Sunday, January 4, 2009

A Place for Conversations

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11 comments:

  1. Anonymous wrote:

    In reply to KCB.

    "Now, for the claim you people are making to be true, that there's no currency inflation due to defaults and bad bets, there must be a flaw in the above analysis, some mechanism that causes the defaults and bad bets to remove currency from the system without involving repayment of loans. So: where/what is it?"

    January 1, 2007. Bank A bets with Bank B that housing prices will have come down for at least 10 % (calculated from now on) by end 2008. If after those 24 months housing prices have decreased for at least those 10 %, Bank A gets a fixed amount of 100 millions of dollars of Bank B. The same applies to the contrary if housing prices won't have decreased at least 10 % at the end of the period. Then Bank B would receive those 100 millions from Bank A.

    End 2007. Housing prices have come back 6 %.

    As Bank A is very sure of its prognosis and its calculation models, it assesses the propability of winning the bet at 75 %. On its balance sheet, bank A therefore values its rights out of the bet against Bank B at 50 millions dollars. At the end of the fiscal year, those 50 millions increase Bank A's annual profits.

    But what with regard to Bank B? One would suspect that the bet had caused a loss of 50 millions of dollars to Bank B, right? Well, surprise! Bank B uses different prognosing- and valuation models than those Bank A uses. In fact, bank B is quite optimistic housing prices will rise again very soon and calculates the odds of winning the bet at even. Therefore, it does book neither additional profit nor loss on its balance sheet.

    BREAK. Here comes the astonishing lesson to be learnt. Although both banks have acted in accordance with valid accountancy rules, the banks' total assets, when added up, have increased by 50 millions - millions 'out of thin air' and only due to different valuation models, although no new money/currency has been printed!

    So, at the end of fiscal year 2007, there is a virtual increase of the amount of currency in the SYSTEM of 50 millions of dollars!

    Well, guess what happens next? During 2008, housing prices decline further, and by the end of 2008, they have declined more than 10 %.

    Bank A receives 100 millions of cash from bank B, which means that Bank A can book an additional profit of 50 millions for 2008.

    Bank B has to pay 100 millions to compensate Bank A and has to book an according loss of 100 millions.

    We see that now, the total amount of currency in the system has decreased again, for 50 millions, and come back to the niveau of begin 2007 once more.

    CONCLUSION?

    Well, the conclusion is that everything depends on the time-frame. If you look at the development of the amount of currency in the SYSTEM from begin 2007 to end 2008, all in all nothing has changed. However: if you look at it year per year, you will realize that during 2008, the amount of currency has actually decreased significantly.

    In my (very simplified) example, I have chosen a very short two-year period for the bet. However, imagine that hundreds of banks around the world have made hundreds of thousands similar bets as the one described, but with regard to much higher amounts of money, and most importantly, with a much longer 'life'-time. As it is a fact that banks use different valuation and accounting models, it now becomes obvious that the world has seen an enormous and artificial increase of (virtual) currency over at least the last decade. Now, however, that more and more bets reach the end of their lifetime and at the same time develop in the way most of the banks have not expected (='turn bad'), this increase will automatically be corrected and brought to the niveau before the virtual currency increase on the major scale started.

    Funnily, there is NOTHING to do about it. I hope this explains why bets going bad decrease the amount of currency in the system.

    ReplyDelete
  2. I guess since this is the proper place for this conversation, I should respond here with what I responded in the original thread:


    But asset valuation and *currency* aren't the same thing! Asset valuation is an item on a balance sheet. It doesn't have any real value until the asset is sold: exchanged for money. In other words, it has *indirect* value in terms of currency.

    Currency itself is the direct medium of exchange used by the society in question. The amount in existence is the sum of deposits plus the amount of physical cash in circulation. In normal times, it is created when a loan is made and destroyed when the loan is paid back. The only other way to destroy it is for a fractional reserve institution to disappear without paying out all its deposits first. During the Great Depression, that's exactly what happened to a lot of banks, and the end result was massive currency deflation.

    So the flaw in your example is the 50 million dollar valuation of the bet. The fact that it's put on the balance sheet means *nothing* with respect to the total amount of currency in the system, because a bet valuation is not itself currency: it does not appear as a deposit nor is it cash on hand.

    This is critical: an asset IS NOT THE SAME as currency!

    If you tell me that we are experiencing price deflation (which means that the value of assets as denominated in the prescribed currency is decreasing), I'll agree with you all day long.

    That is *not* the same as currency deflation! Currency deflation literally means that money is being removed from the system. And unless I'm mistaken, the *only* way that can happen in a fractional reserve system is for a loan to be paid back with cash.


    So unless that 50 million dollars appears as a deposit, it can't be counted as currency. If it *does* appear as a deposit, then from what loan did it originate?

    ReplyDelete
  3. "Currency itself is the direct medium of exchange used by the society in question."

    Currency is only a small part of exchange used by the society. Most of our transactions go thru plastic, a debt instrument.

    Merchants get paid thru credit. Before you pay off your debt, net currency in circulation increases thru your credit, which means inflation. Once you pay off your bill, that money is gone, circa deflation.

    Hope this helped...

    ReplyDelete
  4. Anonymous wrote: "Currency is only a small part of exchange used by the society. Most of our transactions go thru plastic, a debt instrument."

    Yes, but don't you see? In a fractional reserve banking system such as ours, even *currency* is a debt instrument. Almost all of it is issued as a result of loans -- debt.

    And credit cards are issued by banks, so I expect the debt issued on them follows the same fractional reserve rules that other types of loans follow.

    Anyway, I don't see how credit cards, or their use, change the argument regarding currency inflation/deflation at all...

    ReplyDelete
  5. Great comments gentlemen. Allow me to add my two cents. While A and B dickers about their little zero sum shell game of bookkeeping asset devaluation, perhaps there is a third variable. Who was forced to pay off the bet to B on behalf of A? Could it be C - the consumer (taxpayer)? So C now has less real savings, and therefore has less demand for products and the loansharking of both A and B who depended upon C to take loans to instigate currency inflation. Thus, C arrives generates another variable - D. Anyone want to guess what D stands for?
    -PPT

    ReplyDelete
  6. KCB.

    Great posts. I think the confusion resides on the fact that banks lend AGAINST their balance sheet. An inflated balance sheet therefore means currency inflation.

    A $100M optimistic valuation times the 10x multiplier ratio, allows the bank to continue to maintain a $1.0B in loans outstanding that it would otherwise need to close (or raise capital) to stay within its reserve requirements.

    Abrazos,

    ARM

    ReplyDelete
  7. "Anyway, I don't see how credit cards, or their use, change the argument regarding currency inflation/deflation at all..."

    Agreed. Credit card usage illustrates how deflation can occur, as currency is taken off the table when consumer pay back their balances.

    ReplyDelete
  8. Anonymous wrote: "Agreed. Credit card usage illustrates how deflation can occur, as currency is taken off the table when consumer pay back their balances."

    Precisely. And that is just like any other loan. Credit cards are no different except that they are not collateralized. If the borrower defaults on his credit card, the bank has no collateral he can sell to reduce the loan balance.

    If people are paying back their credit cards at a faster rate than they're using them to purchase goods and services with, then that obviously represents a deflationary scenario.

    But the situation we face today isn't that at all (more precisely, the deflationary situation you describe isn't the dominant one today). What we're facing is huge amounts of credit card *default*. And as with any other loan, when a credit card is defaulted upon, the money that was issued for the loan remains in circulation. That is *not* deflationary: it's *inflationary*!

    ReplyDelete
  9. "And as with any other loan, when a credit card is defaulted upon, the money that was issued for the loan remains in circulation. That is *not* deflationary: it's *inflationary*!"

    Correct, the loan remains in circulation but credit has evaporated, thus putting a strain on future net buying power.

    You may have defaulted on yesterday's debt and thought you got away with it, but your bad credit has already prevented you from generating future debt, resulting in a devastating deflationary spiral.

    ReplyDelete
  10. Anonymous wrote: "You may have defaulted on yesterday's debt and thought you got away with it, but your bad credit has already prevented you from generating future debt, resulting in a devastating deflationary spiral."

    Deflationary only if the loans currently on the books are paid back!

    Suppose everyone, in a concerted effort, defaulted on their loans, and instead used the cash they received to pay each other for goods and services, and to take out and repay loans under a self-enforced full-reserve banking system.

    Would the end result be a deflationary spiral? Not at all! Instead, the currency supply would stagnate. There would be neither currency inflation nor currency deflation.

    "Future buying power" is, when applied to loans, something of a misnomer. Because loans inject money into the supply, they cause the price of everything to increase, thus reducing the future buying power of money currently in circulation.

    And, in fact, much of the point that FDR has been making with respect to the system we have is that it is really a net *drain* on the economy. Loans by their very nature are inefficient, because they force the borrower to pay more for something than he would if he paid for it with his own funds.

    So you can argue that people who default on their loans won't have as much access to credit as they would otherwise, and that's true enough, but with respect to currency inflation/deflation, it's relevant only to the degree that it causes a shift in the balance of loan payments (outgoing versus incoming).

    If we have currency deflation right now it's only because people are paying back their loans faster than they're taking them out. Given the reluctance to lend at the moment, it's not hard to imagine that the balance is deflationary. But defaults are driving it only to the degree that they are causing additional reluctance to lend.

    ReplyDelete
  11. Hi FDR,

    Please excuse my ignorance here - there is still inflation and deflation of assets under a gold-backed currency system isn't there? (I know gold-backing stops currency inflation / deflation but what about other assets).

    Thanks.

    ReplyDelete

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