Doom and Gloom and the Economy

Although, this is a tech blog, I strongly believe that a good developer must be an Erudite. Given this, I feel justified in writing about the economy in this blog.

We are living through historic times. Mid last year, I started getting very scared and started blogging about randomness and the economy.
http://orangemile.blogspot.com/2007/05/black-swan.html
http://orangemile.blogspot.com/2007/07/supply-of-money.html

You will notice that in the Supply of Money entry, I actually wrote about the likely hood of the collapse of world economy due to the unsustainable supply of fiat money.

What's interesting about those entries and that time period is why did my mind shift to the arcane topics of money supplies, carry trades, fiat money, when the blog entries before and after clearly deal with the arcane topics of technology. Perhaps, my subconscious started to pick up on the feelings of uneasiness in the global market; hiccups if you will. I can't possibly attribute those entries to knowledge, because I am simply not qualified to speak of money supplies, fiat currency, and carry trades.

So, what is happening today is a global loss of confidence. What is interesting is that companies, specifically, banks are hoarding cash rather then people. I would argue that if people started hoarding cash than we're all doomed. The global economy would come to a scretching halt. Chinese economy will collapse, probably throwing that country into either Marshall law or revolution. America and Europe will fall into severe and prolong depression taking the rest of the civilized world with it. Africa will fall into an even lower level of sustainability with probably wide ranging civil wars due to lack of food and an acute demand for natural resources such as diamonds, gold, and oil. India's economy will also take a severe beating, but I think they will remain a loose democracy. If they position themselves well, they may end up being the next superpower.

Right now, the US government is printing money at an ever faster clip, giving it away, almost for free, and nationalizing large areas of the financial industry. Money is flooding the global economy. What's interesting is that we are actually in the period where money is actually disappearing. As the perceived value of assets fall, money disappears. The US Government then tries to fill in the gap of lost money, by providing more money to the institutions whose wealth disappeared; hoping against all hope that the newly provided money will be used to create more money by the institutions. Let's recap how money gets created. A person decided to do something on credit, let's say by a house. They go to the bank and say give me 300k to buy a house. The banks gives you the money, and you go buy a house. The thing is that the 300k is actually some other depositor's money. Money the bank doesn't actually have. What's happening now is that the bank thought it had 300k loan asset. But instead, the 300k is really only a 200k asset. This means that if you default, the bank looses 100k of someone Else's money. If enough loans do this, the bank won't be able to cover the loses, confidence in the bank erodes, people start to retrieve their deposits, and of course, after some interval, the bank simply runs out of money to give out to depositors. This is why the FDIC was created. This is a standard Ponzi scheme. In other words, if the asset side of the bank balance sheet starts to reduce, they will reduce the amount of new loans they can give out, and by so, reduce lending, which will probably drive the interest rates up because there are less institutions lending. This actually means the opposite of what I said earlier, money isn't destroyed, the rate of creation just reduces. The bank industry is structured as a very calibrated entity, with a minor hiccup in cash flows or perceived cash flows destabilizing the entire industry. The Fed is trying to erase the perceived losses from the Bank's balance sheet, and by so, start up the loan process. Another interesting thing is how many industries rely on having a continuous supply of new loans. Imagine a ponzi scheme applied to the car industry. If Ford borrows money to pay it workers, hoping that in the future it will sell enough cars to pay back the loan, except it doesn't, so it borrows more to keep going. At some point it actually needs to borrow from Person A to pay Person B, and on and on. This should end at some point when there is no-one else willing to lend to the said company. But, unfortunately, for most companies there is always someone willing to lend. This is partly due to the obscurity/opaqueness of the financial industry. Now, our current scenario, where the said company can't get a loan not because of the financial condition of the company, but because of the financial condition of the lender; all lenders.

What the Fed is trying to do now is fight the deflationary path. Money is becoming a scares resource, not because there is not enough of it, but because banks are hoarding it. A lot of people are also talking about hyper-inflationary model. I don't see this happening, even if I believed it for awhile. In a hyper-inflationary model, you have too much money. This is unlikely because the Fed can always mop up the money supply; and because the world is dollar denominated, at least for the foreseeable future. I think what is more likely is nationalization of a number of areas, and banks, a significant increase of money available to the banks, guarantee of bank assets, forced reduction of inter-bank rate, and a forced reduction of the interest rate payed by home owners.

Interesting reads:
http://en.wikipedia.org/wiki/Fractional_reserve_banking
http://en.wikipedia.org/wiki/Credit_default_swap

There is another animal that hasn't received much news: credit default swaps. This instrument is a form of insurance against default. The problem is that this is not based on anything, and the current amount of outstanding CDS is a few times larger than all money combined ever produced. This means that the government needs to do its darnest to make sure those CDS contracts never come due, because if they do, all financial institutions will file for bankruptcy, governments will default, end of the world, etc....

So, what is the government to do. Money must be made cheaper to a point where it is basically free. This will allow the banks to start to give out loans, this would spur the market for re-financing, which should save some borrowers. At the same time, the government will probably start with the regulation. We will see a period of a slow down - recession, in which the disaster of the day, will become a distant memory, and we will start up with the next bubble, maybe energy, maybe the housing sector again to a lesser form, although, this will probably be regulated to the gills. My guess energy or commodities. But the bubble won't start until the people regain confidence, which will take a few years.

I repeat, the Fed must make money cheap. After a recovery, they will attempt to make money more expensive again to starve off another bubble, but they will tread very lightly to avoid any more panic. This means that rates will stay cheap, or only very gradually over a long interval will start to go up.

Of course, there is another animal in this picture: US treasury bonds backed by our taxes. I don't fully understand this animal and it's relationship to the money supply, but hopefully, in the next few blog entries...