Investment

» Normxxx - What Money is Not

What Money is Not

By Robert Murphy | 5 March 2006

With the possible exception of international trade, no topic in economics contains more myths than monetary theory. In the present article I address four popular opinions concerning money that suffer from either ambiguity or outright falsehood.

"Money represents a claim on goods and services."

Although there is a grain of truth in this view, it is quite simplistic and misconceives what money really is.¹ Money is not a claim on goods and services, the way a bond is a legal claim to (future) cash payments or the way a stock share is a claim on the net assets of a company. On the contrary, money is a good unto itself. If you own a $20 bill, no one is under any contractual obligation to give you anything for it.²

Now of course, in all likelihood people will be willing to exchange all sorts of things for your $20 bill; that's why you yourself performed labor (or sold something else) to obtain it in the first place. Nonetheless, if we wish to truly understand money, we must distinguish between credit liabilities on the one hand, and a universally accepted medium of exchange (i.e., money) on the other.

"The purchasing power of money equals the supply of real output divided by the supply of money."

As with the first view, this one too has a grain of truth. Specifically, if everything else is held equal, then the "price level" (if we ignore the problems with measurement and arbitrariness) will go up if the money supply grows by more than real output, and will go down if real output grows by more than the stock of money.

However, other things need not be equal, in particular the demand to hold money. As with every other good, the "price" of money (i.e., its purchasing power — or how many units of radios, televisions, etc. people offer in order to receive units of money) is determined by the supply of dollars and the community's demand to hold dollars. A given stock of money can be consistent with any price level you want, so long as you are allowed to change the demand for money.

For example, even if output and the stock of money stayed constant, all prices could double if everyone in the community wanted to cut in half the purchasing power of his or her cash balance. How is this possible? Initially everyone thinks he or she is holding "too much" cash and so tries to spend it. But since the merchants too think they are holding too much, they agree to sell only at higher prices. (If this seems odd to you, consider: Even if you are uncomfortable with $1000 in your wallet — maybe you just won big at the casino — if someone walked up and offers you another $1000 for your shoes, you'd probably accept.)

If we ignore all of the real world complications caused by timing issues, it's easy to see that in the new equilibrium, where everyone is content with his or her cash holdings, nothing "real" will have changed. Instead, the unit price of everything (in terms of dollars) will have doubled, so that even though the per capita quantity of dollar bills is still the same, now the average person can only buy half as much real stuff with the money in his wallet. Of course this type of example (which I picked up from Milton Friedman) is very unrealistic, but it does serve to illustrate the point that prices are not a mechanical function of physical stocks of goods and dollar bills. On the contrary, people's subjective valuations are also critical.

"Under a gold standard the money is backed by something real, whereas under our present system dollar bills are backed up by faith in the government."

Again, I sympathize with this type of view, but when my upper-level students write such things on their exams, I have to take off points for imprecision. Strictly speaking, under a gold standard the money isn't backed by anything; the money is the gold. Now if we have a government that issues pieces of paper that are 100% redeemable claims on gold, I wouldn't classify those derivative assets (i.e. the pieces of paper) as money, but perhaps as money certificates. Yet this is a minor quibble.

My real objection to the view quoted above is that it denies that our current fiat currency is really money. Although (as a libertarian, Austrian economist) I fully condemn the monetary history of the United States, and deplore the means by which the public was forcibly weaned from the gold standard, nonetheless it is simply misleading and inaccurate to deny that the green pieces of paper in our wallets and purses are genuine money. They satisfy the textbook definition: They are a medium of exchange accepted almost universally in a given region. No one is forcing you to accept green pieces of paper when you sell things. (If you don't want anyone foisting pictures of US presidents on you, then just charge a billion US dollars for everything you sell.) The fact that government coercion (past and present) is necessary to maintain this condition is irrelevant; cigarettes really circulated as money in World War II P.O.W. camps, even though this wouldn't have occurred without the artificial and coercive environment in which those traders found themselves.

"Deflation is undesirable because it cripples investment. If prices in general are falling, no one will invest in real goods because he can earn a higher return holding cash."

Although this last myth is understandable when espoused by the layperson, it is inexplicable that some trained economists believe it. (For three examples: An NYU professor used it to "shoot down" my Misesian friend in class, Wikipedia's entry on deflation mentions this argument, and even Gottfried Haberler advances a version of it in this essay.) For one thing, the argument overlooks the fact that there were many years of actual deflation in industrial economies on gold or silver standards; I don't think investment fell to zero in every single such year. So clearly something must be wrong with the argument.

Specifically the argument fails because it carelessly assumes that the relevant data for an investor are the spot prices of a particular good from one year to the next. But this is wrong. For example, suppose someone is considering investing in bottles of fermenting grapes that will be ready for sale as wine in exactly one year.³ The rate of return on this investment concerns the 2005 price of the grapes and the 2006 price of wine. So let us further refine the example and suppose that all prices fall 50% every year; i.e., there is massive deflation and presumably no one should be willing to invest in wine or anything else.

Yet there is no reason to jump to this conclusion. For example, the 2005 price of the bottle of fermenting grapes might be $100 and the 2005 price of a wine bottle might be $400, while the 2006 price of the bottle of grapes will be $50 and the 2006 price of a wine bottle will be $200. (Notice that, as stipulated, all prices have fallen by 50% per year.) Would our investor prefer to hold his cash, which in a sense appreciates at a real rate of 100% per year? Not at all! With our numbers, the investor would earn a 100% nominal (not just real) return on his money if he invests in the wine industry: He pays $100 for a bottle of fermenting grapes in 2005, then waits one year and sells the resulting bottle of wine for $200.

Had our investor sat on his $100 in cash in 2005, its purchasing power would have risen from 1/4 of a bottle of wine (in 2005) to 1/2 of a bottle of wine (in 2006). But by investing the cash, his purchasing power goes from 1/4 of a bottle in 2005 to 1 bottle in 2006. Once we allow for the prices of capital goods and raw materials to adjust to expectations of deflation, there is no reason for falling prices to hamper investment whatsoever. ⁴

CONCLUSION

Most of the myths concerning money are easily exposed when we consider what money is. Some of the more subtle myths, especially those concerning price deflation, are exposed once we consider the intertemporal price structure. On both counts, the Austrian School of economics serves us well.

[ Normxxx Here:   What he says is true, if simplistic. Mild deflation is no worse than mild inflation (actually better, for savers)— except that the Fed has no easy way to reign it in once the effective rate of interest drops below zero (e.g., the U.S. in the '30s; Japan from about 1986 to 2004). The U.S. suffered bouts of sudden and severe deflation during this period, so wage earners here fell way behind, and there was great suffering; Japan did not, so any suffering was muted there and, in general, wage earners kept pace. But, it is the loss of control that scares the Fed and all other Governments (and me!). ]

Robert P. Murphy teaches economics at Hillsdale College.

¹ For a more systematic introduction to the Austrian theory of money, see this article.

² Even legal tender laws don't affect this statement. If you owe someone, say, $1,000 and the government says a particular $20 bill counts as partial payment, that's not the same as saying that someone owes you an item in exchange for the $20 bill. Rather, it's just the government declaring that your debt can be partially satisfied with the $20 bill in question.

³ I suspect that this story is far from an accurate description of wine making, but it was the easiest way for me to illustrate my point.

⁴ A sophisticated critic could answer that the true problem with deflation is not that it would completely eliminate all investment, but rather that investment would stop at the point at which the marginal real return equaled the real return from holding cash. I'm not sure that even this version of the argument is valid, but in any event it's not what many of the economists (such as the Wikipedia author) seem to be saying."

[ Normxxx Here:   I'll have to get on that Wikipedia article; even though I think this author is simplistic in his analysis of deflation, I abhor innacuracy even more. ]

-- posted by Normxxx

» Normxxx - Signals: Banking

Signals from the Banking World

By Jim Willie CB | 16 March 2006

A few key signals should gain attention as the investment community struggles to fix on accurate indications for US Federal Reserve policy changes. A review is offered to paint a broader picture than a mere glimpse at the Treasury Yield Curve and its future shape. At the same time, a claim is made that debt rating agencies have been solicited to join the US Fed policy. Lastly, FedSpeak is an exported practice of deception, now used in Tokyo, Brussels, and Vienna (OPEC) in order to attempt to control important markets.

This essay is an update to "Bankers Versus USFed" penned in October 2005. We really cannot define what "neutrality" is, where the neutral level might be. It is far too elusive. With a US Economy dog driven by the financial sector tail, a vast dichotomy is presented. My estimate is that a 2% or 3% short-term bond yield might be too tight on the commercial side, and again, a 6% to 8% short-term bond yield might be appropriate for bond speculators to cease and desist their deadly craft. They have forced a crippled evolution. Before too long, US TBonds might be forced to pay junk bond yields, especially if the famed yen carry trade fully unwinds.

Definition Of "Neutrality"
The end of higher rates might be soon, or might be a long time coming. Who knows, because who knows what their motives are really? Last June, the hack novice Dallas Fed Governor Fisher shared his wisdom on the incredibly deceptive and inept "ninth inning" call in a clear piece of disinformation to control the stock and bond market. It fooled me briefly and with embarrassment. Have we had four rate hikes since then, or five? Can they or anyone define the elusive "neutrality" term in any meaningful way? At one time, my unconventional view was that "neutral" meant fixed mortgage rates equaled adjustable rates, motivated by ushering millions of homeowners into fixed contracts in safe fashion. They must be protected from continued tightening and escalating household monthly mortgage costs. That event occurred (almost) a few months ago, when the 15-year fixed rate hit the ARM rate. At a later date, my view changed on neutrality more toward what rate would adequately defend the US Dollar, in an effort to satisfy Asians and Persian Gulfers unhappy with low paying Treasury yields. They had begun dreaded diversification of their foreign dowries won from hapless consumption hogs in the United States. A long-term bond premium yield of 6% to 8% might be necessary for foreigners to hold tight on their mountain of reserves holdings. They are breaking ranks overseas.

The Bkx As Meaningful Signal
An excellent bond market signal can be put forth, the BKX banking stock index. Two months ago, my view was that this index signaled an end to the excessive US Fed rate hikes. Rates are highly likely to go too high. The BKX index addresses the lending market profitability in a true sense, to provide inherent value. It also to some degree reflects big bank trading desk profitability, such as with bond and currency speculation. Lending is a nuisance side show of sorts, tragically, since big banks have evolved (progress in Greenspan's eyes) into hedge fund business segments knee deep in casino operations.

In the last few weeks, my view has changed again. The BKX index might more appropriately signal successful management of the Treasury yield curve itself, in the managed shift away from inversion and toward a gradual steepening. If the short end rises (with USFed rate hike decisions) but the long end rises faster, then the Treasury yield spread trade remains profitable. In fact, the BKX might in time signal successful management of coordinated tightening among the USFed, the ECB, and the BOJ. If the rate differential is maintained among the Americans, the Europeans, and the Japanese, then the carry trades can remain somewhat in place. The reality behind the carry trades must reflect not only the rate spreads, for instance between the short Japanese rate and the long US rate), but also the currency differences.

One is led to wonder to what extent the Japanese yen currency has been pushed down hard in the last 8-10 months in order to satisfy the carry trade players. If the underlying borrowed money currency (the yen) goes down, then the carry trade profits are reinforced. The coordination of the USFed decisions, yield spread management, and inter-relationships with foreign currency signals are covered in the March Hat Trick Letter issue.

My view is that the BKX index is a signal of something much bigger, of health for the carry trades and spread trades. If the central bankers of the world wish to control the bond markets like the octogenarian Soviet Politburo hacks, then they risk disasters of a larger scale. Refer to the Black Monday of 1987, to the Asian Meltdown of 1997, to the LongTerm Capital Mgmt (neither long-term nor well managed) of 1998, to the Russian Bond Default of 1998, to the Tech-Telecom Stock Bust of 2000, to the upcoming US Housing Debacle in 2007. They all have roots in central bank tightening to excess or easing to excess. The BKX has broken out upside. The signal might mean only banking sector profit health. It might mean an avoidance of the deadly yield curve inversion, whose importance was denied, but with avoidance suddenly has been heralded a positive relief. It might mean that the giant yen carry trade will be actively managed so as to preserve it.

Treasury Yield Curve
The uniform rise in term yields across the Treasury spectrum might relieve the threat of inversion, but it poses a different problem. Gone might be the reliable longstanding signal (fully denied by Wall Street joy boys). However, new on the billboards is a signal of global tightening, lost liquidity, and dark clouds over the entire stock market and economic landscapes, from the United States to Europe to Japan. Rather than show the Treasury Yield Curve graph, let's look at a forward indicator on the future shape of the yield curve itself. This chart shows the ratio of the 10-yr TNote yield (TNX) to the 3-month TBill yield (IRX). Instead of the typical spread difference in yield, it is the ratio. It reveals a bottom formation in progress and some upward momentum in the weekly stochastics.

What we definitely do not want to see is a uniformly higher Treasury yield curve which eventually turns into an inverted state, but at a higher level, at a later date down the road. Like a TNX at 5.4% yield against an IRX at 5.75% yield in November 2006. We might see this condition if the US Fed hikes five more times, true to their historical practice of going too far. This would mean we again have the recession signal along with much higher borrowing costs across the board. It is humorous really, that a recession signal was denied from yield curve inversion all this winter. An excuse is offered that global savings have pushed money into the long end. So global factors negate the signal? Here is a different view. Global factors make the US Treasury Yield Curve inversion a negative signal on a global basis. It was signaling a global recession, not just a USEconomy recession. If global factors work to invert the term curve, then global factors are ripe on implications of recession. This is basic science.

Bernanke Control
Lately, my view has again shifted to the realities and vagaries of markets in movement. Neutrality is not the issue to Bernanke, who is a control freak, guided by his desire for bond megalomania. He wishes the control the bond world, to manage the Treasury yield curve, and has embarked in my opinion on a truly historic and monumental mission to coordinate the yield curve and yield differentials at an international level. The USA, Europe, and Japan are all in the midst of simultaneous tightening, or at least we are given unmistakable indications from Tokyo that their five-year Zero Interest Rate Policy (ZIRP) is soon to end, even as Europe hiked a second time. By the way, the jackass did not believe the "one time hike" announced by the Euro Central Bank in January, where they denied a new trend of tightening had begun. My view is that Bernanke is attempting to coordinate rate hikes with the Euro Central Bank (ECB) and Bank of Japan (BOJ) together with the cooperation of critically important debt ratings agencies. Is it a coincidence that the ECB in Brussels decided to hike right before Bernanke took the helm, then again weeks after he was installed as USFed Chairman? Is it a coincidence that Tokyo decided to issue pronouncements of an end to the ZIRP and monetary ease only weeks after Bernanke took over? Methinks NOT on both counts. The financial world has become a more dangerous place in the last five years. More firm control is seen as urgently needed by the Bond Politburo members.

Debt Agencies Involved
Last summer, General Motors and Ford suffered a series of debt downgrades. To the novice investor and clueless public observer, such downgrade decisions were unrelated to the US TBond market. Not so. Just as the Asians discontinued almost all new Treasury Bond purchases with trade surpluses, GM and Ford credit default swap derivatives unwound. Profit was taken on the credit default contracts. US TBonds, which underpinned that spread trade, were bought back (like a short cover). The Detroit woes were timed perfectly to pick up the lost Asian demand and growing slack, a gaping hole more accurately depicted. Standard & Poor, Moody, and Fitch in my view have become partners with the USFed in coordinated policy. Then once more, the Fitch ratings agency downgraded Icelandic govt debt two weeks ago. Their decision was timed one week before the Euro Central Bank hiked rates by 25 basis points. The Iceland krona currency loss was the euro's gain, as well as the USDollar's gain. Money rushed out of emerging market govt debt and back into European govt debt precisely when liquidity would be highly desired.

FedSpeak Exported
In the last few years, a remarkable phenomenon has developed, a true tribute to sheeplike behavior within the investment community. The financial markets routinely respond to spoken words and not to actions taken. To be sure, many actions are hidden and not so transparent. A bizarre trend has spread like a mouth-to-mouth communicable disease. The ECB attempted to control the bond market with the spoken word in January, telling us that their first rate hike was not the first of several, a lame attempt to set opinion on a single "one off event" which did not fool me. They wanted to avoid the appearance of a new series of their own "measure pace" rate hikes. Such a trend perception would do harm to the USDollar. The ECB failed in FedSpeak. They need more practice in the art of deception.

The next student for the deceptive practice is OPEC, led by the Saudi Oil Minister Al Naimi. Last autumn he spoke incessantly (and with occasional anger) about how increased Saudi oil production output would satisfy the shortfalls brought upon by the Gulf Coast hurricane damage. Well (not oil well, just well now), it turns out that OPEC oil output in January was actually below the Oct2004 output incredibly. Saudi output has not increased, and whatever newer production has hit the market is sour crude anyway. Al Naimi is hounded like a porcupine by hunting dogs as press reporters seek clarification, like in Vienna last week when OPEC ministers met. The Saudi oil minister has engaged in numerous attempts to control the important crude oil market. They promise again more increased oil output. They speak of accommodating a market overheated in oil price.

Last spring 2005 OPEC ministers threatened possible output cuts in response to oil price declines. There is less need to threaten such cuts when Mother Nature has a firm grip on depletion and production declines. A key event is worth citing from the same Vienna OPEC meeting last week. The Kuwaiti oil minister made a strong statement that his tiny nation would continue in its oil output in order to stabilize the oil market. Well (very much oil well), just three weeks ago the Kuwaiti govt issued a formal statement that their giant Burgan oil field has officially entered a long slow depletion decline. So either the Kuwaiti oil minister "forgot" that Burgan went into decline, or he is actively engaged in FedSpeak, a tactic learned from his colleague Al Naimi. My guess is FedSpeak was being spoken in broken English, to win favor with the USGovt, who protects this bunch of guys who hijacked the nation for personal gain long ago.

In a more frightening development, dangerous rumblings from the Bank of Japan have been recorded on seismic charts. The BOJ has alerted the financial markets that cost-free money will soon end. How the Wall Street Journal, Barrons, the New York Times, the Financial Times, even the Paris Match and National Inquirer don't cry in loud wails that the financial world has been upside down, turned inside out for almost a decade is beyond me. Imagine buying a car for 0%. Oops, we do that also. Imagine buying a jacuzzi or plasma television for 0%. Oh, we do that too. These days might soon come to an end, with a surefire extreme test for both the speculative and commercial economies to conduct its business without cost-free money. One is left to wonder if and when the BOJ will indeed raise rates. Given they are nil now, even a 0.1% (ten basis point) rate hike would be significant. Clearly BOJ head Fukui can move the markets with his words, more FedSpeak. So call the Japanese prime minister Koizumi. The only missing piece to the FedSpeak assault on our markets, where sentiment indexes have eclipsed hard data, is for the debt rating agencies to issue regular statements about possible downgrades for GM, Fanny Mae, Merck, or Wal-Mart debt. Well, they do so already.

US Fed Governor Comment Signals
Here is where, once again, absolutely frightening signals can be heard. An inverted yield curve is the result of excessive USFed tightening, which might sound strange. What is tight for consumers might be loose still for bond speculators. We live in two worlds under a single monetary policy, a highly dangerous situation. We need a bond world cost of money and a separate commercial world cost of money. Without separation, we will continue to experience havoc and periodic crises.

USFed governors have displayed a clear pattern which seems not to be acknowledged or recognized by the gold community. The signal is of incompetence practiced to the extreme, risk raised to the extreme, in my field of statistical analysis and forecasting. Economic statisticians are paid to deliver forecasts and to advise policy makers to ANTICIPATE conditions and set policy accordingly. We have for several months been told by USFed Governors that they will REACT to economic data. This is incompetent, unprofessional, reckless. Neither Wall Street nor the gold community has addressed the situation. USFED POLICY MAKERS WAIT FOR A PROBLEM INSTEAD OF RELYING UPON FORWARD INDICATORS TO AVOID A PROBLEM??? Tragically, this is the world we live in with our breed of economists at the controls. Just why does the USFed have a habit of overshooting, whether in tightening or easing? The answer is easy. They rely upon faulty statistics. They depend on less than the best forward indicators. Worse, they react to concurrent data, instead of proper forward indicators. In other words, THEY ARE INEPT & INCOMPETENT.

The US Federal Reserve has avoided using reliable forward indicators, and has relied too heavily on CONCURRENT consumer data and growth data. The USFed has discarded Conference Board expertise and its competent track record. Former Chairman Greenspan even distorted that track record to promote his unwise forward indicator, the "real Fed Funds rate" which is the Fed Funds rate minus the highly suspect and grossly distorted Consumer Price Index. The actual CPI is approximately 4% higher than the reported CPI to the public.

Below is a very typical utterance by a Fed Governor, taken in part from a Reuters story. The Federal Reserve has moved interest rates into a range where policy makers have to be sensitive to the possibility of raising rates too far. San Francisco Fed Bank President Janet Yellen on Monday spoke to an economic conference. She offered the usual mumbo jumbo on price inflation being in "pretty good shape" with a focus on the core rate excluding food & energy. More mumbo jumbo on how the USEconomy is near full employment, despite hundreds of thousands having given up looking for work. She openly admits they are setting rates by the seat of their pants or petticoats, with USFed hikes governed "now very much a matter of judgment" on how much further they still should be increased. This is pure heresy without the public hue and outcry. She admits the USEconomy stands hostage to the housing market. This is the housing bubble they urged, they fostered, they nourished, they denied, and now they pop.

"I think we're in a range where Fed decisions have become quite data-dependent and there does need to be sensitivity to the possibility of overshooting. I don't see wage pressures there yet that would be threatening to price stability. We probably do need to see some cooling off in the housing sector. We won't get a slowdown in the economy, I think, unless there is at least some moderation in the pace of house price increases. We do need to be careful about overshooting and (policy) lags. I consider us to be in a range where further moves depend on how the data transpires, but I don't see weakness out there yet."

In her conclusion, she denies much monetary tightening has occurred since long-term rates remain at a low level. So unless we have a severely inverted yield curve, we have endured little tightening? Wow! That is lunatic after fourteen rate hikes. She closed with yet another pep rally statement that our economy remains robust. My view is that our national statistics department remains robust and vibrant, while the actual economy has stalled in a horrible situation where it have grown critically dependent on asset bubbles. At the same time wages are in decline on an inflation adjusted basis for the last four years.

______________


The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx

» SteveT - Potential Bank Sale Raises Interest

Friday, March 31, 2006
INVESTORS' SOAPBOX AM

Merrill Lynch
4 World Financial Center
250 Vesey St.
New York, N.Y. 10080
(Tel) (212) 449-1000

A REPORT THIS MORNING INDICATED Bank of New York is close to selling about 300 retail bank branch offices to J.P. Morgan Chase in a deal that could be worth about $4 billion. While we are not speculating on whether any deal will be completed, we believe a sale in this price range could enhance Bank of New York's share price by about 4%.

We estimate Bank of New York would experience about five cents in earnings-per-share dilution on pro forma 2006 EPS in a sale of the retail bank in this approximate price range. However, we think Bank of New York would get a modest price/earnings multiple upgrade (we estimate to about 16.3 times 2006 pro forma earnings, up from 15.3 times, currently), which should overcome the dilution and imply share-price improvement of about 4%. This P/E improvement would represent closing the gap to peers by about a third, so we believe it may be conservative.

We note that the news story indicated a sale of 300 branches, or slightly less than 90% of Bank of New York's total 342-branch count. In our analysis, we assume a sale of the entire network, so a $4 billion sale price would be grossed up to about $4.5 billion. (Conversely, a sale of 300 branches would imply a lower loss of net income than the $230 million forecast, so the dilution numbers should work out to roughly the same, we believe).

Also in the analysis, we assume Bank of New York would be able to use the after-tax proceeds to execute a share buyback at today's opening price. We note that at any price considerably below $4 billion, the deal would not be that attractive.

We think Bank of New York's retail bank would be very valuable to a large bank consolidator, such as Citigroup or J.P. Morgan, since these companies could solidify market share in the New York City Metro region. For example, our investment banks and brokerage analyst, Guy Moszkowski, indicated in his report dated Feb. 13 after his lunch with J.P. Morgan Chief Executive Jamie Dimon, that Dimon views extending share in local markets to 30% as enhancing pricing, and this acquisition would advance J.P. Morgan's local banking presence toward that goal.

-- Brian Bedell

URL for this article:
http://online.barrons.com/article/SB1143...

.

-- posted by SteveT