care of that problem). Next the bank must identify customers who will be able to repay their loans. Finally, these credit worthy customers must want to borrow some money. This isn’t happening at the rate necessary to keep the economy headed upward. The average American household is choking on debt. They are trying to get rid of debt, not accumulate more debt. As is always the case the more credit worthy the customer, the less likely it will be that he will need to borrow any money. The people who actually want to borrow money, are the least likely to be able to repay the loans. Does it make sense that both the debt and wealth of an individual or a country can continue to increase forever? Remember that only three things can be done with debt. It can be repaid. If not, it is called default when a nation fails to repay their debts or bankruptcy when a private individual fails to repay their debts. If you own the printing presses, you have a third option, monetizing the debt (devaluing the currency). One more thing to consider: Debt that can not be repaid will not be repaid.