Printing Money – Clarified

by Dick McDonald

My article this morning, “When in Trouble – Just Print More Money”, confused more people than it informed. I skipped over some basics – as I am known to do – and I need to repent and describe why Central Banks had to inject funds into the financial markets today to maintain “liquidity”.

1. This morning I used the term “Printing Money” as a metaphor. The amount of physical currency in circulation is just a tiny fraction of our “money supply”.

2. Our “Money Supply” is the total stock of money in the economy - currency held by the public plus money in accounts in banks.

3. Who determines what and how much our money supply is – the Federal Reserve Bank - a semi-governmental agency set up to independently increase or decrease the money supply among other things.

4. What is the purpose of a money supply? We need money as a medium of exchange. We can’t barter everything. Two chickens for a gallon of milk is too inefficient. and impractical.

5. What is the total money supply as it relates to the value of all assets that could be bought or sold? The broad definition of Money supply, M2, stood at $7, 244 Billion or just over $7 Trillion as of June 2007. I believe all the saleable assets of the country amount to more than $400 Trillion. Now real quick cash available for purchasing and normal business M1 only amounted to $1.4 Trillion.

6. Why do we care what the actual dollar amount of the money supply is? As we have to buy and sell things the volume of those transactions needs plenty of money in play to open and close those transactions.

7. Having a money supply is great but what if there isn’t enough to cover the transactions people decide to make. For example if something fantastic came along and everyone wanted to buy $10 Trillion of it? Well the offset would be the accounts of the sellers – their accounts would go up while the accounts of the buyers would go down - there would not be a credit crunch.

8. Then what is the big problem today when the German Central Bank had to pump $130 Billion into their market to avoid a liquidity crunch and our Fed had to follow suit with a much smaller amount. Well what happens is there maybe a huge money supply out there but that doesn’t mean that those holding the supply are going to give that money away if a segment of the market is in a crash and burn mode. They are going to keep a tight hold on their money and cause a “liquidity” crisis,

9. Well what segment of the market caused that problem - well the companies in the sub-prime mortgage lending business. They did a bad thing and lent money to many who couldn’t afford the homes they were buying. These corporations didn’t care – money was cheap – and tomorrow a day away. Well tomorrow came, the borrowers defaulted and there was no money to buy the stock of neither the careless corporations nor the CMOs –the Collateralized Mortgage Obligations.

10. What in tar nation is a CMO? It is a new “security” developed by Wall Street to monetize mortgages – “monetizing” meaning packaging a bunch of mortgages together and selling them as a bundle (one security) to the public. Many banks were instrumental in this arena – Wells Fargo for example. They put together many sub-prime operations, created CMOs and had Wall Street sell them to the public. Wells Fargo is now out of the business as they made their money and the investors are left holding the bag and suffering a liquidity problem. Like a man with the plague no one wants to buy those securities and the investors are screaming for the President to bail them out of their bad investment. Today [8/11/07] he said no. The Fed bought up some US Securities so banks had some extra cash to finance fire sales (the cash infusion to avoid the liquidity crisis)

11. So the Fed increased the money supply in the hands of the public – it bought back billions in US Treasury bonds thus increasing the cash (money supply) in the bank accounts of the sellers. As the sellers keep their money in banks, the banks had more dollars to use to fund fire sale purchases. Ergo the liquidity crisis is averted.

You see in America it is buyer beware. We go by the rules of the jungle in business –survive or perish. Our process is called “creative destruction” – when you fail you are removed from the game. Buying sub-prime mortgages may have seemed like a good bet if you had no knowledge of the boom and bust cycles of real estate – if you were aware of the greed of those delivering the cheap mortgage money to the unschooled, you didn’t buy CMOs.

Money, its Value and Its Home

Money is a commodity just like pork bellies and corn. It is traded on the commodity market and users and speculators on the exchanges set its value on a daily basis. The country issuing the money has a Central Bank that administers the total amount issued and supports the its value from time-to-time by entering the market and either buying or selling its own bonds

The country can institute policies that greatly affect the value of its currency. For example, Brazil had a 1 million to 1 devaluation of its dollar (the cruziero to crusado) twice in the eighties. A country can issue more of its currency and increase its money supply and thus reduce the value of its unit of currency.

If you ever wondered why the US Dollar these days is only worth 75 cent in foreign currencies it is because we increased the money supply to avoid a depression. The Fed reduced the interest rate dramatically and issued credits (money) to banks at a below-market rates thus increasing the supply of money, Many buyers were allowed to buy homes they couldn’t afford at normal interest rates. The Fed was issuing cheap money for banks to lend. So when the Fed tries to move rates up to a normal level we have these defaults and we have to reduce the inflated price of homes. This is the normal cycle we always go through in real estate.

When the Fed manages the supply of money it does the following:

To increase the money supply:
-It buys back US Treasuries thus flowing cash back into banks.
-It loans out money to banks at low rates increasing cash they can lend

To decrease the money supply :
-It sells US Treasuries to take money out of circulation.
-It raises rates charged to banks thus discouraging borrowing from the Fed

Liquidity of markets

To add liquidity to commodity markets, speculators who are neither producers nor users of a commodity are encouraged to speculate on the direction of the market. The money of speculators - both long and short - make getting in and out of market much easier for the producers and users. So when you hear about a liquidity crisis - a dysfunction exists in the market and the market will correct it. President Bush made a good call this morning. Let the market correct the problem.