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Deflation 4: Does Wealth = Money? If so, What About Oil, Gold and the Mexican Peso?
Economists who adhere to Milton Friedman’s concepts say that inflation keys off the money supply, although the number-keepers define inflation in terms of the prices of goods and services. So pervasive is the Friedman idea that lots of people now say the dollar will sink and inflation will reign because the government has been “printing” so much money and is planning to “print” even more - they equate the huge Federal deficits with an increase in the money supply. (I put “print” in quotes because most of the money is not cash - it’s accounts at banks that exist in the form of computer digits.)
But what if the money supply is more than M3 or M2, which measure institutional accounts where people and companies keep their “money”? What if the money supply also includes the net value (after debt) of people’s homes and their stock portfolios and the market value of privately owned businesses? In other words, what if wealth = money?
The wealth supply has been drying up over the past six to twelve months at a huge clip. Many trillions of dollars in the U.S. alone has disappeared - and a lot more than that in global terms. Federal deficits - both present and projected -are minor in comparison with the loss of wealth. Thus in this sense there are fewer dollars around compared with GNP. Therefore, the value of the dollar should be rising. And guess what? This is what it has started to do. The U.S. dollar index is up about 9% since early September, 2008.
Does money = wealth? Well, we’ve been using houses like we use bank accounts and we sometimes use stock certificates in the same way. Charities are happy to accept stock certificates - so are many mutual funds that will create an account in exchange for stock. Banks will lend against either one, creating accounts which are certainly part of the money supply in anyone’s measure. Private companies also use their net worth to create new bank accounts when they see an investment opportunity. So it seems very likely to me that we must include these assets - normally called “wealth” rather than “money” - in the money supply.
And if that’s the case, then the money supply has been very much in decline over the recent past and is likely still declining. Therefore it is not surprising to see the dollar strengthening as equity values and housing prices continue to decline. And since both defaults on car loans and commercial loans are likely to increase markedly over the next year thus destroying a lot more wealth in the banking system, money supply is likely to continue to decline regardless of “huge” Federal deficits in the next few years.
If declining money supply means fewer dollars available compared with demand for them, the dollar may well continue to strengthen as the U.S. economy continues to suffer. A strong dollar also implies weak commodity prices (as denominated in dollars), including oil and perhaps gold which is also looking weak lately.
Of course, the counter-argument is that foreign dollar holders may want to sell them in view of U.S. budget deficits. My guess is that foreign dollar holders don’t have much alternative. Name another strong economy with a fiscal surplus and a liquid currency aside from the U.S. I don’t know any such animal. Moreover, if the dollar does continue to strengthen, that will also give foreign holders the confidence to continue holding dollars.
This point of view was circulating in my mind when I read an analysis by Hoisington Investment Mgt. Co. forwarded by John Mauldin. It stated the following:
The late Nobel Laureate, Milton Friedman, noted in his 1963 book, Monetary History of the United States (coauthored with Anna Swartz), that the money stock decreased by a massive 31% in the Great Depression. The turnover of that money, called velocity, fell 21%. Nominal GDP equals money multiplied by velocity. Consequently, from 1929 to 1933 the breakdown of both measures resulted in a contraction in nominal GDP of approximately 50%. However, Friedman postulated that if the Fed had not let money shrink, velocity would have been steady and the Great Depression would have been averted, i.e., nominal GDP would not have collapsed.
If you consider equity and housing values as another component of “money”, how much more dramatic than the quoted decline of 31% was that of the Great Depression? I can’t quantify the decline to date in either traditional money supply or total wealth. But it has to be huge.
American banks include trillions of dollars of assets on their books that are presently known to be toxic (collateralized debt obligations - CDO’s) and even more loans based on cars and commercial real estate that are expected to become toxic in the next year or so. These assets are very much part of the money supply. Their decline in value and their lack of liquidity are a major reason so many banks are not making new loans. They are why Krugman and others are saying that many banks are worthless and need to be recognized as such, liquidated, and consolidated and not “bailed out” by federal cash.
John Mauldin seems to be in substantial agreement with these ideas. In his 1/17/09 letter he wrote the following:
We got the Consumer Price Index numbers today, and they tell a tale of deflation. On an annualized basis, the CPI for the last three months was a negative -12.7%! Even core CPI, which is without food and energy, was a minus 0.3%. The CPI for 2008 was just 0.1% for the whole year. This was the smallest calendar-year increase since 1954, and it’s down from 4.1% for 2007. (To see the whole release and data, you can go to www.bls.gov.)
As I have been pounding the table about, a credit crisis and imploding balance sheets, a housing crisis, and a massive earnings shortfall that yields a relentless stock market drop are all independently deflationary. The combined forces are massively so. To think that a mere trillion or so dollars in stimulus will be enough to reflate the US and the world economies is simply not realistic.
A liquidity trap is a situation in monetary economics in which a country’s nominal interest rate has been lowered nearly or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy. In these situations, borrowers prefer to keep assets in short-term cash bank accounts rather than making long-term investments. This makes a recession even more severe, and can contribute to deflation. (Wikipedia)
He said it better than I. I just had to say it in my own words to feel like I understand it. In either case the conclusion has to be the same: one should be very careful about owning stocks. And if I’m right about the dollar actually getting scarce despite huge federal deficits and thus leading to dollar strength, then oil and most commodities - and therefore oil stocks - will not fare any better than the average stock, perhaps worse.
Mexico
Incidentally, my favorite short is the Mexican peso. Mexico has been holding interest rates extraordinarily high for many months which has kept the decline in the peso to only the 30% +/- that occurred in September and October last year. Mexico announced last Thursday that its weak economy requires it to reduce interest rates. Have you ever seen only one interest rate reduction? No, they come in waves, and I suspect this is the first of many to come for Mexico.
As I’ve written so often, Mexico is dependent on oil exports to support over 40% of its federal budget. It cleverly fixed its oil export prices at $75 through the fall of 2009 by hedging but that will run out soon enough. More importantly, their production is falling, oil exports are falling even faster, and Mexico could become an oil importer within five years. Add to all that a major drug war and endemic political corruption in Mexico and you get a very sick and potentially dangerous country.
I think Mexico is a major debacle in the making. And if Mexico gets pneumonia it will be hard for the U.S. not to catch some part of the bug.
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22 responses so far ↓
1 Jose // Jan 20, 2009 at 3:32 pm
“Does money = wealth?”.
No, it is not. Only if you believe it, and can convince the others (fiat).
http://elbronce.blogspot.com
2 Isaac // Jan 20, 2009 at 10:40 pm
“Name a strong economy with a fiscal surplus and a liquid currency. I don’t know any such animal.” Does China fit that description? Why don’t they put their money into their own economy, rather than buying our treasuries? Thanks for the explanations. Gobama.
3 KV // Jan 20, 2009 at 10:45 pm
Why do we have to invoke Friedman et. al. (through third or forth hand) and convoluted thinking about dollar to justify commodity prices, driven up by speculation to nearly bubble levels, that are correcting to may be a level where Economics 101 theory of supply-demand might begin to operate?
Exxon closed at $76.29 (1/20/09); it was about $35 at the beginning of 2003. It is still over 100% gain in five years. Exxon’s profits are much more dependent on how many gallons of gas they sell, and how many barrels of oil they process. Here is politically correct observation: go Obama! Stimulate the economy and especially alternate energy so that oil has competition and we never get taken for a ride by snake-oil salesmen from Texas or from anywhere else in the world.
4 Simon // Jan 21, 2009 at 2:32 am
Really interesting essay Jim. I’m beginning to get a theme in my head for 2009. Thanks
5 Karol // Jan 21, 2009 at 3:14 am
Hi Jim,
Somehow I think of wealth and health together, having a whole lot of money is not having either, rather it is just having a whole lot of money.
I think that people who try to explain things as being the way they are are doing a good job. It never ceases to amazes me the way events can be explained.
The current concern for the Energy Investors is…did we miss the train?
Not likely is my answer. And even if one of us did stay in the train station we all know it wasn’t the last train.
You must have chips to play meaning you hold stocks…AND it also means you have cash on the sideline. Cash holdings could be dollars or pesos. It could even be hiding in the form of a company that pays dividends and does not bounce much such Frontline or hiding in gold and silver ever so slow.
We all know about the James Bond movie Gold Finger. It’s like the gold being stored at Fort Knox is worth stealing. Well, today’s gold is being store on lots of double hulls and…the trading market. Few are those who have an 18 wheeler ready to pick up their black crude.
Lastly.
Since the Energy site you watch over is now considering general market conditions, since some people believe that the market is a tide which raises and lowers all boat I pegged you to consider this:
Peak Oil!!!!
Peak oil is happening to different countries of the world at different times. You keep us posted with regards to Mexico. That is to say Mexico has reached it’s peak oil.
So now you advise shorting Mexico…?
Not a good thing.
Why?
Because shorts help to destroy.
(which may not be a bad thing)
6 KV // Jan 21, 2009 at 7:32 am
Issac - liked your post. Gobama! Also, something called “Reserved Currency” drives the accumulation of dollars by Chinese. Chinese currency is not a “reserve currency”, for whatever reasons.
Much of Jim’s argument is based on dollar being a reserve currency. When Saddam started pricing oil in Euro, he threatened the $ standard or commodities - oil - from being priced in $ to something else, like Euro, and that would require US to hold Euro like Chinese holding dollars to get a price break on oil.
If Chinese don’t hold dollars in their reserves, people would not sell them stuff, oops, commodities, at slight discount. Chiense factories then can produce good cheaply and flood the market, while piling up the reserve currency. See the Ponzi scheme here?
So, commodities - oil is one hence energy, finance - money, and politics all intermingle, and if we remain ignorant of this stuff, the snake-oil salesmen from Texas or for that matter anywhere in the world can take us for a ride. Called speculation in learned circle, and gambling in the real world.
7 Peter Wenzl // Jan 22, 2009 at 3:42 am
Jim,
there’s an interesting study on the historic relationship between monetary base (or alternatively “broad money”) and inflation in different countries:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=708265 (click “Download” at the top of the page).
I found the charts quite intriguing..,.
Best, Peter
8 KV // Jan 22, 2009 at 9:02 am
Peter - Here is what Treasury Secretary Nominee has to say:
“The immediate goal should be for us to convince China to adopt a more aggressive stimulus package as we do our part to try to pass a stimulus package here at home,” Geithner wrote.
In fact he stressed that all of the U.S.’s trading partners would have to inject financial stimulus into their economies.
If not, they will become the garbage cans for inflating dollar.
9 KV // Jan 22, 2009 at 12:13 pm
OK, let us see if this passes Jim’s censorship.
The report cited by Peter (comment # 7) is very important for all to read as it indirectly shows that fixed debt disappears (becomes smaller and smaller portion in % becoming nearly worthless) when money supply is inflated. And, each and every Lassie Faire (unregulated) economy practices have failed (including Reagan and Bush II) resulting in severe financial crisis. S&L under Reagan, and Banks under Bush II. Deflation is a buzz word for the advocates of the Lassie Faire to hide behind to continue to plunder. If the countries that are tied to “Reserve Currency” (see my comment # 6) do not inflate they become the garbage can for inflated dollars while toiling away producing goods at lower and lower inflation adjusted prices. They will be wise to listen to Tim Geithner’s advice, (comment #8) though deflation advocates will not agree with him as plundering diminishes and we go back to Economy 101, the rules of supply and demand, and not the rules of crapshoot or gambling, like oil going to $250 or more. Finally, I will not be surprised if a generalized reserve currency comes into existence in a few years.
10 jkingsdale // Jan 22, 2009 at 1:03 pm
Nobody is advocating deflation. As I’ve repeatedly said, deflation is the enemy. It is a psychologically reinforced economic phenomenon that destroys values and economies. Once deflationary psychology takes hold it is very hard to change the downward direction of the economy. That’s why economists fear deflation so much. It is not a good thing.
I don’t think deflationary psychology has taken hold yet. But it’s not far away, I suspect. The risk that it will take over is primarily why I prefer to stay mostly in cash rather than bet that “the bottom” is close.
Nobody is advocating inflation either. The fact that debts become of lesser value during inflations is simple arithmetic. So what? Nobody wants to buy a bond when there is a stong inflationary trend. That’s why interest rates rise when inflation grows, so bonds can be sold.
The point I was trying make is simply that the monatary base that economists say determines whether deflation or inflation or neither is extant perhaps should be expanded to include other forms of wealth than simply “money” as defined by M2 - like the equity value of businesses and houses. My argument is that such equity values can easily be translated into M2 when the equity owners desire and thus are semi-money. Strong evidence behind my argument is that equity values help determine people’s spending patterns just as money does, and spending is the key.
We are having a discussion about how things work in the economy, not an argument about what should be done. There is no hidden political agenda here and no need for histrionics.
Does the reserve status of the U.S. currency contribute to its value? Sure. In fact I wrote that “huge” federal deficits will probably not cause the dollar to fall precisely because it is a reserve currency. I said, “My guess is that foreign dollar holders don’t have much alternative. Name another strong economy with a fiscal surplus and a liquid currency aside from the U.S.”
11 KV // Jan 22, 2009 at 1:50 pm
The very reason we are in financial crisis is that we allowed “equity value”, actually, we did better. We even allowed future anticipated rise in “equity value” and mortgages for 110% of current equity values were given out. Nor there were any checks on income, except personal certification. Then, this all was transformed into A, through AAA rated debt securities and marketed to us all (insurance companies, pension funds, IRAs etc: see Aflac and AIG). If this was not enough, there were debt swaps and nobody really knows who owns what and who owes what. Total unregulated nightmare. Here are things that have not worked in the economy, though they were very attractive in the short term.
Paul Volker thinks it will take 2.5 Trillions to unwind this, or a pile of 1000 dollars bills that will reach more than half way to the Moon.
Between deflation and inflation, there is something called stagflation. All my favorite restaurants and stores have increased prices by 10% or more, though I do not have to wait in line. A perfect sign of stagflation.
On reserve currency: it came into existence by an accord, and it can end by an accord, and Geithner does not want to go there as that will unleash massive inflation in the US, so he is advocating world-wide monetary inflation. The dollar is liquid only because of the accord. For the record, we don’t have fiscal surplus.
12 Gramps // Jan 26, 2009 at 12:13 pm
Wealth = money?
Jim, so if you want to argue that wealth=money, and collapsing wealth is equivalent to a collapsing money supply (aka deflation)… I have to ask the very obvious question:
When “wealth” was increasing 15-20% per year (housing notably) from 2001-2006, did you advocate that Fed Funds should be increased to match that “inflation”? Can you provide a link to an article where you make this argument?
I have asked this question of all the deflation advocates — and not one has replied.
If you want to argue that wealth = money, then it should also hold when times are good — otherwise, you are simply arguing for keeping rates perpetually too low
Please give us the link to the article in which you argued for 15-20% Fed Funds during the boom
13 Jim Kingsdale // Jan 26, 2009 at 1:34 pm
Hi Gramps. Yes I did remark on the inflation in asset prices that we were seeing sometime around the summer or fall of 2007. I don’t recall if I said that interest rates should be increased but certainly in retrospect it’s clear they should have been. There are other ways to fight asset inflation in addition to interest rates - such as increasing margin requirements - that would have been appropriate. Now, of course, the market is taking care of the problem of inflation.
If and when we get to a time when home prices and stock prices have stabalized and perhaps turned up and if the Fed is still printing money, then at that point I suspect we will see inflation again. But I continue to think that so long as non-monatary wealth measures are declining, an increase in the money supply per se will not result in general price increases.
14 KV // Jan 27, 2009 at 1:37 pm
In the light of the following article in Bloomberg, could we say that peak oil is dead? First, these oil fields are way deep, and may be the whole coast of north and south Americas is just oil. And may be, just may be the “wealth” Jim sees as deflating, is really a correction in the bubblonomics?
Exxon, Hess Oil Field May Hold 10 Billion Barrels, Estado Says
By Jessica Brice
Jan. 25 (Bloomberg) — Exxon Mobil Corp., Hess Corp. and Petroleo Brasileiro SA’s BM-S-22 offshore block in Brazil’s so- called pre-salt area may hold as much as 10 billion barrels of oil, O Estado de S. Paulo reported, without saying where it got the information.
The block operated by Exxon Mobil in Brazil’s Santos Basin may have more potential than the nearby Tupi field, which contains as much as 8 billion barrels, the newspaper said, citing unidentified people with access to results of some studies.
If confirmed, Exxon Mobil could become the operator of the biggest oil reserve in Brazil, the newspaper said. Based on crude prices around $40 a barrel, the oil may be worth as much as $400 billion, Estado said.
Exxon Mobil, Hess and Petrobras, as Brazil’s state- controlled oil company is known, announced Jan. 20 that they found evidence of oil in the block. The companies haven’t determined if the find can be developed commercially. Exxon and Hess each own 40 percent of the concession, and Petrobras holds 20 percent.
A message left by Bloomberg News with Exxon Mobil’s press office was not immediately returned.
15 Karol // Jan 27, 2009 at 11:26 pm
wealth/money and advocating deflation:
Yes, Jim had discussed inflation in asset. And any comment toward increasing interest rate were not needed. The general population was simply blind sided by the “big guns” of banking.
I am of the thinking that housing still needs to fall to the 1999/2002 level which means deflation.
Next, peak oil is not dead. As I understand things oil is a form of carbon. The finest form is diamonds. Is it the case that just digging a little deeper will yield bigger stones?
Then again, why are diamond mines and oil fields so far apart?
And !!! can it be that a car could be fueled with diamonds?
16 KV // Jan 28, 2009 at 12:09 am
For near to mid term, peak oil is dead. Long term depends on how fast we develop alternates and tax oil to keep demand in check. And, oil is hydrocarbon, not just carbon, as such, we can burn anything that is hydrocarbon, and that includes all mamals, for that matter all life on this Earth, and even biodiesel. Of course, you can drive a car by burning diamonds, but it might look like a locomotive, and coal is cheaper.
Solar, wind, waves are without carbon, and will last longer than our civilization.
17 KV // Jan 28, 2009 at 4:19 pm
From Fortune: …Putin, now Russian Prime Minister, delivered a 40-minute speech touching on everything from why the dollar should not be the sole reserve currency to how the world needed to enter into a smart energy partnership with Russia.
…Putin’s withering reply to Dell: “We don’t need help. We are not invalids. We don’t have limited mental capacity.”
Link: http://money.cnn.com/2009/01/28/news/companies/dell.davos.fortune/index.htm
I only wonder how we got here!
18 robert essian // Jan 29, 2009 at 1:09 pm
It is estimated that spending $150 billion dollars on stimulas equals 1 million jobs.
That it is estimated to complete a state of the arts electrical grid will cost 2 trillion dollars. It seems to me we could committ that kind of money when we pay 500 to 700 billion dollars on importing oil.
If we spend 500 billion a year then we would pay this off in 4 years. After that it’s free (essentially). We use wind, solar, and wave energy.
Take natural gas and use it as Grandpa Pickens suggest for our heavier fleet, use electric/natural gas hybreds, trains, and we have time to figure all the other stuff out.
After 4 years we can take the 500-700 billion savings and put it towards our legacy costs like social security, national health care or any number of things.
Energy, (hydrocarbon) base is believed to be running out at least in a cost bases. Meaning for every dollar spent we get 7 dollars of oil, and this profit margin is dropping pretty quickly. In 1970 it was 30 to 1 ratio (approx.). The point is no one will spend more to get oil out of the earth if it isn’t profitable.
It’s time to pull our feet out of the mud and do something positive because truthfully no one person has the answers, but we are killing this planet because of hydrocarbons. That appears to be the truth.
Even this is debated endlessly though. I say the proofs in the pudding, and even if it’s not why risk something we cannot reverse for at least a thousand years if ever.
Oh!, the benefit of building out the infrastructure would probably employ everyone wanting full time employment in their chosen field. These newly employed, and spin off economy would remove our burgening housing supply, values would go up, and communities would have the money to upgrade schools, insulate them, make them more energy efficient or build new ones with their own tax base. No help from the government.
The employed would save some money in our banks and they can lend again. Profits would be up, and toxic debt would gain value again. We wouldn’t have to guess what it’s worth, create a bad bank so the government could pay way to much for this crap and yada yada yah!
The employed would pay taxes that could in turn be used to clean up whatever else is broken.
Now before anyone chides this as symplistic maybe it’s because it is that simple.
Inflation-Deflation will always be a balancing act but really what will it matter if there’s nothing to inflate or deflate when the planet decides to correct all our misgivings. What would it cost to humanity, and to the world economy’s if a Katrina hit New York’s coast line or China’s coastline flooded, and New Orleans floods again not to mention Florida.
Jim and everyone else I read says “stop trying to figure it out” well the way I see it is we need some victories to feel good about. We better figure it out and at least do something so obvious as building out this must needed ELECTRICAL INFRASTRUCTURE.
My God in heaven, we could have done this already with the money we spend protecting the free flow of oil around the world. The World Trade Centers would still be standing and our kids wouldn’t be fighting in country’s that are never, ever are going to appreciate anything about us. I don’t get it, I really don’t…Peace
19 KV // Jan 29, 2009 at 2:09 pm
RE - when greed goes rampart, reason goes away, and belicose take over.
20 robert essian // Jan 29, 2009 at 2:50 pm
KV, honestly I really don’t get it. What is the worlds infactuation with blowing things up with instruments of mass distruction that has no stimulative effect on anything except to make more things so they can blow other stuff up.
Greed is rampant that is true, and what is so sad is you can’t take it any money with you when you leave this place.
I could give a hoot about as to whether wealth=money, I know this, money pays bills, money creates more money by investing it, money pays taxes, and money moves economy’s. However, if you give money to the rich they hoard it for bigger pleasures than the other rich hoarder. Give money to the middle class and they’ll spend it if they know they have a job to look forward to.
Deflation, Inflation, stagflation, how about ruination…Peace
21 KV // Jan 29, 2009 at 9:03 pm
RE - Here is how I understand it: fear, that is transformed in hate and anger. So we blow things up, inciuding others’ kids by using our kids. And, if our kids get blown up we call them heros, and others’ kids are anything but heros. It is the fear of survival in all of us that greedy people exploit. Oil was elevated to survival level for the wants, you see, we all took a pill - red or blue and marched on. Same, in finance, we all wanted to amass enough wealth to last for generations.
22 robert essian // Feb 3, 2009 at 5:00 am
Professor, I need your help. As you know I am trying very hard to catch up on a lifetime of not being informed. I will admit I am groping for anything positive to validate my time spent reading and researching. I guess I need to know that my time is not being wasted on something I’ll never understand.
My question is: If the electrical infrastructure is stimulative short term, sustainable, and necessary (environmentally/employment) long term, would pay for itself in short order, and we could grow our economy without the constant threat of an oil caused recession (4 of the last five) lurking about that we don’t committ to this?
As always I respect (in advance) anything you have to say…Peace
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