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Two economies

March 11th, 2008

The Australian economy is still booming, but the shadow of the global credit crisis is growing longer every day. Some items

* Most observers now agree the US is in recession
* With negative real interest rates in the US for terms up to five years (you can actually buy negative-rate inflation-protected bonds) commodity price inflation seems bound to continue. This is good for the Oz economy while it lasts
* It now seems clear that someting like half of all subprime mortgages will eventually go into default (many have already been foreclosed and 20 per cent are currently delinquent
Much the same is true for Alt-A and other limited-doc loans. The big question now is whether mortgages guaranteed by the quasi-public Fannie Mae and Freddie Mac are in fact secure. As with all implicit guarantees, the assumption that the Federal government stands behind these corporations is marvellously effective until it is actually tested.

Can we keep on growing while all these processes and more work themselves out? I don’t know and I doubt that the Reserve Bank does either. But if I were setting monetary policy, I’d be very cautious about any further increase in interest rates.

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  1. SJ
    March 13th, 2008 at 21:20 | #1

    “but someone definitely made off with half of your money.”

    That was bad cutting and pasting, and premature hitting of the submit button.

    The final sentence should have read something like:

    “Somebody probably benefited during the intervening week, and you can’t tell who it is, but half of your money is gone.”

  2. Will
    March 13th, 2008 at 21:24 | #2

    SJ, I agree that cash is increased by printing more of it and reduced by destroying it. But its not increased or decreased by anything else, and certainly not by “fractional banking”. Fractional banking is nothing magical, and it doesn’t create cash. It simply creates equal amounts of assets and liabilities (a bank deposit is an asset to the depositor and liability to the bank). When you net these out the cash stays the same except, as you say, to the extent that it has been printed or destroyed.

    And in finance I strictly don’t care about the real value of the cash. I just want to end up with more cash than I started with. That is not a moral statement; finance is simply about cash, nothing more. Economics, presumably, is about value.

    Now it may be that I can increase my cash by taking it from other investors and players in the financial markets. But if I happen to lose it, then maybe I can get the government to print more and give it to me on the basis that I am too important to “fail”. The banking/finance industry is happy to pursue both strategies. Of course as you very correctly point out, the latter leads to inflation and a devaluation of money. That is why it is still, effectively a transer from the winners in the game back to the losers and, I think, a bad thing.

  3. March 13th, 2008 at 21:35 | #3

    Not another thread of doom!
    .
    SJ,
    Money is not a claim on something of value. There are several well-known definitions of money and I do not think any of them is that wide. Even Rothbard (who said insurance contracts were money) would not go that far!

  4. SJ
    March 13th, 2008 at 21:40 | #4

    Will Says: “SJ, I agree that cash is increased by printing more of it and reduced by destroying it. But its not increased or decreased by anything else, and certainly not by “fractional bankingâ€?. Fractional banking is nothing magical, and it doesn’t create cash.”

    This suggests to me that you need to go back and re-read some of your texts.

    Tell me what you think “cash” is. Does it include what you have deposited at, e.g. Westpac?

  5. SJ
    March 13th, 2008 at 21:47 | #5

    Andrew Says:

    SJ,
    Money is not a claim on something of value. There are several well-known definitions of money and I do not think any of them is that wide.

    Andrew, after you suffered an embarrassing putdown by James Haughton earlier today, I’m quite surprised that you’re looking for another one.

  6. March 13th, 2008 at 22:58 | #6

    “Money� is a claim on something of value. For example, under the gold standard, money was a claim on a chunk of gold. Under a government backed fiat money system, the money is a claim on the government’s future revenue stream, i.e. a sort of general claim on the economy of the country.

    Money is not always a claim. In fact it is often not. A neat example is the story of the Swiss Dinar:-

    http://en.wikipedia.org/wiki/Swiss_dinar

    Even with gold standards it depends on the variety. The Bretton Woods gold standard was essentially an offer not a claim. They offered to convert dollars for gold at a fixed ratio and people took them up on that offer. Whilst the private currencies of Australia pre 1910 were very much promisory in nature.

    http://terjepetersen.wordpress.com/2007/04/12/the-bank-notes-act-of-1910/

    A fiat gold standard such as Bretton Woods entails an offer to exchange X currency for Y gold as this moment in time. A gold backed promisory note offers to exchange X wads of promisory notes for Y ounces of gold for all time.

    Of course it all depends on how loose you want to be with the word “claim”.

    Fiat money such as the current Australia dollar is not valuable because it is redeemable for anything. It is valuable because it has utility in trade and a degree of scarcity. Its value is set by supply and demand, much the way the value of gold is set (or potatoes for that matter). It differs from a promisory note which has value by virtue of its redeemable nature and the reputation of the party offering the promise. And the value for the unit of account used in the particular instance to formulate such a promise is of course central.

  7. Will
    March 13th, 2008 at 23:10 | #7

    SJ, to be honest I’m not very worried by what textbooks say about finance. My deposit with Westpac is absolutely not cash as a financier thinks of it. It is a financial asset; in fact, it is our job to create financial assets, so we certainly know there is a big difference between the two. That is why, to say the least, depositors in banks sometimes worry about getting their cash back and why we bother to have bank regulation.

    From Westpac’s side, my deposit claim is a financial liability that, in the overall financial world, is created at the same time and exactly offsets my financial asset. The only cash left from my depositing $100 with Westpac is the $100 that they now have and I don’t.

    Now Westpac can lend that $100 out and get it back as a deposit 200 times if they like, creating $2,000 in new money supply, by that definition; the fabled multiplier. But there is still only the same $100 cash, and $100 in net assets. That is what is was referring to as conservation.

  8. SJ
    March 13th, 2008 at 23:13 | #8

    Terje Says: “Money is not always a claim. In fact it is often not. A neat example is the story of the Swiss Dinar:”

    Terje, you’re confused. It’s often the case that the value of the claim becomes less, but it’s just wankery to say that there wasn’t a claim in the first place.

  9. SJ
    March 13th, 2008 at 23:16 | #9

    Will, I’ll respond to your latest post tomorrow. Time to get some sleep.

  10. Will
    March 13th, 2008 at 23:21 | #10

    SJ, middle of the day for me, but I look forward to it.

  11. smiths
    March 14th, 2008 at 09:24 | #11

    andrew,

    i didnt actually call you delusional, just a general reference to the optimists,

    economics is not a science, as a result it leaves a lot of room for opinions and egos on all sides,

    i just have a thing about anyone talking as if something is known and certain,

    it is my contention that hardcore freemarket acolytes ought to be taking stock and re-assesing some of their cherished beleifs at the moment,
    yet despite all the problems occurring even the mention of regulation is sneeringly dimissed,

    and china as another example, it amounts to a heresy in australia at the moment to suggest that china might not be able to continue as it it has,

    i shouldnt have made it personal, for that i apologise, i want to discuss and learn, not argue

    maybe i’m sensitive because the last time i posted two years ago in a discussion on china and trade i addressed razor and said
    razor, your faith in the “economies that are flexible enough and government policy that is flexible enough� to deal with large problems is brave indeed,
    given that there are some very good accounts available of how much for instance, the US fed and money funds are now interefering in the markets to try and prop them and how much money is being printed i think your faith is misplaced,

    smiths – that piece reads like the Da Vinci Code and has about as much credibility…
    As for your claim about ‘printing’ money – I’m not seeing the high inflation rates that printing money has historically caused – why isn’t this happening?

    mocked

    but where’s inflation now? and how well is the economic system dealing with all these shocks?

  12. smiths
    March 14th, 2008 at 09:30 | #12

    and
    actually andrew it was in that thread 2 years ago that you wrote this,
    I remember talking with a member of the League of Rights during the 80s and hearing an ernest explaination of how the amount borrowed in the world was more than the amount lent. This was apparently the result of some banking conspiracy.

    given the discussion in this thread about what constitutes money, i have another question,

    if the amount borrowed is to be repayed plus interest, is the interest ‘created money’ and how does this not increase the money supply and therefore amount to more repayed than lent

  13. March 14th, 2008 at 11:44 | #13

    Terje, you’re confused. It’s often the case that the value of the claim becomes less, but it’s just wankery to say that there wasn’t a claim in the first place.

    No it isn’t. Rum became money in the early NSW colony. Rum was never a claim on anything. Likewise gold coins have been used as money without being a claim on anything. However as I said earlier:

    Of course it all depends on how loose you want to be with the word “claim�.

  14. March 14th, 2008 at 11:52 | #14

    if the amount borrowed is to be repayed plus interest, is the interest ‘created money’ and how does this not increase the money supply and therefore amount to more repayed than lent

    No the interest isn’t created money. Or at least not necessarily. It is renumeration for a service. The notion that you are alluding to is summed up in the following story:-

    http://www.bullnotbull.com/blog/?p=48

    However the story of the eleventh round ignores some fundamentals and is flawed.

    Firstly banks don’t on aggregate lend their own money but rather they lend other peoples money. And so the interest flows not from borrowers to banks but mostly from borrowers to lenders. And the lenders essentially provide the money to the borrowers to finance the interest payments by buying the labour, services and goods of the borrowers.

    Money circulates and lending merely alters the flow.

  15. John
    March 14th, 2008 at 13:54 | #15

    Andrew Reynolds,

    Did a bureacrat steal your girlfriend once?

  16. March 14th, 2008 at 15:25 | #16

    Smiths,
    Again, I defer to Terje on this – I believe he is right.
    .
    John,
    No – I just have to deal with people blindly (or, occasionally not so blindly) enforcing regulation on a daily basis. It gets really frustrating explaining things to someone who has power over people but no real stake in their future, no real care level about their present and no interest in their past – but has a fixed idea about the rules.

  17. SJ
    March 14th, 2008 at 21:14 | #17

    Terje:

    Sorry, it was late, and I should have read the “Swiss Dinar” story more carefully. I didn’t, and jumped to a wrong conclusion. My fault.

    Will:

    I guess I’ve gotten used to thinking of M1 as “cash” rather than currency as cash. I even typed “M1″ above when I meant “M0″.

    E.g. cash on hand on a balance sheet doesn’t refer to a pile of banknotes in the company safe.

    So yes, you’re right that currency is conserved (in nominal terms).

    I don’t think this necessarily gets us anywhere in identifying who the winners and losers are in the current debacle, and it invalidates the explanation you gave at #43:

    It is simply confirming the previous transfer of money wealth from investors and their bankers to those who previously sold assets to them at inflated prices; i.e. prices that valued the net assets in the system (assets less liabilities) at more than the amount of cash available to buy them.

    But the amount of what you call “cash”, i.e. currency, is never enough and there never has been enough currency to buy all of the available assets, so if there’s any explanatory value in your model, I’m just not seeing what it is.

    Andrew:

    Chin up. :)

  18. Will
    March 14th, 2008 at 22:07 | #18

    SJ, thanks for the conversation but I’ll make this my final post on the subject.

    I think the simple answer to the “money” issue is that all loans and debt securities (in fact almost all financial transactions) are denominated in and require payment in currency.

    Now it is more convenient for the recipient to direct that the currency be paid into its designated bank account (in which case the recipient is, effectively, immediately on-lending the currency to their bank), rather than brought round in a suitcase.

    But that doesn’t change the obligation on the borrower to provide currency, and they have to ultimately get it from the fixed pool of currency that is, at that point, available in the economy (whether physically or through the payments system).

    I think that the rest of my comments are self-evident if you focus on this, so ‘ll just leave your last comment about explanatory power because I’d only be repeating my previous posts if I tried to respond.

    Cheers.

  19. SJ
    March 14th, 2008 at 22:37 | #19

    It’s OK, Will. Discussions like this force us to think about our assumptions. I’m not doing this to prove that I’m “right” about anything, and I’m pretty sure that you’re behaving the same way.

    We have to test our ideas somehow.

    I look forward to reading your next comment on this or any other subject. :)

  20. Will
    March 14th, 2008 at 23:03 | #20

    SJ, I should probably use more smiley faces! I’ve really enjoyed the conversation and this forum is certainly the best outlet I’ve found for this type of discussion.

    And in the spirit of The Untouchables, never take MTM* to a M0 fight.

    * Mark-to-market valuation

  21. Ian Gould
    March 15th, 2008 at 00:42 | #21

    Following on from the Swiss Dinar – during World War II Japanese forces in New guinea issued promissory scrip in exchange for good requisitioned from the locals (The promissory scrip was in effect a promise to redeem the scrip for Yen after the war).

    The Japanese government repudiated the scrip after the war. However it continued to circulate in th highlands of New Guinea along with notes from the pre-WWI German colonial government; allied promissory script and various British and Australian notes.

    Some of the Japanese scrip was printed on plastic meaning it wasn’t at risk of rotting or being colonised by fungus like the other currency in use. This scrip traded at a premium to other currencies.

    It’s probably no longer in circulation but Japanese scrip continued to be used as currency for twenty or more years after the war.

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