Unusual Activity at the Federal Reserve

It’s not very often you see graphs like this:

The above would be highly inflationary except that the Fed simultaneously has been selling treasuries. The graph, also in billions of dollars (note that the time scales is shorter than the above):

Both curves have a sudden movement of about 180 billion dollars, but in opposite directions. I suppose that otherwise we would suffer from a sudden increase or decrease in the money supply and this would cause economic problems.

When a State has a problem where there is too much debt as compared to the value of the assets, and the debt is denominated in the currency of the State, the usual solution is to “monetize” some of the debt of the State, thereby increasing the money supply. This eventually causes asset prices to increase, which solves the debt problem. The people who hold debt lose part of their wealth to inflation, but the system holds together.

This solution is not available to countries where their debt is denominated in a currency they do not control (as has happened to various 2nd / 3rd world countries over the years). But it is available to the US and I’ve been expecting it for years. The usual term for this is “monetization”.

Uh, “monetize” means to turn the debt into money. This is done by having the Federal Reserve (or equivalent in other countries) buy the debt with newly created money. The money is created by typing a few keystrokes at a computer terminal, but it’s good money as far as the market is concerned and the money supply is instantly increased.

The current chairman of the Federal Reserve is Ben Bernanke. He gave a famous speech while chairman where he said that deflation is not a problem for the US because they can make as much money as they want, any time they want to. That speech discusses a lot of the stuff that the Fed is doing right now. Because the speech used the phrase “helicopter drop” to describe how the Federal Reserve puts money into the economy, his nickname is “helicopter Ben.”

You see a lot of people talking about how bad the economy is, but the US is not yet in recession, and since recession is defined as “two consecutive quarters of negative growth in GDP” and the US grew in the first two quarters of 2008, it’s likely the US will avoid recession for this year at least.

The US money supply can be increased at the will of the Fed because the US dollar is “fiat money” which means it has value only because people think it is valuable. This was not always the case. In the distant past, the US dollar was backed by gold and could not be inflated at the will of anyone, unless they had a lot of gold.

Since capitalism first began (as long ago as 1000 years) there has always been a business cycle of booms and busts. A famous early capitalism boom and bust was the tulip bulb mania of the 1630s. Manias create financial instruments that feed manias. These are not new problems of capitalism. Nor are derivatives an invention of the 21st century. 1637 saw the Dutch trading tulip futures. If derivatives were outlawed in the US, our businesses would pursue them outside the US.

My belief is that the human tendency to mimic is the cause of the business cycle, and since this human attribute is impossible to control, business cycles are inevitable. For example, it must be noted that business cycles are world-wide. Since any one country’s political party can control only what goes on in that country’s business (and in a divided system like the US very little of that), it is silly to blame the world-wide problem on a single political party or more ridiculously, on a single individual.

If you saw your neighbor get rich by mining coal, you might be inclined to emulate him. Except that coal mining is hard and dangerous work. But buying tulip bulbs (or any financial instrument) requires very little effort and so the urge to emulate your neighbor is far stronger.

In addition to being proficient mimics, humans also tend to hold identical beliefs (correct or not so). And when a lot of people become convinced that tulips, or houses, or stocks, or beanie babies are a great investment, they can and will drive the price higher by buying more of them. And their buying just drives the price higher convincing them that they were right. The result is a boom. Of course this eventually comes to some sort of ruin.

These same human features explain a lot of the problems in physics today. The majority of the race does not think for themselves. When they see a lot of other people doing physics one way, they imitate. As in financial booms and lemming runs, the key is lemmingsknowing where the cliff is.

As far as the current situation, we can have one or two outcomes. If the Fed manages to keep things under control, we’ll return to the previous course and houses will still be a primary way that Americans save money for their retirement. This may run into trouble when the country starts graying and a lot of people need to retire at the same time, but that difficulty would attend any way that people tried to pay for retirement. Whatever choice they made would get driven down in price when they all tried to cash out at the same time.

The US Trade Deficit

The US has run a large trade deficit for so long that many people are unaware that there was ever any other such thing. But the US had a trade surplus as recently as 1992:

The consequence of running a large (and growing) trade deficit for long periods of time is that a large number of dollars end up being held overseas. Since the dollar is a fiat currency, there are only a few reasons to hold them: (a) you expect to make a profit because they are going to go up relative to whatever alternatives you have, (b) you hold them as a store of value, (c) you hold them because you know you’re going to need them someday to buy something from an American, and (d) you hold them because you need them to pay your US taxes.

So if the US inflates the currency to save the banks it is always possible that foreigners will suddenly decide to get rid of their dollars. And since humans are lemmings, the typical situation is that they will all try to do it at the same time. (I am reminded of the classic stock market trading advice: “Do not panic. However, if you absolutely must panic, try to do it before everybody else does.”)

Now the reason the US has run such a huge deficit for so long is not because of some moral superiority or inferiority of somebody and it’s not because one or another political party is in control of the US. It’s because foreigners like dollars. They suck the money out of the country by refusing to spend the money we give them when we buy stuff from them. That we’ve ended up with a huge trade deficit for so many years is because the world’s economy has been growing very well for several decades. They are wealthier so they can afford to own more dollars.

In the event that foreigners panic out of the dollar the huge numbers that they hold will drive the US dollar waaaay down. In the US, that will mean incredibly high oil and food prices. US farmers will suddenly find themselves very wealthy. The price of gold, the traditional alternative store of value to the dollar, will go through the roof.

If they change their minds about holding the dollar, there are things we can do to stop them from using those dollars to buy up stuff in the US. But if we do that sort of thing (i.e. laws against foreign ownership of property here) it will seriously annoy them and they probably won’t forgive us for quite some time (but like the lemmings, they’ll be back just as soon as they see other people making money by holding dollars again).

7 Comments

Filed under economics, History

7 responses to “Unusual Activity at the Federal Reserve

  1. carlbrannen

    By the way, does anyone know how to eliminate “possibly related posts”? I’ve got one showing up with a foul word that I’d rather not see here.

  2. carlbrannen

    Thanks.

    Well I can only get rid of it for all posts, and some of the time it’s worthwhile so I’ll leave it running.

  3. Back onto the topic of the post —

    There you go. Just yesterday I was using the tulip mania of the 17th century as an example of how the latest news didn’t just get invented.

    Education. A marvellous thing. Puts everything in perspective.

    Sorry that the “related post” function is giving you grief.

  4. carlbrannen

    Yeah, humans tend to see whatever is going on around them as a unique experience, one that has never happened before. But these are interesting times.

    I wonder what the Dutch were talking about while the tulip mania was going on. Surely there was something before that.

  5. Pingback: Scrap Metal and European Banks Collapse « Mass

  6. Pingback: Financial Markets Show Quantum Mechanical Properties - Science Forums

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