Oct 27, 2007

Kevin Duffy on the government printing press

The lure of easy money begins with the government printing press. First, the central banker buys an asset – typically a government debt instrument – writes a check on itself and deposits it into the banking system. Since the bank never "redeems" the check, this is equivalent to creating money out of thin air. The banker, happy to receive fresh "reserves," loans out all but a sliver. This new money ends up back with the banks, is counted again as reserves, mostly lent out, and so on and so on. Through this process of fractional reserve banking, credit is expanded at a multiple of the initial central bank deposit. Through such a system, the creation of money and credit (the promise to pay money) looks like an upside-down pyramid – essentially a pyramid scheme on top of a counterfeiting operation.

As James Grant has counseled, the inflation process gives a finite pool of capital the illusion of an endless sea of liquidity, in effect "turning all the traffic lights green."

Such a scheme is a concoction of government privilege (or mercantilism), not laissez faire. The so-called "capitalists" are no longer efficient allocators of capital to its most productive uses, but beneficiaries of and cheerleaders for a monetary fraud in which capital is debased, taken for granted, and abused. As long as they remain chummy with their friendly liquidity provider of last resort, they can act recklessly without fear of igniting an economic forest fire – or if they do, without fear of having to bear the costs. And as long as the value of their collateral is constantly inflated, they never feel the need to worry about default.

Liberated from the gold standard straightjacket, the system has few restraints. For starters, the counterfeiter has an incentive not to draw attention to his racket. But the effectiveness of his ongoing propaganda campaign has weakened this deterrent. The real inflationary action, however, is in credit expansion. For example, in the last 6 years, the Federal Reserve has grown its balance sheet less than $300 billion while the nation’s money supply has expanded by $4.3 trillion, or 14 times as much. In other words, the central banker can bait the hook, but lenders and borrowers still have to take the bait.

This new money is never evenly distributed, but instead gets funneled into whatever narrow area happens to capture the public’s fascination. As prices and valuations soar, greater doses of credit are required to keep the game going. Either more marginal borrowers are drawn in at ever more precarious levels or greater leverage must be applied to existing borrowers. This is what ultimately doomed the housing bubble. In the end, nearly anyone who could fog a mirror was getting an invitation to join the party.

The trouble with pyramid schemes is that they’re not designed to go in reverse. Eventually, the number of willing dupes is exhausted. The same people who panicked late to get into the game are just as likely to panic when the music stops. The longer the music plays, the more leveraged and unstable the inverted credit pyramid becomes. As the late economist Hyman Minsky observed, "stability is unstable."

~ Kevin Duffy, Bearing Asset Management, "It's a Mad, Mad, Mad, Mad World," May 22, 2007

No comments: