Thursday, February 5, 2009

Where Did All the Money Go?

From the Desk of Joe Rollins

We received some interesting questions from a Rollins Financial client over the weekend that we think our blog readers have also likely wondered about over the past few months. He asked what happened to all the money that used to be in the money supply. Since at some point life was good, stocks were up, property values were strong and people had money to spend, why and how is the world is now broke? Where did all the money go?

He also wondered what happens when the government pumps a bunch of money into the economy (like they’re doing with the stimulus package). Once it starts gaining traction, would we not be at risk for inflation? He also inquired why any asset wouldn’t be a good investment in a pre-inflationary environment.

Lastly, he asked how long it took for our economy to recover after the Great Depression. These are all great questions that I’ll try to answer in this post.

First, the money supply is basically fixed. There are two basic types of money supply (cash): the money supply held by non-governmental sources and the money supply held by the government itself. When you read about various forms of money supplies, they are typically referred to as M1, M2, and in prior years, M3. These are the different types of money in circulation at any point in time. It does not refer to the amount of money held by the government, which is periodically drained out of the system to better control inflation.

When the government wants to inspire further growth in the economy, they flood the money supply with excess money (I will explain this in greater detail later in this post). Conversely, when the government wants to restrict growth, they’ll drain cash out of the system, strangling the economy for the lack of cash.

The way the government handles the money supply can be thought of much the same way as adding kindling to a fire: Kindling is placed on a flickering fire to make it more robust, but if your goal is for the fire to burn out, then you wouldn’t add any fuel (or kindling) to it. This is essentially what the government does with cash.

While there is a fixed amount of cash in the money supply, there is a difference between the cash held by the public and the cash held by the government. Even though you may not realize it, there’s an enormous amount of cash in the U.S. economy at the current time. At one time, the U.S. stock market was twice as large as the cash in available money market accounts. Due to investors getting out of the stock market and conserving their cash, commercial money markets today exceed the total value of the listed securities on all of the exchanges.

This is an unusual circumstance, particularly in this era of historically low interest rates. Even though many forms of securities provide returns two to three times the total rate of return on cash from money market accounts, many investors are unwilling to take the risk associated with seeking those higher yields. I referred to this in Tuesday’s post, when I noted that investors were finally getting more comfortable with taking on risk in the marketplace. When investors feel comfortable accepting higher risk, they will move from the money market accounts back into higher yielding securities.

While it may seem that people suddenly have no money, this is somewhat of an exaggeration. During September of 2008, our government scared us back to reality. Due to their loud and continuous exclamations that the banking system was facing failure, consumers shut down their spending habits. It was just reported that for the month of December, consumer savings increased 3.2%. What is particularly unusual about this action by consumers is that it occurred during the Christmas season.

For the last decade, consumers have been hesitant to save money. They’ve basically continued to spend money which, of course, promotes additional commerce. In fact, by using credit cards and home equity loans, consumers have leveraged up and used those available resources to spend additional sums of money for things they could not live without. From September through today, consumers have been unwilling to take those same risks. Instead, they are accumulating cash in money market accounts and paying down their debts.

As pointed out previously, this risk aversion to spending money and paying off consumer debt has helped the consumer at the economy’s expense. Accordingly, the consumer is in a better financial condition today than in some time; they’ve saved money, paid off debts and now hold cash reserves for potential further economic downturns.

We have now gone through about four months where consumers have not utilized cash they earned from their employers to buy consumer goods. At some points, consumers will revert to using that cash to buy products which will, in turn, stimulate the economy.

The main problem with the auto companies in the U.S. (and arguably, with auto companies around the world) is that consumers are unwilling to enter into a long-term financing arrangement to purchase a new automobile. It was recently reported that the average age of cars in the United States is older than it’s ever been – 9.5 years. Never before have Americans continued driving cars that are this old. Some of this is because cars produced today are of higher quality than in prior years, but I suspect much of it has more to do with consumer skepticism on incurring new debt.

Additionally, I don’t think the average person takes into consideration the cash held by major corporations when thinking about the economy. The last decade has been an extraordinarily profitable time for major corporations. Many of these corporations have accumulated vast amounts of cash in their operations. For example, Microsoft, Merck, Exxon Mobil and many other corporations have vast cash holdings. Each of the corporations mentioned have current available cash well in excess of $20 billion each. This enormous amount of stashed cash is not reflected in any reports regarding money market accounts.

In short, the amount of cash in the system today is not any less than it was when times were good. It’s just that the cash is allocated differently and to more conservative sectors.

The foregoing doesn’t, however, explain the reduction in wealth for hard assets. Cash is cash, which everyone understands. It’s essentially worth about the same year-in and year-out. However, asset values are an entirely different matter.

Take, for example, a block of identical houses, where every house on the block has the exact same features, qualities and amenities and are all valued at $100,000. However, due to circumstances beyond anyone’s control, one of the homeowners is forced to sell their house under extreme conditions and finds an opportunistic buyer who pays them $80,000. Even though none of the other houses on the block had any part of this transaction, each and every remaining homeowner will take a steep downward valuation of their net worth of 20%. Of course, the same thing happens on the upside, but that’s not what’s been occurring recently.

The same thing happens with listed securities. When one buyer sells a stock at a reduced price, then all holders of that security suffer. Even though the remaining holders were not a part of that transaction, they all suffer proportionate to the person selling the stock at a reduced price. Over the last year and a half, we have seen a massive reduction in the value of assets due to the revaluation of real estate and the downward valuation of listed securities.

One of the most frustrating aspects of watching the national financial news is the tendency to over-extrapolate. I hear all the time that if prices continue to go down, they will one day reach zero. While this may be true from a mathematical standpoint, the explanation is wrought with a lack of financial reality. I’m often asked how low house prices can go. While there is certainly a limit to how far down prices can go, it all has to do with the available supply and demand. As long as there are more houses for sale than people buying them, housing prices can continue to go down. As explained above, each time prices go down, every other similar house will take on an equal or lesser value.

As defined under the economic theory of supply and demand, at some point the supply of homes will equal or be less than the number of corresponding buyers. When builders can no longer build homes for a price that buyers are willing to spend, they will stop building. This is exactly what’s happening in the U.S. today; there are very little new homes being built. As the chart entitled, “U.S. Houses for Sale: Thousands: NSA” illustrates, we are now sitting on an inventory of homes equal to the amount of homes we had in 2004, which was a very robust economic year.

I recognize that those who are pessimistic about the real estate market would say that this does not address the issue of the new homes entering the market due to foreclosure. My thought is that at some point, even those homes will be acquired by ready buyers. With the government’s proposed housing stimulation credit of $15,000 and the potential for government-guaranteed loans at 4%, we will soon see homeownership available to almost anyone who can afford an apartment. Since the government will be furnishing the down payment in the form of a tax credit and interest rates will be at all-time historic lows, every renting person with good credit should be able to afford a home. Click here to review my “Fixing the Housing Crisis” blog posted on for more details. Interestingly, the proposal that the government is now considering is exactly what I proposed in that post. It just goes to show that the private sector moves at warp speed compared to government bureaucracy.

While no one can exactly predict when a bottom in the real estate market will occur, you cannot help but think those days are drawing near. With the downturn in the number of new homes being built along with the current extraordinary and favorable buying terms, inventory levels will quickly be exhausted and new home construction will recommence.

The more important part of the question relates to how the flood of money the government is pushing into the economy affects future economic activity. As discussed previously, the Federal Reserve goes directly to the banks they control under the Federal Reserve System and buys government securities from them. Essentially, all the banks are covered up in cash today. Contrary to what you read, the issues with the banks have never been about liquidity. They all have plenty of available cash to loan. However, they’ve taken such large hits on the write-downs of their unmarketable securities that it’s affected their statutory capital requirements. Therefore, they could not lend even if they wanted to do so.

In an ironic twist of accounting, the SEC has required the banks to write-down these illiquid securities to a level far below their fair market value. By virtue of writing them down, they’ve reduced their regulatory capital and restricted their ability to lend. On one hand you hear Congress saying that banks should be forced to lend, yet a government division is restricting the banks’ lending ability. While the write-downs make big news in the financial press, they do not affect cash flow. This is because it strictly has to do with bookkeeping and has nothing to do with profits.

Banks are currently covered up in cash that they can do very little with. CD and money market interest rates are falling off a cliff. Banks simply do not care whether they write new CD’s and gain more money market assets. There’s virtually nothing they can do with these assets to earn anything, and therefore, holding them is detrimental to their financial situation. In fact, the banks are paying back to the U.S. Treasury TARP money at a 5% rate. If they are just holding that cash in the bank, it is impossible for them to earn 5%. At some point the banks will be forced, for their own self-preservation, to begin lending money. The so-called experts who pontificate about banks being unwilling to lend just do not understand the profit motivation of current banks.

When I was researching Bank of America yesterday, I noticed that they currently have on their balance sheet one-quarter of a trillion dollars on deposit in non-interest bearing checking accounts. Essentially, they have a quarter of a trillion dollars of client money that they are not paying a single dime for that is available for lending. If a bank could lend that money at even the prime rate, they would make a spread between the cost of money and its earning ability at a rate higher than has been earned by banks in decades. I forecast explosive bank profits in the coming years. They’ll have the potential to make more money in the coming years than ever in their history.

The other component of fiscal stimulation by the government is represented by the new $900 billion stimulus bill currently being debated. Notwithstanding my criticisms and recommendations, it’s almost absolutely clear that some version of this bill will be passed within the next two weeks. A very simple illustration of the magnitude of this bill is in order.

You may recall that in the early part of 2008, Congress passed a stimulus bill wherein approximately $150 billion was pumped into the economy via tax refunds. While this is certainly a lot of money, it was arguably not enough money to make a huge difference. The problem with that stimulus bill is that it went to many higher paid people who saved it or paid down debt instead of spending it. Many of the provisions in the current stimulus bill solve that problem by putting tax refunds in the hands of people who are more likely to spend than save.

There is an economic term called the “velocity of money,” which states that money is spent seven times before it’s exhausted. For example, if you purchased $100 of goods from the grocery store, that is the first step in the velocity of money. The grocery store would take that money to help pay its employees and vendors. In turn, the employees would buy consumer goods, proliferating the money cycle. Therefore, for each dollar spent in the economy causes a compounding effect of seven times that original amount spent, creating seven times that amount in new GDP.

If you realize the magnitude of the numbers we are discussing, you can see the issue. If the bill is approved at $900 billion and the velocity of money is seven times, then the resulting GDP would be $6.3 trillion. The expected GDP when dealing with numbers this large is almost incomprehensible. If GDP increased by $6.3 trillion due to this stimulus package, that would be an economy larger than every economy in the entire world except the United States. We are talking about a number that would potentially increase GDP by an amount greater than the economies of Japan, China and all of the European countries.

A new term has entered the vernacular recently. You may have read where the government is purchasing $500 billion in governmental and mortgage-backed securities. Their goal is to reduce interest rates by buying these securities and holding them in the Treasury. I often read in the financial press that the money buying up these securities has been “monetized.” This is “Fed talk” for them going out and printing new money. The Federal Reserve is usually reluctant to print money because of the potential of future inflation. But in this particular case, they thought the need justified the risk.

Basically, the government prints new dollars and then uses them to purchase bonds and securities. This newly printed money is in addition to the TARP money and the new stimulus money. If you’ve lost count, that’s $700 billion (TARP) + $900 billion (new stimulus) + $500 billion (monetized) = $2.1 trillion. The person who sold those securities now has cash, and the investment opportunity and earning capacity of cash is extraordinarily low. Eventually those who have traded in their securities for cash will seek higher returns. This taking on of additional risk by the holders of cash will generate higher returns which will force-up equity values.

My client asked how this money will help the economy and when we will see some positive results. These tax reductions in the stimulus package will almost immediately positively impact the economy. Taxpayers will have available cash to spend on consumer goods; retailers will see an uptick in business and will have to hire more employers, and all of this will generate additional cash flow into the economy. First-time homebuyers will be able to purchase inexpensive homes with the government providing the down payment and they will also have very low interest rates. The owners of the homes being sold will move up to middle level houses and those in the middle level houses will move up to higher level houses. Since the number of people able to afford homes is being vastly increased, shortly thereafter there will be a scarcity of new homes, creating new homebuilding.

The banks will be awash in money at unprecedented levels. They will be forced for their own self-preservation to loan this money, impacting the economy. As small businesses get this money they will be able to build new plants and purchase equipment, pay employees and suppliers. The answer is forcing the money into the economy, and it is coming like a freight train and will be in the economy over the next six months.

Most economists are forecasting the economy to get better in the second half of 2009. As we sit here today, we are only six months away from their projected better economy. I find it distressful to hear forecasts of a recession that will go on for a decade. Either they are not educated in economic terms or they believe we are in a new era where traditional economics no longer works. Obviously, having gone through many economic cycles in my professional career, I am unwilling and unprepared to assume that economics no longer works and that capitalism needs to be abandoned.

Finally, there is no question that all this money will create inflation. In all likelihood, this inflation is several years down the road, but it will come at some point. All of this money sloshing around in the economy and seeking out new consumer goods and assets under the most basic economic term of supply and demand will increase their values. Home prices will go up, equity prices will go up, and virtually everything will cost more.

While inflation can be damaging to an economy, it can also be productive. For example, a business that holds a large inventory of goods for sale gets an increase in net worth when inflation makes the stock inventory more valuable. However, as with anything, too much inflation is a negative. When the government determines that inflation is too high, it will drain the cash it is currently investing away from the economy. Frankly, given the difficult economic era in which we live, I look forward to the day when the government begins draining away liquidity rather than injecting it.

The last question was how long it took the U.S. economy to recover from the Great Depression. I pointed out in my post, “Reminders of My Father’s Sermons,” for many years I incorrectly thought that the FDR’s “New Deal” was a raving success. My incorrect belief was that the economy’s recovery was due to FDR’s spending under the New Deal. After reviewing this matter in detail, I discovered that the economy did not improve until about 1941. Therefore, the Great Depression lasted an entire decade. Even as the U.S. began gearing up for World War II, the unemployment rate at that time was still 17%.

However, it’s impossible to compare the Great Depression to today’s U.S. economy. There were no backstops to the economy in the 1930’s – there was no unemployment insurance, no Medicare, and no Social Security. Welfare and food stamp programs did not exist. Therefore, when people were laid off from work, they had nothing to fall back on to help with their finances. People who were old, sick or unable to work were basically left to be begging on the streets.

Many of the troubles during the 1930’s were solved for today’s world because of the financial backstops that were subsequently instituted such as unemployment insurance, welfare and food stamp programs and Social Security. Even today, the Congress is moving to extend unemployment insurance to a full two years after an employee is terminated. While all of us can argue whether that is a good or bad thing, none of us could argue that it’s not a good thing for the person who lost their job and is struggling to find work.

The main reason that the New Deal didn’t work under FDR was because he refused to incur deficits in governmental spending. He was willing to spend the available money, but did not want to spend anything more. In contrast, the current bill being debated by the Senate, 100% of the $900 billion price tag of the new stimulus bill will be deficit spending. As pointed out before, if the velocity of money is truly seven times the GDP that will be created under this single bill is vastly greater than the GDP of the entire United States in the 1930’s.

While it’s true that it took 10 years for the economy to improve from the Great Depression, what we have now is completely different. With the massive influx of cash into the economy, I would anticipate a significant recovery in the economy within the next 12 months.

I did not set out to write a long dissertation on economics, but since it is so important to today’s economic environment I elected to go through the entire explanation. For those of you who do not believe economics works anymore, I highly recommend you refer back to this posting in 12 months to determine the credibility of the information I have provided. While we receive a lot of questions from our blog readers, it’s not practical for us to address all of them on a national blog. We usually answer questions on an individual basis, but this time I thought the questions were important enough to all of my readers that I wanted to take the time to fully answer them.

As always, thanks for taking the time to read the Rollins Financial blog. Please let us know if you have any questions or comments. Best regards.

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