“Well those are whole pennies, right? I’m just talking about fractions of a penny here. But we do it from a much bigger tray and we do it a couple a million times.” – Office Space
If being in the Federal Reserve® offices give you a cold, what should you do? Sudafed.
The Federal Reserve© is scared. And inflation is currently not on their list of Halloween boogiemen –the monster they fear is deflation. Well, deflation and accidentally mixing up Pride Month and Bulgarian History Month. I think the main reason that the Fed™ is worried about deflation is that then people become like me in 2000 when I was looking to buy a computer.
Every six months I waited, the computer I could buy for the same amount of money was much faster with more memory. Computers were really a deflationary item at the time as advances kept making them better and better on a nearly monthly basis. It made sense to wait, because I could get a better deal later.
For computers, that was okay – there was a solid market for them at the time, and Intel® wasn’t going to go out of business because its next chip was going to be faster next year. But if you apply that to the entire economy, then people would have been steering clear of the toilet paper aisle in February. Live and learn.
Deflation is great for consumers – they get more stuff for less money. Deflation also discourages debt – why borrow money when the dollar you’re borrowing will be worth less than the dollar you have to pay it back with?
But deflation in an economy slows everything down worse than a Kardashian trying to take a college entrance exam. Most economies in the world are built on endless growth. Part of the economic growth is required because more people enter the labor force every year. The other part is the system is built on growing income, growing revenues, growing the bottom line – stock prices are built (mostly) not on the intrinsic value of a company here and now, but on the value of the company in the future.
I hate stonks. Gentlemen prefer bonds.
I’ve written about deflation before, but it’s probably a good time to mention some of the clues coming from the financial system. But first, I have to explain that when a loan is paid back to the bank, money is actually destroyed. I know that doesn’t make sense, but I’m a trained professional, and we’ll get there. And by trained, I mean trained as a cook at a Chinese restaurant. Okay, not trained – it was more of a wok-through.
Let’s start with a bank. In this case, my bank.
If I were to deposit $100 in my account, I have $100 in my account, right?
Kinda.
The bank now thinks it’s their money. It turns out that when you open a checking or savings account with a bank, you’re actually lending them money. The banks in the United States are actually what’s known as “fractional reserve banks” in that they only have to keep a portion (or fraction) of the money that I deposited on hand for people who come in and want cash.
Traditionally, that fraction has been around 10%. So, if I open an account with that $100 in it, the bank can lend $90 of that money out. The theory is that not everyone wants to come in and get their money back all at once, so you only have to keep that 10% on hand for people who want their money back on any given day for whatever purpose. It’s like stealing, but totally legal.
If too many people come in, the idea of the Federal Reserve™ (the Fed®) is that they’ll send the bank some cash if needed because tons of people borrow money all at once from the bank. That way if Lady Gaga is coming to Modern Mayberry and everyone decides to fork over $1000 a seat for VIP tickets to listen to her sing about her her her Poker Face, the Fed will give us extra cash. That’s why it’s called the Federal Reserve® – it’s a reserve for banks if they need cash because Lady Gaga is coming to town.
When you microwave a Muppet®, it will even countdown with the timer!
I didn’t want to go see Lady Gaga, so I still have my $100 in the bank. Therefore, my bank has loaned out $90 to Johnny Depp who was a little short for the show after buying some killer weed.
But I still think I have $100.
But the bank lent out $90.
And Johnny Depp puts his money in his account in another bank until it’s time to pay for the ticket. So, that bank now has Johnny Depp’s $90, and can immediately lend out $81 to someone else, who deposits it back in my bank.
Thus, my original $100 deposit now accounts for $171 in the economy.
As soon as the loans are paid back, the transaction unwinds and the actual amount of “money” in the system disappears. There’s a theoretical limit to the amount of money that can be created with a certain reserve rate.
But I said the Fed was scared. And I said it was scared of deflation.
My bank used to have to keep $10 in the vault in case I come back looking for my $100. Used to. As of March 15, 2020, that reserve that banks are required to keep is – drumroll please – zero. Yes. I’m not making that up. It’s right here on the Fed’s own website (LINK). The press release is here (LINK).
What this means is that banks have to keep enough cash around so if yokels like me want to withdraw $23.73 for a trip to buy some really nice earplugs the night of the Lady Gaga concert, the bank had to have that much actual cash. But now, the banks are free to loan all of it out. They could loan not $90 to Johnny Depp, but the full $100. And when he put it in his bank, they could loan out $100 as well.
In the 10% reserve, there was at least some limit to the money that the banks could create by lending the same $100. But at zero reserve? The number of times that $100 could be lent is only constrained by the number of people who want to borrow it. My original $100 could (in theory) create infinite dollars. That’s Congress level math!
My-my-my-Joker® face . . .
This means the Fed is worried about keeping banks lending, so they can keep the money supply up. The Fed also wants to keep the money moving – they want me to buy my Lady Gaga earplugs and the person I bought them from to buy some PEZ® from Wal-Mart® and Wal-Mart™ to pay that money to an employee who buys ice cream sandwiches. If people save their money, it’s nearly the same as there being less money in the economy.
That’s where the Plunge Protection Team comes in. People with 401k investments get scared when the stock market goes down. Stock market plunges are deflationary. Plus, they really hurt the investment banks, so the one thing we know about both Democrat and Republican? They both really want to make the investment bankers happy.
Wall Street crashing? Let’s have a series of well-timed purchases of stock to turn it around. Since you can look at the Fed’s balance sheet yourself, and compare it with the stock market, perhaps the Dow Jones Industrial Average (DJIA)® going up 500 points on a day when multiple large American cities are actively on fire. The Plunge Protection Team, it is rumored, buys (or has groups like Goldman-Sachs™ buy) stocks on multiple markets to keep a crash from happening.
I hate it when the Plunge Protection Team kneads my back while I’m sleeping.
The idea is that by keeping the stock market from crashing, the economy is saved. In one sense, that’s a logical conclusion. Falling stock markets have panic as the main feature – people literally are scared to death, so they sell even solid stocks at bargain prices. As a strategy, it’s a lot like buying a drunk guy another dozen shots of whiskey. The problem’s gone. At least for now.
But you can only game a system for so long. Eventually, the game playing will come back to haunt you. And the Fed may be scared of deflation right now, but all of the injection of money via loans and balance sheet inflation and stock market propping up? The system failures get bigger, and bigger. The old tools don’t work. And the system fails. This time for good in a spasm of deflation followed by inflation followed by currency collapse.
I know you’re worried about the investment bankers getting caught up in the deflation-inflation-collapse. Don’t be! Right now, they’re selling their stock after the plunge protection team bumps up the price and buying bunkers in Montana or old missile silos in Nebraska. Yay, free market capitalism!
I’m sure that it’s a coincidence.
I’m not saying that we’ve reached the point where we’ll see the financial systems fail with this cycle. It may not be this leg down. But like the Fed®, keep one eye open.
Deflation might be hiding under the bed.
No discussion of the Fed fighting deflation is complete without some mention of Ben Bernanke’s famous 2002 speech about “helicopter money” and the “printing press”. So here ya go….
https://internationalman.com/articles/ben-bernanke-revisiting-the-helicopter-speech/
The Fed will eventually fail and we are in the end game now. The only question is whether or not we have a deflationary period before getting to the inevitable inflationary period.
The fact of the matter is that in the past 90 days we have entered not “deflation” or “inflation” but textbook “1970s stagflation” territory – we are officially in a recession with stagnating demand combined with both rising inflation and record breaking unemployment. COVID-19 and George Floyd have blasted us Back To The Future – the 1970s Carter malaise on steroids, only without the disco balls.
Just wait until July 31 when all those COVID-19 government handouts end. That’s when the real party starts.
Interesting times indeed – but at least we don’t have bell bottoms . . . .
Let’s say the bank reserve rate is 5%.
Old way: Banks can lend out 95% of their assets.
New way: Banks can lend out 19 times their assets.
This is how credit card companies work. Every time you use your credit card, the bank behind it creates the funds out of nothing. The money is just bits in a database in the ‘debt’ column. When you pay off your bill, the money is destroyed, because the debt is cleared.
Yes. And now the reserve rate is zero. So we can create infinite money . . . not a good plan . . .
Fractional reserve banking is how banks have operated since the Renaissance. The banks are, of course, vulnerable to runs, but that requires some sort of economic crisis. The alternative is that all purchases, including houses, cars, computers come out of accumulated savings. Also, since banks need profits to stay in operation, if they cannot lend out your deposits, then they have to charge you a storage fee for those deposits. That actually is how some banks operated in the Middle Ages.
How banks work was actually explained in Capra’s “It’s a Wonderful Life.”
That’s how it’s worked since the Medici’s and Rothschild families took over the world’s banking…..
That’s how it used to work. Now a 5% reserve means the bank can lend out 19 times their total assets.
Indeed. Pop Wilder was a small town banker. But he fixed the banister.
Technological innovation (PCs got faster for cheaper, which you call deflation), and currency inflation (official counterfeiting the federal reserve does), are not the same effect moving in opposite directions. Instead, they are completely separate and unrelated effects with completely separate and unrelated causes. Technological innovation is a good thing, and we want more of it; currency inflation is a bad thing, and we want none of it. What we have actually received is technological innovation and currency inflation at the same time.
Technological progress is the main driver behind “increased productivity”. Nobody knew this better than the Soviets.
https://www.airforcemag.com/article/0497secrets/
After the Cold War, deliberately offshoring our technological edge and letting others build stuff for us to buy at WalMart and Best Buy and car lots is one of the reasons we have swooned. Once the genie is out of the bottle, it’s too late to take it all back / MAGA.
Exactly. But as the money stops, deflation appears again.
As an engineer, I like to dig down into a phenomenon to uncover the first principles: atoms, electrons, electromagnetic fields and waves, etc., and build on them. But when it comes to money, the deeper I go, the less it makes sense.
One of the things I don’t understand about Money is “where does the money to pay interest come from?” If I were the bank’s only customer, and deposited my money, where would they get money to pay the interest I’ve “earned”? If I took out a loan, where would I get the money to pay the interest that I owe? Now, imagine one more customer (the farmer that I work for, perhaps). He borrows money to buy seeds and fertilizer, and pays some of it to me for my labor. I pay some of it back to him for my food. I can’t pay more than I earn, so how does he pay the interest? Now, imagine that somebody comes into town with some money of his own. He can pay the farmer, the farmer can pay the interest, but before long, the banker has all the money (again).
I’ve just finished reading a college-level textbook on “Fundamentals of Investments”. In the section on bond investing, it has a formula for calculating the proper price of a bond, based on its face value, its time to maturity, the risk-free rate of return (e.g., Treasuries), and risk (“beta”). It’s one of several formulas in the book that are technical enough to have earned somebody a PhD (or Nobel Prize), but its still just algebra. However, the “risk” factor is described but not defined; that is, it’s a matter of subjective judgement. Different analysts will assess the same security as having different risk levels, and that throws a wrench into the objectivity of the whole calculation. What is the analyst to do, when it’s time to defend his risk assessment to the customer? A subsequent section of the book gives the answer: we can rearrange the terms of the equation to solve for the risk factor, given the prices that The Market agrees on for the securities. When you put these equations side by side, it becomes apparent that their logic is circular. I guess that explains how the smartest guys in the room can stumble into bankruptcy.
This edition of the book was published in 2003, and it’s grim entertainment to see how many of the titans of the financial industry have collapsed since then. They even describe the hedging strategy so successfully used by Bernie Madoff!
One of the things I don’t understand about Money is “where does the money to pay interest come from?”
You understand it perfectly. The currency to pay the bank interest is collected from the currency’s users who earn net losses, via the users with net profits who now have the additional currency to pay the interest. Structurally, somebody has to be unprofitable each year or the bank can’t be paid interest.
The bank’s sales pitch is the total amount of currency represents the total amount of economic activity going on. So the banks print one zillion dollar bills at a cost of not that much for paper, ink, and printing press operation. At the end of the year, let’s say the bank has “earned” 3% interest. The bank now holds currency markers which can be exchanged for 3% of the total economic activity, an amount they “earned” by printing the currency a year ago. Next year they’ll own another 3%. Then the bank just prints more dollars from time to time, hides and lies about the quantities in circulation, to make the spreadsheet harder to construct by suckers I mean voters like you. This is so important that any national politician who doesn’t talk about it in their first week of being in office is either incompetent or in the pay of the bankers and knows it.
Read this history of money in the US: https://mises.org/library/mystery-banking
Did you know there already have been two hyperinflations of the national money? Let’s make that a third. Repudiate the national debt in a debt jubilee, everything you now have loans on you own, and use gold and silver coins.
Wonder what history will say about the Fed in ten years?
This is all true but there is no way to unravel the system. Posts like this need to be printed hard copy and saved for the next generation so when they rebuild from the ruins, they know what to avoid.
there is no way to unravel the system
Sure there is. Exchange all your paper wealth for useful things like gold and silver coins, buckets of wheat, and ammo. Then lots of people stop paying taxes, and defend their ownership of their stuff they bought with loans. You still have your land, your house, and your car. You still have your savings in the form of Silver which is necessary for electrical contacts in an industrial economy, and Gold which is necessary for computer chips. Your “retirement” was always fake because it’s a pyramid scheme, you didn’t lose it because you never had it. Only the bankers lose.
What’s even funnier is you can just sit back and watch, because the bankers will be doing this to themselves when they hyperinflate to pretend to pay for future retirement and healthcare promises. There’s a term in each new government where it promises to pay for the old government’s debts? Don’t accept that.
Normally they’re remembered for hundreds of years . . . like the money clause in the Constitution?
The purpose of the American Revolution was for a new wanna-be North American aristocracy to steal the North American taxpayer-sheep from the British aristocracy at gunpoint. This war was militarily successful because the Atlantic ocean was so expensive to fight across.
The celebrity British traitors (Washington, Jefferson, etc.) formed a business entity which went into debt to Atlantic seaboard families to fund their war. The business goal was to conquer the Whites under a milder form of the treatment Jefferson applied to the slave he repeatedly raped her whole life. Obviously, when the founding lawyers took out these loans there was no “American” “legislature” to agree in their capacity as “representatives” to “tax” the “citizens” to repay these loans. Apparently, “no taxation without representation” is as bedrock a moral principle as whatever NPR is bleating this news cycle.
Americans on the edge of settlement in Western Pennsylvania started distilling the grains they grew into alcohol, which stores and travels better than grain, and using it for money. Oops. Not using the US national money based on debt to Atlantic seaboard families meant the Atlantic seaboard families weren’t getting their war loans repaid. Using commodity money with intrinsic value which you manufacture rather than print means you don’t pay interest to third parties; which means there are no third parties who rapidly come to own a controlling share in your national economy. Oops. You’ve evaded the whole point of government, which is to promote a state religion using an established church to obscure that government is merely a protection racket.
Washington formed an army as large as the Revolutionary War army, with officers drawn from the Atlantic seaboard families. Then he squashed the Whiskey Rebellion. When you read the liberal media’s account on wikipedia, you’ll see it doesn’t contradict my analysis:
https://en.wikipedia.org/wiki/Whiskey_Rebellion
Government never likes competition . . .
Excellent explanation of the Fractional Reserve BS.
I thought I was well-informed, but I was unaware the banks went from 10% reserves to 0%. Let’s see how that plays out…
Yeah, I found it in researching the post . . .
Thank you.
What I am seeing is the start of the fire sale. Everything here has the same nominal value but you can get the goods at up to 50% discount.
Admittedly, everyone is scared that when the government stops paying wage subsidies (over the next month the scheme winds up) a lot of small businesses will close and no one will be buying because all spare cash will be used for food and firewood. (It is the cold season here)
Deflation doth hunt with the winter of discontent