Banking, Lending Standards, Dot-Com, Subprime Mortgage and Bill Clinton’s Recessions

Posted by PITHOCRATES - March 19th, 2013

History 101

Lending more made Banks more Profitable as long as they Maintained Good Lending Standards

Money is a commodity.  And like any commodity the laws of supply and demand affect it.  If a lot of people want to borrow money interest rates rise.  This helps to make sure the people who want to borrow money the most can.  As they are willing to pay the higher interest rates.  While those who don’t want the money bad enough to pay the higher interest rates will let someone else borrow that money.  If few people want to borrow money interest rates fall.  To entice those people back into the credit markets who had decided not to borrow money when interest rates were higher.

Okay, but who is out there who wants people to borrow their money?  And why do they want this?  The key to any advanced civilization and the path to a higher standard of living is a good banking system.  Because if ordinary people can borrow money ordinary people can buy a house.  Or start a business.  Not just the rich.  For a good banking system allows a thriving middle class.  As people earn money they pay their bills.  And put a little away in the bank.  When a lot of people do this all of those little amounts add up to a large sum.  Which converts small change into capital.  Allowing us to build factories, automobiles, airplanes, cell towers, etc.  Giving us the modern world.  As banks are the intermediary between left over disposable cash and investment capital.

Banks are businesses.  They provide a service for a fee.  And they make their money by loaning money to people who want to borrow it.  The more money they lend the more money they make.  They pay people to use their deposits.  By paying interest to people who deposit their money with them.  They then loan this money at a higher interest rate.  The difference between what they pay to depositors and what they collect from borrowers pays their bills.  Covers bad loans.  And gives them a little profit.   Which can be a lot of profit if they do a lot of lending.  However, the more they lend the more loans can go bad.  So they have to be very careful in qualifying those they lend money to.  Making sure they will have the ability to pay their interest payments.  And repay the loan.

With the Federal Reserve keeping Interest Rates low Investors Borrowed Money and Poured it into the Dot-Coms

Just as a good banking system is necessary for an advanced civilization, a higher standard of living and a thriving middle class so is good lending standards necessary for a good banking system.  And when banks follow good lending standards economic growth is more real and less of a bubble.  For when money is too easy to borrow some people may borrow it to make unwise investments.  Or malinvestments as those in the Austrian school of economics call it.  Like buying an expensive car they don’t need.  A house bigger than their needs.  Building more houses than there are people to buy them.  Or investing in an unproven business in the hopes that it will be the next Microsoft.

America became the number one economic power in the world because of a good banking system that maintained good lending standards.  Which provided investment capital for wise and prudent investments.  Then the Keynesians in government changed that.  By giving us the Federal Reserve System.  America’s central bank.  And bad monetary policy.  The Keynesians believe in an active government intervening in the private economy.  That can manipulate interest rates to create artificial economic activity.  By keeping interest rates artificially low.  To make it easier for anyone to borrow money.  No matter their ability to repay it.  Or how poor the investment they plan to make.

The Internet entered our lives in the Nineties.  Shortly after Bill Gates became a billionaire with his Microsoft.  And investors were looking for the next tech geek billionaire.  Hoping to get in on the next Microsoft.  So they poured money into dot-com companies.  Companies that had no profits.  And nothing to sell.  And with the Federal Reserve keeping interest rates artificially low investors borrowed money and poured even more into these dot-coms.  Classic malinvestments.  The stock prices for these companies that had no profits or anything to sell soared.  As investors everywhere were betting that they had found the next Microsoft.  The surging stock market made the Federal Reserve chief, Alan Greenspan, nervous.  Such overvalued stocks were likely to fall.  And fall hard.  It wasn’t so much a question of ‘if’ but of ‘when’.  He tried to warn investors to cool their profit lust.  Warning them of their irrational exuberance.  But they didn’t listen.  And once that investment capital ran out the dot-com bubble burst.  Putting all those newly graduated computer programmers out of a job.  And everyone else in all of those dot-com businesses.  Causing a painful recession in 2000.

Based on the Labor Force Participation Rate we are in one of the Worse and Longest Recession in U.S. History

Encouraging malinvestments in dot-coms was not the only mismanagement Bill Clinton did in the Nineties.  For he also destroyed the banking system.  With his Policy Statement on Discrimination in Lending.  Where he fixed nonexistent discriminatory lending practices by forcing banks to abandon good lending standards.  And to qualify the unqualified.  Putting a lot of people into houses they could not afford.  Their weapon of choice for the destruction of good lending practices?  Subprime lending.  And pressure from the Clinton Justice Department.  Warning banks to approve more loans in poor areas or else.  So if they wanted to stay in business they had to start making risky loans.  But the government helped them.  By having Fannie Mae and Freddie Mac buying those risky, toxic loans from those banks.  Getting them off the banks’ balance sheets so they would make more toxic subprime loans.  And as they did Fannie Mae and Freddie Mac passed these mortgages on to Wall Street.  Who chopped and diced them into new investment vehicles.  The collateralized debt obligation (CDO).  High-yield but low-risk investments.  Because they were backed by the safest investment in the world.  A stream of mortgage payments.  Of course what they failed to tell investors was that these were not conventional mortgages with 20% down payments.  But toxic subprime mortgages where the borrowers put little if anything down.  Making it easy for them to walk away from these mortgages.  Which they did.  Giving us the subprime mortgage crisis.  And the Great Recession.

So Bill Clinton and his Keynesian cohorts caused some of the greatest economic damage this nation had ever seen.  For Keynesian policies don’t create real economic activity.  They only create bubbles.  And bubbles eventually burst.  As those highly inflated asset prices (stocks, houses, etc.) have to come back down from the stratosphere.  The higher they rise the farther they fall.   And the more painful the recession.  For this government intrusion into the private economy caused a lot of malinvestments.  A tragic misuse of investment capital.  Directing it into investments it wouldn’t have gone into had it not been for the government’s interference with market forces.  And when the bubble can no longer be kept aloft market forces reenter the picture and begin clearing away the damage of those malinvestments.  Getting rid of the irrational exuberance.  Resetting asset prices to their true market value.  And in the process eliminating hundreds of thousands of jobs.  Jobs the market would have created elsewhere had it not been for the Keynesian interference.  We can see the extent of the damage of these two Clinton recessions if we graph the growth of gross domestic product (GDP) along with the labor force participation rate (the percentage of those who are able to work who are actually working).  As can be seen here (see Percent change from preceding period and Employment Situation Archived News Releases):

Labor Force Participation Rate and GDP Growth

The first Clinton recession caused a decline in the labor force participation rate (LFPR) that didn’t level out until after 2004.  Even though there were not two consecutive quarters of negative GDP growth during this time.  Usually what it takes to call an economic slump a recession.  But the falling LFPR clearly showed very bad economic times.  That began with the dot-com bubble bursting.  And was made worse after the terrorist attacks on 9/11.  Eventually George W. Bush pulled us out of that recession with tax cuts.  The much maligned Bush tax cuts.  Which not only caused a return to positive GDP growth.  But it arrested the decline of the LFPR.  But the good times did not last.  For the second Clinton recession was just around the corner.  The subprime mortgage crisis.  Created with President Clinton’s Policy Statement on Discrimination in Lending.  That unleashed real economic woe.  Woe so bad we call it the Great Recession.  The little brother of the Great Depression.

This recession not only had two consecutive quarters of negative GDP growth but five of six consecutive quarters showed negative growth.  And one of those quarters nearly reached a negative ten percent.  Which is when a recession becomes a depression.  This recession was so long and so painful because those artificially low interest rates and the pressure on bankers to lower their lending standards created a huge housing bubble.  Pushing housing prices so high that when the housing bubble burst those prices had a very long way to fall.  Worse, President Obama kept to the Keynesian policies that caused the recession.  Trying to spend the economy out of recession.  Instead of cutting taxes.  Like George W. Bush did to pull the economy out of the first Clinton recession.  Worse, anti-business policies and regulations stifled any recovery.  And then there was Obamacare.  The great job killer.  Which he helped pass into law instead of trying to end the Great Recession.  GDP growth eventually returned to positive growth.  And the official unemployment fell.  A little.  But the president’s policies did nothing to reverse one of the greatest declines in the LFPR.  More people than ever have disappeared from the labor force.  That will take a lot of time and a lot of new, real economic activity to bring them back into the labor force.  And no matter what the current GDP growth rate or the official unemployment rate are it doesn’t change the reality of the economy.  Based on the LFPR it is in one of the worse and longest recession in U.S. history.  And the worse recovery since the Great Depression.  Because of President Obama’s embrace of Keynesian policies.  Which do more to increase the size of government than help the economy.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Microeconomics and Macroeconomics

Posted by PITHOCRATES - September 10th, 2012

Economics 101

Keynesians cannot connect their Macroeconomic Policies to the Microeconomic World

Economics can be confusing.  As there are actually two genres of economics.  There’s microeconomics.  The kind of stuff most people are familiar with.  And is more common sense.  This is more of the family budget variety.  And small business budget.  Where if costs go up (gasoline, commodities, food, insurance, etc.) families and businesses make cuts elsewhere in their budget.  When revenue falls (a decline in sales revenue or a husband/wife loses their job) people cut back on expenses.  They cancel the family vacation.  Or cancel Christmas bonuses.  Straight forward stuff of living within your means.

Then there’s macroeconomics.  The big economic picture.  This is the stuff about the national economy.  GDP, inflation, recession, taxes, etc.  Things that are more abstract.  Unfamiliar.  And often defy common sense.  Where living beyond your means is not only accepted.  But it’s national policy.  And when some policies fail repeatedly those in government keep trying those same policies expecting a different outcome eventually.  Such as using Keynesian economic policies (stimulus packages, deficit spending, printing money, etc.) to get an economy out of recession that never quite works.  And then the supporters of those policies always say the same thing.  Their policies only failed because they didn’t spend enough money to make them work.

Keynesian economics focuses on macroeconomics.  And cannot connect their macro policies to the micro world.  There is a large gap between the two.  Which is why Keynesians fail.  Because they look at the macro picture to try and effect change in the micro world.  To get businesses to create jobs.  To hire people.  And to reduce unemployment.  But the politicians executing Keynesian policy don’t understand things in the micro world.  Or anything about running a business.  All they understand, or all they care to try to understand, are the Keynesian basics.  That focus on the demand side of economics.  While ignoring everything on the supply side.

When the Economy goes into Recession the Fed Expands the Money Supply to Lower Interest Rates

Keynesians have a few fundamental beliefs.  And one of the big ones is the relationship between interest rates and GDP.  In fact, it’s the center of their world.  High interest rates discourage people from borrowing money.  When people don’t borrow money they don’t build things (like factories).  And if they don’t build things they won’t create jobs and hire people.  So the higher the interest rates the lower the economic output of the nation (GDP).

Low interest rates, on the other hand, encourage people to borrow money.  So they can build things and create jobs.  The lower the interest rates the more people will borrow.  And the greater the economic output of the nation will be.  This was the driving factor that caused the Great Recession.  The central bank (the Fed) kept interest rates so low for so long that people bought a lot of houses.  A lot of expensive houses.  The demand for housing was so great that buyers bid up prices.  Because at low interest rates there was no limit to how much house you could buy.  All this building and buying of houses, though, oversupplied the market with houses.  As home builders rushed in to fill that demand.  They built so many houses that there were just so many houses available to buy that buyers had a lot of choice.  Making it a buyers’ market.  So much so that people had to slash their asking price to sell their house.  Which popped the great housing bubble.

The Fed lowers interest rates by increasing the money supply.  They create new money and inject it into the economy.  By giving it to bankers.  Banks have more money to lend.  So more people can borrow money.  This is what lowers interest rates.  Things that are less scarce cost less.  More money to borrow means it’s less scarce.  And the price to borrow it (i.e., the interest rate) falls.  If the Fed wants to increase interest rates they pull money out of the economy.  Which makes it a little harder to borrow money.  Because more people are trying to borrow the limited amount of funds available to borrow.  And this is the basics of monetary policy.  Whenever the country enters a recession and unemployment rises the Fed expands the money supply to encourage businesses to borrow money to expand their businesses and create jobs that will lower unemployment.

Keynesian Economic Policies hurt the Higher Stages of Production where we Create Real Economic Activity

If low interest rates create greater economic activity why in the world would the Fed ever want to raise interest rates?  Because of the dark side of printing money.  Inflation.  Increasing the money supply gives people more money.  And when they have more money they try to buy what everyone else is buying.  As the money supply grows greater than the amount of economic output there is more money trying to buy fewer goods and services.  Which raises prices.  Just like those low interest rates did in the housing market.  The fear is that if this goes on too long there will be an economic crash.  Just like after the housing bubble burst.  From boom to bust.  Higher prices reduce consumer spending.  Because people can’t buy as much when prices are high.  As consumers stop spending businesses stop selling.  Faced with overcapacity in a period of falling demand they start cutting costs.  Laying off people.  People without jobs can buy even less at high prices.  And so on as the economy settles into recession.  This is why central bankers raise interest rates.  Because those good times are temporary.  And the longer they let it go on the more painful the economic correction will be.

This is why Keynesian stimulus spending fails to pull economies out of recession.  Because Keynesians focus only on the demand curve.  Consumption.  Consumer spending.  Not supply.  They ignore all that economic activity in the higher stages of productions.  That activity that precedes retail consumer sales.  The wholesale stage (the stage above retail).  The manufacturing stage (above the wholesale stage).  And the furthest out in time, the raw commodities stage (above the manufacturing stage).  As economic activity slows inventories build up.  Creating a bulge in the middle of the stages of production.  So manufacturing cuts back.  And because they do raw commodities cut back.  These are the first to suffer in an economic downturn.  And they are the last to recover.  Because of all that inventory in the pipeline.  When Keynesians get more money into consumers’ pockets they will increase their consumer spending.  For awhile.  Until that extra money is gone.  Which provided an economic boost at the retail level.  And a little at the wholesale level as they drew down those inventories.  But it did little at the higher stages of production.  Above inventories.  Manufacturing and raw material extraction.  Who don’t expand their production or hire new workers.  Because they know this economic activity is temporary.  And because they know all that new money will eventually create inflation.  Which will increase prices.  Throughout the stages of production.

The Keynesian approach focuses on the macro.  By playing with monetary policy.  Policies that ultimately hurt the higher stages of production.  At the micro level.  Where we create real economic activity.  If they’re not hiring then no amount of stimulus spending at the retail level will get them to hire.  Because giving the same amount of workers (i.e., consumers) more money to chase the same amount of goods and services only causes higher prices in the long run.  And it’s the long run that raw commodities and manufacturing look at.  They are not going to invest to expand their businesses unless they expect improving economic conditions in the long run.  All the way up the stages of production to where they are.  When new economic activity reaches them then they will expand and hire people.  And when they do they will add a lot of new consumers with real wages to go out and spend at the retail level.

One of the most efficient ways to achieve this is with tax cuts.  Because cuts in tax rates shape economic activity in the long run.  Across the board.  Unlike stimulus spending.  Which is short term.  And very selective.  Some benefit.  Typically political cronies.  But most see no benefit.  Just higher prices.  And continued unemployment.  Which is why Keynesian policies fail to pull economies out of recessions.  Because politicians use them for political purposes.  Not economic purposes.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Consumption, Savings, Fractional Reserve Banking, Interest Rates and Capital Markets

Posted by PITHOCRATES - January 23rd, 2012

Economics 101

Keynesians Prefer Consumption over Savings because Everyone Eventually Dies

Consumer spending accounts for about 70 percent of total economic activity.  This consumption drives the economy.  In fact, someone built a school of economics around consumption.  Keynesian economics.  And he loved consumption.  John Maynard Keynes even created a formula for it.  The consumption function.  Which basically says the more income a person has the more that person will consume.  Even created a mathematical formula for it.  No doubt about it, Keynesians are just gaga for consumption.

Of course, Keynesians don’t love everything.  They aren’t all that fond of saving.  Which they see as a drain on economic activity.  Because if people are saving their money they aren’t doing as much consuming as they could.  In fact, their greatest fear when they propose stimulus spending (by giving people more money to spend) to jump-start an economy out of a recession is that people may take that money and save it.  Or, worse yet, pay down their credit card balances.  Which is something most responsible people do during bad economic times.  To lower their monthly bills so they can still pay them if they find themselves living on a reduced income.  Of course, being responsible doesn’t increase consumption.  Nor does it make Keynesians happy.

Keynesians don’t like people behaving responsibly.  They want everyone to live beyond their means.  To borrow money to buy a house.  To buy a car.  Or two.  To use their credit cards.  To keep shopping.  Above and beyond the limits of their income.  To spend.  And to keep spending.  Always consuming.  Creating endless economic activity.  And never worry about saving.  Because everyone eventually dies.  And what good will all that saving be then?

To Help Create more Capital from a Low Savings Rate we use Fractional Reserve Banking

Intriguing argument.  But too much consuming and not enough saving can be a problem, though.  Because before we consume we must produce.  And those producing the things we consume need capital.  Large sums of money businesses use to pay for buildings, equipment, tools and supplies.  To make the things consumers consume.  And where does that capital come from?  Savings.

A low savings rate raises the cost of borrowing.  Because businesses are competing for a smaller pool of capital.  Which raises interest rates.  Because capital is an economic commodity, subject to the law of supply and demand.  Also, with people living beyond their means by consuming far more than they are saving has caused other problems.  Borrowing to buy houses and cars and using credit cards to consume more has led to dangerous levels of personal debt.  Resulting in record personal bankruptcies.  Further raising the cost of borrowing.  As these banks have to increase their interest rates to make up for the losses they incur from those personal bankruptcies.

To help create more capital from a low savings rate we use fractional reserve banking.  Here’s how it works.  If you deposit $100 into your bank the bank keeps a fraction of that in their vault.  Their cash reserve.  And loan out the rest of the money.  When lots of people do this the banks have lots of money to loan.  Which people and businesses borrow.  Who borrow to buy things.  And when buyers buy things sellers will then take their money and deposit it into their banks.  The buyer’s borrowed funds become the seller’s deposited funds.  These banks will keep a fraction of these new deposits in their vaults.  And loan out the rest.  Etc.  As this happens over and over banks will create money out of thin air.  Providing ever more capital for businesses to borrow.  Which all works well.  Unless depositors all try to withdraw their deposits at the same time.  Exceeding the cash reserve locked up in a bank’s vault.   Creating a run on the bank.  Causing it to fail.  Which can also raise the cost of borrowing.  Or just make it difficult to find a bank willing to loan.  Because banks not only loan to consumers and businesses.  They loan to other banks.  And when one bank fails it could very well cause problems for other banks.  So banks get nervous and are reluctant to lend until they think this danger has passed.

A Keynesian Stimulus Check may Momentarily Substitute for a Paycheck but it can’t Create Capital

Consumption, savings, investment and production are linked.  Consumption needs production.  Production needs investment.  And investment needs savings.  Whether it is someone depositing their paycheck into a bank that lends it to others.  Or rich investors who amassed and saved great wealth.  Who invest directly into a corporation by buying new shares of their stock (from an underwriter, not in the secondary stock market).  Or by buying their bonds.

Collectively we call these capital markets.  Where businesses go when they need capital.  If interest rates are low they may borrow from a bank.  Or sell bonds.  If interest rates are high they may issue stock.  Generally they have a mix of financing that best fits the investing climate in the capital markets.  To protect them from volatile movements in interest rates.  And from competition from other corporations issuing new stock that could draw investors (and capital) away from their new stock issue.  Even to secure capital when no one is lending.  By going contrary to Keynesian policy and saving for a rainy day.  By buying liquid investments that earn a small return on investment and carrying them on their balance sheet.  They don’t earn much but can be sold quickly and converted into cash when no one is lending.

A lot must happen before consumers can consume.  In fact, high consumption can pull capital away from those who make the things they consume.  Because without capital businesses can’t expand production or hire more workers.  And no amount of Keynesian stimulus can change that.  Because there are two things necessary for consumption.  A paycheck.  And consumer goods produced with capital.  A stimulus check may momentarily substitute for a paycheck.  But it can’t create capital.  Only savings can do that.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

The Line of Diocletian, the Byzantine Empire, Italian City-States, Banking, Usury and the Protestant Reformation

Posted by PITHOCRATES - January 3rd, 2012

History 101

Europe began to Awake from its Slumber of the Dark Ages in about 1300 Italy

Once upon a time the only lending was to help someone in need.  Such as someone with a poor harvest to survive the winter.  We did it out of the goodness of our hearts to help others in need.  So to charge interest for a loan like this would have been cruel.  Taking advantage of someone’s misfortune wasn’t the Christian thing to do.  Or the Jewish.  Or the Muslim.  That’s why no one then charged interest for loaning money.  You just didn’t kick a person when he or she was down.  And if you did you could expect some swift justice from the religious authorities.  As well as the state.

Rome was once the center of the civilized world.  All roads led to Rome, after all.  Then Diocletian split the Empire into two in 285.  Along the Line of Diocletian.  Into East (Greek) and West (Latin). The West included Rome and fell around 486, ushering in the European Dark Ages.  Meanwhile the Eastern half, the Byzantine Empire, carried on.  And skipped the Dark Ages.  Its capital was Constantinople (named in 330) .  Formerly Byzantium.  Modern day Istanbul.  Where all Asian overland trade routes led to.  This city of Emperor Constantine.  His city.  Who reunited East and West.  And adopted Christianity as the Empire’s new religion (381).  Located at the crossroads between Europe and Asia, trade flourished and made the Byzantine Empire rich.  And long lasting.  Until weakened by the Venetian-financed Fourth Crusade (1202–1204).  (The Latin Christians’ attack on the Greek Christians was fallout from the Great Schism of 1054 where Christianity split between Latin Catholic and Greek Orthodox).  And then falling to the Ottomans in 1453.

Europe began to awake from its slumber in about 1300 Italy.  Great city-states arose.  Genoa.  Pisa.  And Venice.  Like those early Greek city-states.  Great ports of international trade.  Rising into trade empires with the decline of the Byzantine Empire.  Where these Italian merchants bought and sold all of those Asian goods.  Putting great commercial fleets to sea to bring those Asian goods into Genoa, Pisa and Venice.  Getting rich.  But to make money they had to have money.  Because in the international trade game you had to first buy what you sold.  Which included the cost of those great merchant fleets.  And how did they pay for all of this?  They borrowed money from a new institution called banking.

That Europe that Slumbered during the Dark Ages Arose to Rule International Trade

Modern finance was born in Italy.  Everything that makes the commercial economy work today goes back to these Italian city-states.  From international banking and foreign exchange markets to insurance to the very bookkeeping that kept track of profits and losses.  It is here we see the first joint-stock company to finance and diversify the risk of commercial shipping.  London would use the joint-stock company to later finance the British East India Company.  And Amsterdam the Dutch East India company.  Where the Dutch and the English sent ships across oceans in search of trade.  Thanks to their mastery of celestial navigation.  And brought back a fortune in trade.  Putting the great Italian city-states out of business.  For their direct sea routes were far more profitable than the overland routes.  Because the holds of their ships could hold far more than any overland caravan could.

The Catholic opposition to usury (charging interest to borrow money) opened the new banking industry to the oppressed Jews in the European/Christian cities.  For it was one of the few things the Christian rulers let the Jews do.  Which they did.  Even though it was technically against their religion.  And they did it well.  For they had an early monopoly.  Thanks to that same Catholic Church.  Then came another schism in the Christian church.  The Protestant Reformation.  Where, among other things, Protestants said the Old Testament did not bind them to all rules that the Jews had to follow.  Then John Calvin took it a step further and said commercial loans could charge interest.  And, well, the rest is banking history.

Europe was then the dominant region of the world.  That region that slumbered during the Dark Ages arose to rule international trade.  Thanks to their navigational abilities.  And their banking centers.  Which financed their trade.  And the great things to come.

The Enlightenment led to the Modern World, Limited Government, the Industrial Revolution and Beyond

With the fall of the Byzantine Empire and the rise of the Italian city-states, Greek thinkers left the Byzantine Empire and went West.  To those rich Italian city-states.  Bringing with them great books of Greek knowledge.  The intellectual remnants of the Roman Empire.  Translated them.  And massed produced them on the new printing press.  And kicked off the Enlightenment.  Which then spread throughout Europe.

The Enlightenment led to the modern world.  From limited government.  To the Industrial Revolution.  And beyond.  All thanks to those Italian city-states.  International trade.  And banking.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Time Value of Money, Interest, Risk, Opportunity Costs and Banking

Posted by PITHOCRATES - January 2nd, 2012

Economics 101

Entrepreneurs have to Borrow Money because their Income comes AFTER they Build Things

A lot of things came together to give us a modern civilization.  Food surpluses, division of labor, money, religion, rule of law, free trade, free labor, prices, incentive and competition.  As well as other important developments.  Such as banking.  That addressed the time value of money.  And the risk of lending.

Before farmers can sell their harvests they have to plant them first.  This takes money.  Which raises an obvious question.  How do farmers get money to plant a crop?  When their income comes AFTER the planting of that crop?  Entrepreneurs have the same problem.  They can build things to sell.  But like the farmer they have to buy materials first.  Which takes money.  So how do entrepreneurs get money to build the things they build?  When their income comes AFTER the building of these things?

Of course farmers and entrepreneurs have to borrow money.  Say from a parent.  Who has been saving up for a really nice vacation.  A parent can loan the farmer or the entrepreneur money.  But that means that they may have to postpone their plans.  Or change their plans. For the same vacation may cost more next year than it does this year.  If they loan their money and get the same amount back they won’t be able to afford that same vacation.  Unless they charge interest.  So that when they get their money back AND the interest they can then afford that same but now more expensive vacation.

A Bank collects Deposits from Numerous Depositors so they can lend it to the People who Need Capital

This is the time value of money.  Over time money buys less.  Because it’s worth less.  The same amount of money will buy more today than it will 10 years from now.  This lost value is the cost of borrowed money.  And why borrowing money typically incurs interest.  Money a borrower owes in addition to the amount borrowed.  The interest compensates the lender for the lost value of their money.  So when you repay it they don’t lose any purchasing power.  And the lender can buy the same things that they could have when they loaned you the money.  Like a postponed vacation that became more expensive over time.

As the economy became more complex it required more borrowed money to pay for the production of other things.  Things that we sell much later than when we purchased the material to make these things.  Expensive things.  Tools.  Equipment.  Factories.  Trucks.  Costs so great that a person’s parents may not have enough savings to finance these things.  But they could if we combine their savings with other people’s savings.

Alexander Hamilton said a person’s savings was just money.  But when added to the savings of other people that money became capital.  Large pools of money available to loan.  So entrepreneurs could borrow money to buy tools, equipment, factories and trucks.  This important part of business became a business in itself.  The banking business.  A bank collects deposits from numerous depositors.  So they can lend it to the people who need capital.  They pay interest to depositors to encourage them to deposit their money.  And charge interest to borrowers to pay the depositors’ interest and other costs of running the bank.

Charging Interest Compensated the Lender for the Risk they were Taking and is a Necessary Part of Capitalism

Banks get a lot of bad press these days.  Since the dawn of banking, really.  People say bankers get rich for doing nothing.  Using other people’s money to boot.  Some call it a sin.  Usury.  Making money simply by lending money.  The ancient Jews forbade it.  So did the Christians.  Even the Muslims.  (And still do.)  But without banks we wouldn’t have a modern civilization.  In fact, if we had no banks you would not recognize the world you’d be living in.  There would be no middle class.  And our economic system would probably still be based on Manorialism.  Where most of us would still be serfs.  Working the land for the Lord of the Manor like our distant ancestors did in the Middle Ages.

There would have been no Industrial Revolution.  No cell phones.  No Internet.  Because all of these things required capital.  The pooling of people’s savings.  To provide the investment capital it takes to finance these things we take for granted in our lives today.

But things changed.  First the Jews started lending money for interest.  Then the Christians followed.  Seeing that business and commerce needed to borrow money.  And that lending money incurred risk.  (Some people might not repay their loans.)  And there were opportunity costs.  (The other things they could do with that money.)  Charging interest compensated the lender for the risk they were taking.  It wasn’t usury.  It was a necessary part of capitalism.  And the modern world we take for granted today.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , ,

The Fed to Buy $600 Billion in Government Bonds

Posted by PITHOCRATES - November 5th, 2010

The Fed’s $600 billion government bond Purchase may Worsen the Recession

The Fed is preparing to buy some $600 billion in government bonds.  They call it quantitative easing (QE).  The goal is to stimulate the economy by making more money available.  The problem is, though, we don’t have a lack of money problem.  We have a lack of jobs problem.  Unemployed people can’t go to the store and buy stuff.  So businesses aren’t looking to make more stuff.  They don’t need more money to borrow.  They need people to go back to work.  And until they do, they’re not going to borrow money to expand production.  No matter how cheap that money is to borrow.

This isn’t hard to understand.  We all get it.  If we lose our job we don’t go out and buy stuff.  Instead, we sit on our money.  For as long as we can.  Spend it very carefully and only on the bare necessities.  To make that money last as long as possible to carry us through this period of unemployment.  And the last thing we’re going to do is borrow money to make a big purchase.  Even if the interest rates are zero.  Because without a job, any new debt will require payments that we can’t afford.  That money we saved for this rainy ‘day’ will disappear quicker the more debt we try to service.  Which is the opposite of what we want during a period of unemployment.

Incidentally, do you know how the Fed will buy those bonds?  Where they’re going to get the $600 billion?  They going to print it.  Make it out of nothing.  They will inflate the money supply.  Which will depreciate our currency.  Prices will go up.  And our money will be worth less.  Put the two together and the people who have jobs won’t be able to buy as much as they did before.  This will only worsen the recession.  So why do they do it?

Quantitative Easing May Ease the Global Economy into a Trade War

A couple of reasons.  First of all, this administration clings to outdated Keynesian economics that says when times are bad the government should spend money.  Print it.  As much as possible.  For the economic stimulus will offset the ‘negligible’ inflation the dollar printing creates.  The only problem with this is that it doesn’t work.  It didn’t work the last time the Obama administration tried quantitative easing.  As it didn’t work for Jimmy Carter.  Of course, when it comes to Big Government policies, when they fail the answer is always to try again.  Their reason?  They say that the government’s actions that failed simply weren’t bold enough.

Another reason is trade.  A cheaper dollar makes our exports cheaper.  When the exchange rates give you bushels full of U.S. dollars for foreign currency, those foreign nations can buy container ships worth of exported goods.  It’s not playing fair, though.  Because every nation wants to sell their exports.  When we devalue the dollar, it hurts the domestic economies of our trading partners.  Which they want to protect as much as we want to protect ours.  So what do they do?  They fight back.  They will use capital controls to increase the cost of those cheap dollars.  This will increase the cost of those imports and dissuade their people from buying them.  They may impose import tariffs.  This is basically a tax added to the price of imported goods.  When a nation turns to these trade barriers, other nations fight back.  They do the same.  As this goes back and forth between nations, international trade declines.  This degenerates into a full-blown trade war.  Sort of like in the late 1920s.  Which was a major factor that caused the worldwide Great Depression.

Will there be a trade war?  Well, the Germans are warning this action may result in a currency war (see Germany Concerned About US Stimulus Moves by Reuters).  The Chinese warn about the ‘unbridle printing’ of money as the biggest risk to the global economy (see U.S. dollar printing is huge risk -China c.bank adviser by Reuters’ Langi Chiang and Simon Rabinovitch).  Even Brazil is looking at defensive measures to protect their economy from this easing (see Backlash against Fed’s $600bn easing by the Financial Times).  The international community is circling the wagons.  This easing may only result in trade wars and inflation.  With nothing to show for it.  Except a worse recession.

Businesses Create Jobs in a Business Friendly Environment

We need jobs.  We need real stimulus.  We need to do what JFK did.  What Reagan did.  Make the U.S. business friendly.  Cut taxes.  Cut regulation.  Cut government.  And get the hell out of the way. 

Rich people are sitting on excess cash.  Make the business environment so enticing to them that they can’t sit on their cash any longer.  If the opportunity is there to make a favorable return on their investment, guess what?  They’ll invest.  They’ll take a risk.  Create jobs.  Even if the return on their investment won’t be in the short term.  If the business environment will reward those willing to take a long-term risk, they will.  And the more investors do this the more jobs will be created.  And the more people are working the more stuff they can buy.  They may even borrow some of that cheap money for a big purchase.  If they feel their job will be there for awhile.  And they will if a lot of investors are risking their money.  Creating jobs.  For transient, make-work government jobs just don’t breed a whole lot of confidence in long term employment.  Which is what Keynesian government-stimulus jobs typically are.

We may argue about which came first, the chicken or the egg.  But here is one thing that is indisputable.  Jobs come before spending.  Always have.  Always will.  And quantitative easing can’t change that.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

FUNDAMENTAL TRUTH #27: “Yes, it’s the economy, but the economy is not JUST monetary policy, stupid.” -Old Pithy

Posted by PITHOCRATES - August 17th, 2010

DURING UNCERTAIN ECONOMIC times, people act differently.  If business is down where you work, your company may start laying off people.  Your friends and co-workers.  Even you.  If there is a round of layoffs and you survive, you should feel good but don’t.  Because it could have been you.  And very well can be you.  Next time.  Within a year.  In the next few months.  Any time.  You just don’t know.  And it isn’t a good feeling.

So, should this be you, what do you do?  Run up those credit cards?  By a new car?  Go on a vacation?  Take out a home equity loan to pay for new windows?  To remodel the kitchen?  Buy a hot tub?  Or do you cut back on your spending and start hoarding cash?  Just in case.  Because those unemployment payments may not be enough to pay for your house payment, your property taxes, your car payment, your insurances, your utilities, your groceries, your cable bill, etc.  And another loan payment won’t help.  So, no.  You don’t run up those credit cards.  Buy that car.  You don’t go on vacation.  And you don’t take that home equity loan.  Instead, you hunker down.  Sacrifice.  Ride it out.  Prepare for the worse.  Hoard your cash.  Enough to carry you through a few months of unemployment.  And shred those pre-approved credit card offers.  Even at those ridiculously low, introductory interest rates.

To help hammer home this point, you think of your friends who lost their jobs.  Who are behind on their mortgages.  Who are in foreclosure.  Whose financial hardships are stressing them out to no ends.  Suffering depression.  Harassed by collection agencies.  Feeling helpless.  Not knowing what to do because their financial problems are just so great.  About to lose everything they’ve worked for.  No.  You will not be in their position.  If you can help it.  If it’s not already too late.

AND SO IT is with businesses.  People who run businesses are, after all, people.  Just like you.  During uncertain economic times, they, too, hunker down.  When sales go down, they have less cash to pay for the cost of those sales.  As well as the overhead.  And their customers are having the same problems.  So they pay their bills slower.  Trying to hoard cash.  Receivables grow from 30 to 45 to 90 days.  So you delay paying as many of your bills as possible.  Trying to hoard cash.  But try as you might, your working capital is rapidly disappearing.  Manufacturers see their inventories swell.  And storing and protecting these inventories costs money.  Soon they must cut back on production.  Lay off people.  Idle machinery.  Most of which was financed by debt.  Which you still have to service.  Or you sell some of those now nonproductive assets.  So you can retire some of that debt.  But cost cutting can only take you so far.  And if you cut too much, what are you going to do when the economy turns around?  If it turns around?

You can borrow money.  But what good is that going to do?  Add debt, for one.  Which won’t help much.  You might be able to pay some bills, but you still have to pay back that borrowed money.  And you need sales revenue for that.  If you think this is only a momentary downturn and sales will return, you could borrow and feel somewhat confidant that you’ll be able to repay your loan.  But you don’t have the sales now.  And the future doesn’t look bright.  Your customers are all going through what you’re going through.  Not a confidence builder.  So you’re reluctant to borrow.  Unless you really, really have to.  And if you really, really have to, it’s probably because you’re in some really, really bad financial trouble.  Just what a banker wants to see in a prospective borrower.

Well, not really.  In fact, it’s the exact opposite.  A banker will want to avoid you as if you had the plague.  Besides, the banks are in the same economy as you are.  They have their finger on the pulse of the economy.  They know how bad things really are.  Some of their customers are paying slowly.  A bad omen of things to come.  Which is making them really, really nervous.  And really, really reluctant to make new loans.  They, too, want to hoard cash.  Because in bad economic times, people default on loans.  Enough of them default and the bank will have to scramble to sell securities, recall loans and/or borrow money themselves to meet the demands of their depositors.  And if their timing is off, if the depositors demand more of their money then they have on hand, the bank will fail.  And all the money they created via fractional reserve banking will disappear.  Making money even scarcer and harder to borrow.  You see, banking people are, after all, just people.  And like you, and the business people they serve, they, too, hunker down during bad economic times.  Hoping to ride out the bad times.  And to survive.  With a minimum of carnage. 

For these reasons, businesses and bankers hoard cash during uncertain economic times.  For if there is one thing that spooks businesses and banks more than too much debt it’s uncertainty.  Uncertainty about when a recession will end.  Uncertainty about the cost of healthcare.  Uncertainty about changes to the tax code.  Uncertainty about new government regulations.  Uncertainty about new government mandates.  Uncertainty about retroactive tax changes.  Uncertainty about previous tax cuts that they may repeal.  Uncertainty about monetary policy.  Uncertainty about fiscal policy.  All these uncertainties can result with large, unexpected cash expenditures at some time in the not so distant future.  Or severely reduce the purchasing power of their customers.  When this uncertainty is high during bad economic times, businesses typically circle the wagons.  Hoard more cash.  Go into survival mode.  Hold the line.  And one thing they do NOT do is add additional debt.

DEBT IS A funny thing.  You can lay off people.  You can cut benefits.  You can sell assets for cash.  You can sell assets and lease them back (to get rid of the debt while keeping the use of the asset).  You can factor your receivables (sell your receivables at a discount to a 3rd party to collect).  You can do a lot of things with your assets and costs.  But that debt is still there.  As are those interest payments.  Until you pay it off.  Or file bankruptcy.  And if you default on that debt, good luck.  Because you’ll need it.  You may be dependent on profitable operations for the indefinite future as few will want to loan to a debt defaulter.

Profitable operations.  Yes, that’s the key to success.  So how do you get it?  Profitable operations?  From sales revenue.  Sales are everything.  Have enough of them and there’s no problem you can’t solve.  Cash may be king, but sales are the life blood pumping through the king’s body.  Sales give business life.  Cash is important but it is finite.  You spend it and it’s gone.  If you don’t replenish it, you can’t spend anymore.  And that’s what sales do.  It gets you profitable operations.  Which replenishes your cash.  Which lets you pay your bills.  And service your debt.

And this is what government doesn’t understand.  When it comes to business and the economy, they think it’s all about the cash.  That it doesn’t have anything to do with the horrible things they’re doing with fiscal policy.  The tax and spend stuff.  When they kill an economy with their oppressive tax and regulatory policies, they think “Hmmm.  Interest rates must be too high.”  Because their tax and spending sure couldn’t have crashed the economy.  That stuff is stimulative.  Because their god said so.  And that god is, of course, John Maynard Keynes.  And his demand-side Keynesian economic policies.  If it were possible, those in government would have sex with these economic policies.  Why?   Because they empower government.  It gives government control over the economy.  And us.

And that control extends to monetary policy.  Control of the money supply and interest rates.  The theory goes that you stimulate economic activity by making money easier to borrow.  So businesses borrow more.  Create more jobs.  Which creates more tax receipts.  Which the government can spend.  It’s like a magical elixir.  Interest rates.  Cheap money.  Just keep interest rates low and money cheap and plentiful and business will do what it is that they do.  They don’t understand that part.  And they don’t care.  They just know that it brings in more tax money for them to spend.  And they really like that part.  The spending.  Sure, it can be inflationary, but what’s a little inflation in the quest for ‘full employment’?  Especially when it gives you money and power?  And a permanent underclass who is now dependent on your spending.  Whose vote you can always count on.  And when the economy tanks a little, all you need is a little more of that magical elixir.  And it will make everything all better.  So you can spend some more.

But it doesn’t work in practice.  At least, it hasn’t yet.  Because the economy is more than monetary policy.  Yes, cash is important.  But making money cheaper to borrow doesn’t mean people will borrow money.  Homeowners may borrow ‘cheap’ money to refinance higher-interest mortgages, but they aren’t going to take on additional debt to spend more.  Not until they feel secure in their jobs.  Likewise, businesses may borrow ‘cheap’ money to refinance higher-interest debt.  But they are not going to add additional debt to expand production.  Not until they see some stability in the market and stronger sales.  A more favorable tax and regulatory environment.  That is, a favorable business climate.  And until they do, they won’t create new jobs.  No matter how cheap money is to borrow.  They’ll dig in.  Hold the line.  And try to survive until better times.

NOT ONLY WILL people and businesses be reluctant to borrow, so will banks be reluctant to lend.  Especially with a lot of businesses out there looking a little ‘iffy’ who may still default on their loans.  Instead, they’ll beef up their reserves.  Instead of lending, they’ll buy liquid financial assets.  Sit on cash.  Earn less.  Just in case.  Dig in.  Hold the line.  And try to survive until better times.

Of course, the Keynesians don’t factor these things into their little formulae and models.  They just stamp their feet and pout.  They’ve done their part.  Now it’s up to the greedy bankers and businessmen to do theirs.  To engage in lending.  To create jobs.  To build things.  That no one is buying.  Because no one is confident in keeping their job.  Because the business climate is still poor.  Despite there being cheap money to borrow.

The problem with Keynesians, of course, is that they don’t understand business.  They’re macroeconomists.  They trade in theory.  Not reality.  When their theory fails, it’s not the theory.  It’s the application of the theory.  Or a greedy businessman.  Or banker.  It’s never their own stupidity.  No matter how many times they get it wrong.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,