Debt, is this not the Great Depression?

I was on the Federal Reserve website checking out the major holders of debt in the United States historically. Both charts that I created show basically the same data. The first though shows the difference in the amount of debt over time, though it is nominal terms not real terms. The second just illustrates more lucidly the amount allocated to each type of provider. There were no data from earlier, but we can generalize that the banking system in the Great Depression looked a lot more like the 1943 data than the 2003's data points.

So it is obvious that the financial system has evolved, not in the Victorian sense that evolution necessarily means for the better, just that it has mutated. Securitized pools which do not exist in the data until the end of the 1980's come to make up over 30% of debt extended in its halycon days of 2003. A securitized pool is a pool of debt instruments for instance mortgages, or credit card debt, or automobile debt, or just general loans. These are sold to investors, usually pension funds, mutual funds, etc. The idea is that these instruments should be safe but yield more than comparable government bonds or AAA corporate bonds. These pools also allow the end borrower to borrow more cheaply than had investors not bid up the price they would pay for these structures.

The reason to make the distinction between the two eras or even to look back at how the debt market has evolved is that the response of the players should be different as well. When a bank in the 1920s and 1930s funded itself via deposits and then constructed a loan portfolio of assets it was subject to a risk of concentration. The first part of the concentration risk was that since there was no FDIC the deposits were not insured, so if all the people of the town came asking for their money at the same time there would not be enough cash in the vault to meet their claims. The second risk that stems from the first, was that if the financial system was in dire enough shape for people to be asking for their cash deposits back it meant that the economic system was in arrears as well with unemployment sure to follow. Thus, the loan portfolio (mortgages, small business loans) concentrated in the area in which the bank was would probably not pay back all the cash flows it was expected to generate. These are the reasons that the social safety net was constructed with unemployment insurance and deposit insurance.

So, what can be expected of the banks to do now? Well, banks will keep on doing what they have been doing. Making loans where it is profitable to do so and winding down bad loans. It is instead the securitized pools that worry me. Some of those pools were brought back onto the originating banks balance sheets, which then ties up their regulatory capital, thus decreasing their lending. Now a securitized deal cannot even be done without a guarantee from the Federal Government backing it. If we lop off the 25% of debt structure of the United States it will be hard to recover back to normal and "normal earnings and revenues." It's what PIMCO has been saying for awhile now that a new normal may be in store.

Inflation

The quantity theory of money describes inflation and has a long history dating back to thinkers in the Renaissance. Coepernicus among others noted that as gold arrived from the New World the price of goods rose. Thus the theory expounds that there is a positive relationship between increases in the money supply and prices of goods and services.

An easy example would be coffee. Imagine a Dunkin Donuts as it started in the 1950s, it charged a nickel. Now to buy that same cup of joe it costs 2 pieces of silver ($2.00.) Is it because the coffee is better, or because people enjoy it more? Nope, according to the theory, your dollar's value is less, so before a 20th of a dollar got you some warm goodness now it costs two. So how did the dollar come to be valued less? Isn't monetary policy off the gold standard?

It wouldn't be economics if supply and demand were not involved. The money supply is based on the Federal Reserve through its operations including its open market operations. Again, it buys bonds to increase the money supply and it sells them to decrease the money supply. For the next example it is assumed that the Federal Reserve keeps the money supply constant. The money demand however is controlled by people. Some factors that affect how much money people want to hold are: that availability of credit through credit cards, the availability of withdrawing funds either through an ATM or from a bank's teller. Underlying this idea though is the cost of goods/services because as they are priced higher than people must carry more cash for daily transactions. Since the people carry higher balances with higher prices than the demand for money is greater.

Here is a chart.

The blue line is the fixed money supply. The Red line is the Money Demand. The demand line curves downward because as the value of money falls or conversely the price level is higher people desire a larger quantity of money. The equilibrium is shown by the dotted line it is where the price level and the value of money intersect.

Now as the Fed performs open market operations, say buying treasury bonds, it will increase the money supply. The next chart shows the money supply parallel shifting out (from blue to orange.) This cause the value of money to fall and thus price levels to rise.

It is important to note that the fundamental economy has not been affected by this injection of money. The capital level has not changed, the labor productivity has not changed, knowledge is static, everything in short is held constant. However, because there is now more money chasing the same amount of goods then prices must therefore rise.

This brings up another point, that prices should not matter or restated that there exists a monetary neutrality. If prices double, then so should wages because the inputs for the good/services include labor, thus everything should be equal in the long run.

Now back to MV=PY or V=(PY/M) so the velocity of money should equal the price level times real output divided by the quantity of money. During most times V is stable, however, during financial crises this does not have to be so.

The Federal Reserve

I have been searching, fruitlessly, for a chart depicting the year on year change in price levels before the Federal Reserve and since its creation in the early 1910s. I cannot find it and will instead describe it. It shows a noise chart above and below zero. In the beginning the variance is large if it were a seismograph it would be showing an earthquake. (Shown above) As the Federal Reserve is instituted the variations shrink and adhere more closely to a long-term trend. The chart shows why the Federal Reserve exists and why interest rates are not allowed to freely float.

The Federal Reserve is made up of 12 regional banks and a board of directors. The regional banks are tasked with regulating and keeping the banking system healthy. These banks also act as a lender of last resort or the banks’ bank. The Board has a distinctive but related task to control the country’s money supply. The Board of Governors plus 5 regional bank presidents together make up the Federal Open Market Committee. 4 of the bank presidents rotate, as the New York bank always has a spot.

The committee controls the money supply in three ways:
A) By buying and selling bonds via the open market operations,
B) Reserve requirements, and
C) The discount rate

A) Open Market Operations - When it buys bonds it adds new money to the financial system and when it sells bonds it takes away money from the financial system. This seems counterintuitive but view it from the viewpoint of a bank. When the bank sells its bond to the Federal Reserve it now has cash instead. It can then lend this cash out. However, when the Federal Reserve sells bonds the bank must use its cash to purchase the bonds and thus loses the ability to lend out the money it purchased the bond with.

B) Reserve requirements – regulations on the minimum amount of “cash” reserves a bank must hold against customer deposits. This affects the money supply because if the banks have to hold more in reserve the banks then have less to lend out. Vice versa, lowering the requirement allows banks to loan out more money.

Here is how it works:
Bank A
Assets
Reserves 100.00
Liabilities
Deposits 100.00

This is if there was a 100% reserve requirement. Obviously this is untenable as the banks could only keep the money safe, as a warehouse. No entity would undertake this responsibility, as there would be no profit. So the banking system consists of a “fractional reserve system,” which only means that a fraction of each dollar of deposits is actually held at the bank. The rest is loaned out, which is a banking asset, to create profit for the bank.

Bank A
Assets
Reserves: 20.00
Loans: 80.00
Total: 100.00
Liabilities
Deposits: 100.00
Total: 100.00

Thus, seemingly the banks has created money, in an earlier post we said that money was currency plus demand deposits. So 80 + 100 = $180. However, it must be said that the economy is not wealthier, there is just more money or liquidity. This is because those 80 dollars of loans, though bank assets, are liabilities to entities that undertake them.

The process does not end here though. If the person, who took the $80 loan, maybe did not have an immediate need for the funds, so he deposited it at his bank.

Bank B
Assets
Reserves: 16.00
Loans: 64.00
Total: 80.00
Liabilities
Deposits: 80.00
Total: 80.00

This iterative process can be completed ad infitnitum, so as a general solution we can take the initial deposit and divide it by the reserve requirement ratio. So $100 divided by 20/100= 500. Thus, the money multiplier at this reserve requirement will be 5.

C) The Discount Rate – Acting as the banks’ bank it loans out reserves to bank who find them short of the reserve requirement. Picture the end of the day and a customer comes in at 4:30 PM and withdraws 10 dollars of deposits from Bank A. Bank A would still have 80 dollars worth of loans but now only 10 dollars of reserves. It would need to find 10 dollars of reserves to meet the Federal Reserve’s requirement. It thus can go to the Fed and borrow the 10 dollars at the discount rate. Then it would to try and unwind one of its loans to rid itself of the borrowings from the discount window.

Bank A (after 10 dollar withdrawal)
Assets
Reserves: 10.00
Borrowed: 10.00
Loans: 80.00
Total: 100.00
Liabilities
Deposits: 90.00
Borrowings: 10.00
Total: 100.00

The discount rate follows the laws of supply and demand. So when the rate is high banks wants to borrow less and when the rate is low the banks are more willing to borrow. Finally, this also acts as insurance against a bank run, as the banks can borrow from the discount window freely, thus generating the liquidity to survive a financial crisis like in 2008 and in 1987.

Greg Mankiw in his Principles of Economics points to two major problems with controlling the money supply through these three mechanisms. First, the Fed cannot control how much money people will want to hold on deposit with banks. Thus, a bank run can have systemic effects on the money supply. Secondly, the Fed cannot control how much the banks lend. Unlike China, you cannot force the banks to underwrite loans that the banks deem too risky given a current economic situation.

These two forces have been a key puzzle for economist over the past century. It is described by a simple equation M x V= P x Y, where:

M= quantity of money
V= velocity; the link between money, price and output
P= price level
Y= aggregate income or GDP

In the short run V and Y can be held constant thus the price level would be affected only by the money supply. This is how Milton Friedman came out with the proclamation that “inflation is always and everywhere a monetary phenomenon.”

However, as we have experienced lately the Federal Reserve and the Treasury have instituted a number of initiatives to increase the money supply and velocity but velocity has only declined to negate their works. I will expand on this in the next post on Inflation.

Money, it's what you want?

Why? The money we use today, the pieces of green paper with some old dudes on it, funny symbols and words, and pictures of architecture is essentially worthless, fiat. Why do we exchange them for goods and services, that is, why can you give them to a cashier at Starbucks and receive a latte?

There are three basic functions of money: medium of exchange, unit of account and store of value. Medium of exchange is the most obvious. Imagine that instead of money we had a barter system. You would create a pair of socks and you would then try and find me a person who needed socks. Then of course I would need to be able to give something back to you that we felt equaled the value of the socks. Basically you needed to have a "double coincidence of wants." Money obviates the above situation by its ability to be freely substituted for goods and services. Thus, you can sell your socks for money and then use your money to buy a bushel of grapes without having to find someone who had a need for socks and owned a bushel of grapes.

It also works as a yardstick, like an inch of a foot. It makes it easy to compare two relatively different goods or services into like terms. So having a maid clean your house is equal to 10 car washes. Instead we would just say that the maid's services cost 100 dollars and a car wash is 10 dollars.

Finally, it holds value. When the Starbucks or the sock maker takes the cash, they can delay their consumption to a later period. Thus, money can be a holder of wealth.

Here is where money becomes tricky though. It is enough to look in your piggy bank and see a collection of metallic coins and the occasional two-dollar bill which is money, but what else is money? How about the money in your checking account known as a demand deposit? What about CDs. or savings or money market accounts? There are several definitions of money as categorized by the Federal Reserve. M2 is probably the most appropriate measure. It includes:

• demand deposits - checking accounts
• traveler's checks
• other checkable deposits -
  
• currency
• savings deposits
• short time deposits
• money market funds
• various accounts
  

Unemployment

Just a few charts to discern what happens to employment during a recession. Really more of a vocabulary post.



So this is the the percentage of the adult civilian population (> than 16 years old) that could be employed. It is divided into three subsections: employed, unemployed and not in the labor force. The not in labor force are generally retirees and students. Now the percentages look different than what you may hear described on tv or in print. This is because they are again percentages of the total employable universe. The unemployment rate measures only the unemployed versus the labor force. This is shown below.



So here you can see the 9.4% unemployment figure that economist describe.

So the largest category is Civilians over the age of 16 and it is right now approximately 235.9 million people. It is made up of the labor force and the aptly titled Not in Labor force, which stand at 154.5 and 81.4 million people respectively. 9.4% of the labor force is unemployed currently and that represents 14.5 million people.

I wanted to look at the chart again. There are some interesting nuances going on in the data. One is that the not in labor force number is growing both in percentage terms and nominal terms as the population has increased. This most likely stems from the baby boomer generation entering their retirement years. This is why the employment as a percentage of adults has fallen below 60%.This is the first time it has been this low since 1984.

Supply and Demand for Funds Redux

In my last post I wrote about the market for loanable funds and one way to shift the supply of funds and one way to shift the demand of funds. I wanted to talk about another way to move the supply of funds, through government expenditures.

In the textbook I am reading, it shows the standard economic rhetoric. First, imagine the government spends more money than it receives in taxes. This is a deficit. How does this affect savings? Well, we showed that Savings=(Y-t-C) + (t-G). So if the government runs a deficit in this equation it decreases savings (increase a negative.) Thus, because savings is equal to investment, it is decreasing the supply of loanable funds.



In the previous example, where households are delaying consumption and instead saving their excess earnings we moved from the intersection of the blue and red lines down to the the intersection of green and red. In this example of the government running a deficit the supply curve instead shifts left and real interest rates rise. This has not occurred in the current crisis. Why not?

As TARP money flowed into the financial system in 2008 and record bailouts occurred it was "common" wisdom on the street that the increased supply of Treasury securities would choke the market and the bond vigilantes would drive down the price of Treasury securities and the yields would increase. These vigilantes keep the government honest.

Here is Brad Delong. "It is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp..."

He points us to JR Hicks and his essay "Mr Keynes and the Classics."

Figure one is the IS-LM or Investment Savings-Liquidity preference Money Supply. Point P is where goods and services equal the money supply. In figure 2 it shows the LM curve only. Basically, what Keynes proposed, at least through Hick's interpretation is that if the LM curve is shaped as it is in figure 2 than the government can run a deficit which shifts the IS curve to the right but which will not allow interest rates to rise. So basically if Point P is anywhere between zero and the beginning of the dashed LM line no amount of change in IS will raise interest rates. Secondly, the dashed LM curve shows that even by adding to the money supply and shifting LM outwards, the horizontal segment will still stay the same and will not allow interest rates to rise.

How can the LM curve be shaped like this, what theory underpins this formulation?

Basically, firms and households desire more savings, remember savings in economics is the purchase of securities like bonds, and when bond prices are bid up, the yields which are inversely related to price fall. The next step should be the equilibrium where firms now see that they can meet their investment hurdle rates and households no longer want to save at such low rates of return. However, because both are so scarred they do not act in this manner and instead wish only to hold cash until a more stable economic environment emerges. Because firms are not putting out investments, especially firms such as banks whose investments are loans, the monetary velocity falls and reach that horizontal asymptote shown in figure 2.

Milton Friedman, Alan Greenspan and Ben Bernanke would advocate the monetary vision that by adjusting the money supply will increase prices. However, as shown in figure 2 and discussed above the expansion of the LM curve does not alleviate the flat part of the curve, just pushes it out further (the dashed version) and thus the IS curve is unaffected. So what can be done?

As Hicks explains Keynesian responses are made for this situation. Hicks stated "So the General Theory of Employment is the Economics of Depression."

As it has been shown above the monetary supply increases will not increase the interest rates of an economy in a depression. Thus, the Federal Reserve is basically powerless except to provide liquidity, but to bring the rise in prices, to move from the horizontal segment to the normal economic environment, shown in the first example, is through fiscal expenditures by the government. This is why some economists such as Paul Krugman, the aforementioned Brad DeLong and countless others offered that a stimulus package should be instated. The hope was that by having the government invest in infrastructure or transferring money directly to the states so that they would be able to maintain their current spending, (states must run balanced budgets thus when recessions come and their tax revenues decrease they must decrease their spending, this is a bad thing when they all do it at the same time; not so bad when it is just a single state like Michigan.) It is hoped/proposed that by having the government invest money that firms and households are not willing to, the money multiplier can be brought to a positive relationship.

With the unfolding crisis over the past 2+ years here is the 10 year Treasury yields, remember yields falling is because prices are rising. I think Hicks is vindicated in his understanding of Keynes and Depression Economics.

Savings versus Investments

Remember the scene in the Neverending Story where Atreyu must look into the Magic Mirror gate to reveal his true identity? Well savings and investment is basically the same, it is a true identity.

So when it is said that GDP equals consumption plus investment, government expenditures and net exports (NX, which will be ignored.) The right side must always equal the left side. Let's put it into equation form and figure out how we know savings equals investment.

Given:
Y= GDP
C= Consumption
G= Government Expenditures
I= Investment
NX= Net Exports, which we ignore because we are proposing a closed economy.
S= Savings
t= taxes

The equation from above is: Y=C+G+I
We can re write this to state: Y-C-G=I
So If we take GDP and subtract out consumption and government consumption we are left with Savings. Y-C-G=S and therefore S=I

We can then rework Y-C-G=S to include taxes, t. S= (Y-t-C) + (t-G). You can see that the t, taxes, cancel each other out. In this manner we can see that Private Savings equals (Y-t-C) and Public Savings equals (t-G). Or in ingles, private savings is equal to the remaining GDP after taxes and Consumption. The tax monies transfer to the government who then spend, G. If t is greater than G than there is a surplus and if not there is a deficit. When we net public and private savings, what is remaining is investment.

Thus, from earlier we can see that the financial system ensures that S=I by moving the money from people who can save it to people who can invest it.

It is important not to think of savings and investment as interchangeable words, they are not in economics. You do not invest when you buy a bond, you are saving. An entity invest when it purchases capital, such as, buildings or machinery.

Supply and Demand for Funds


The familiar supply and demand chart. This shows that as the real interest rate falls more funds are demanded. That is, business and consumers can undertake projects that will earn them more than the rate of interest charged for utilizing the funds. Conversely, less firms will loan at lower interest rates because they will not make enough return to compensate them for given their funds to risky clients. The balance is struck in this example at 1200 and a real interest rate of 5.5%. This is because the "invisible hand" will correct any meandering. Let's imagine that the real interest rate was higher than 5.5%, say 7%. What would happen? Well, more people would think that 7% was a good deal, thus they would increase the supply of savings to be invested. This would push down interest rates because of the additional supply. The market will work back to its equilibrium.

Let's examine the current situation. The financial crisis of 2007 and 2008 has now caused people to put more towards savings. The savings rate is up to 5.2% from 4% in the first quarter. This means that there has been an increase in funds that can be loaned.


In our example, we can see that the supply shifts parallel to the right. This means there is now a lower "real*" rate of interest than in the previous quarter, as the funds have moved from 1,200 to about 1,350. So the current financial crisis has encouraged households and businesses to save rather than consuming the money.

What could cause the demand curve to shift? Any encouragement of investment, say a tax credit for buying an automobile. This would cause the demand curve to parallel shift to the right as more entities used the tax credit plus a loan to purchase a new automobile.

*Real versus nominal: nominal is the quoted interest rate you see on Bloomberg, or the Wall Street Journal. The "real" rate of interest is adjusted for inflation.