Debt Rattle, April 26 2008: The Velocity of Money

Stoneleigh: The velocity of money is an important concept underpinning the liquidity trap we are entering. John Mauldin has a good explanation as to how it interacts with the money supply in this article, and I suggest that everyone reads the whole piece.

What is happening is something we have touched on here before - hoarding. The hoarding mentality is a psychological shift in response to perceived shortage. Hoarding represents a lack a trust that the supply of something will be adequate, or the price reasonable, in the future. The response is to stock up, even though this compounds the problem for everyone. People are currently hoarding food in many places, which acts to drive the price up further due to the increase in demand (see comment below with accompanying article).

Similarly, even if the money supply is increasing, a lack of trust results in banks hoarding cash, which sends the price of cash (in the form of interest rates on inter-bank lending) sharply higher and the availability lower. This decrease in the velocity of money makes it increasingly difficult to keep the market supplied, even though central banks are intervening in more and more aggressive ways. Combined with the on-going destruction of credit (which has acted as a money equivalent during the long expansion), the failure of the securitization model (which has acted to increase the velocity of money), the need for banks to rebuild reserves and the need for individuals and businesses to both cut spending and build savings, the liquidity trap becomes inevitable.

The Velocity Of Money

Now, let's introduce the concept of velocity of money. Basically, this is speaking of the average frequency with which a unit of money is spent. Let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 of flowers from you. You in turn spend $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, we would have $2400 of "GDP" from our $100 monetary base.

So, what that means is that gross domestic product is a function of not just the money supply but how fast the money supply moves through the economy. Stated as an equation, it is P=MV, where P is the Nominal Gross Domestic Product (not inflation adjusted here), M is the money supply and V is the velocity of money. You can solve for V by dividing P by M.

Now, let's complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few pages, please. Let's assume an island economy with ten businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the Gross Domestic Product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.



But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc., and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet.

Now let's complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. In order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does not increase, that means that (in our simple island world) on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase, GDP will stay the same. The average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.

Each business now is doing around $80,000 per month. Overall production is the same, but divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars so they buy less and prices fall. So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money "neutral."

It is basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down as will the price. If the central bank increases the money supply too much, you would have too much money chasing too few goods and inflation would manifest its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)

Let's say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP would grow to $24,000,000. That would be a good thing, wouldn't it? No, because we only produce 20% more goods from the two new businesses. There is a relationship between production and price. Each business would now sell $200,000 per month or double their previous sales, which they would spend on goods and services which only grew by 20%.

They would start to bid up the price of the goods they want and inflation sets in. Think of the 1970's. So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let's assume 10 million businesses, from the size of Exxon down to the local dry cleaners and a population which grows by 1% a year. Hundreds of thousands of new businesses are being started every month and another hundred thousand fail. Productivity over time increases, so that we are producing more "stuff" with fewer costly resources.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, new population and productivity or deflation will appear. But if money supply grows too much then you would have inflation....



....Now, why is the velocity of money slowing down? Notice the real rise in V from 1990 through about 1997. Growth in M2 (see the above chart) was falling during most of that period, yet the economy was growing. That means that velocity had to rise faster than normal. Why? Primarily because of the financial innovations introduced in the early 90's like securitizations, CDOs, etc. It is financial innovation that spurs above trend growth in velocity.

And now we are watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in and Wall Street began to game the system. End of game.

What drove velocity to new highs is no longer part of the equation. Its absence is slowing things down. If the money supply did not rise significantly to offset that slowdown in velocity the economy would already be in a much deeper recession.

For more information go to: http://www.frontlinethoughts.com/learnmore

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Predators

"Let me issue and control a nation's money supply and I care not who makes its laws."
-- Mayer Amschel Rothschild, Founder of Rothschild Banking Dynasty

Of course this is where we have descended to in the G7. With the big money center and investment banks fully in charge of the 545 people mentioned above. The G7 is now just banks run riot over us all. Recently a public servant decried PREDATORY the lenders and mortgage brokers. But the rot extends far, far wider than just those souls to encompass the person who uttered those words and, at this point, the current financial system itself. The US Congress and public servants are bought and paid for throughout the G7, and this is why we know our fate even now. To know our destination is to know history and the nature of men.

Public Servants and the current banking systems are stripping the G7 to the bone and the economy is the victim. Its hollow carcass on the verge of collapse and the gorging on it by the aforementioned groups must moderate to regain health or accelerate to keep it alive like a brain dead person is kept alive through artificial means. The current sub-prime debacle is just the tip of an iceberg of immoral banking practices condoned and enshrined in law, and paid for by campaign contributions to the 545 people mentioned above. Or the public servants wherever you reside in the G7.

The banking and financial systems have been robbing people for so long that this robbery is now just taken for granted. Let’s take a look at the current state of affairs.

The constituents of the G7, the US and Britain in particular have been hooked up by the banking systems like mice on a spinning wheel. Taught by the public servants and banks that they can have today what they cannot afford till tomorrow by signing a loan agreement for a credit card, which can be used to buy or consume anything, a home loan, a car, etc., whether you can afford it or not. Once on this spinning wheel of debt it becomes almost impossible to get off. Borrowers’ interest rates are set so high in what can be called legalized loan sharking. Low rates on credit cards can be 9 to 15%, but average rates are 21 to 35%. Using the rule of 72 we can then calculate that if you buy something and are charged 21% then you have doubled the price if it takes a year to pay for.

From your public servants, bought and paid for by the banking industry. New bankruptcy laws make it virtually impossible for you to break their chains of debt. Product vendors no longer make money selling their goods and services; they make their money FINANCING the purchase.

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Stoneleigh: Bagehot's point is important. Long term rates will indeed be going up, reflecting increased risk as the credit crunch deepens. Don't expect cuts in short term rates to be reflected in your mortgage rate in an era of uncertainty. Access to credit will be greatly reduced over the next few years, with credit probably being available only to the extremely wealthy, and even then at a high price.

Bagehot's Lessons for the Fed

Fast backward 135 years to 1873, when Walter Bagehot, the eminent Victorian institutional economist and constitutional scholar, wrote "Lombard Street." The London capital market was the center of world finance under the gold standard. Bagehot described the intricacies of how money markets worked, including counterparty risks and all that – but he also prescribed how the Bank of England should confront major financial crises.

Bagehot called a seizing up of internal markets "a domestic drain" (of gold), and the flight of capital abroad "an external drain." He wrote that "The two maladies – an external drain and an internal – often attack the money market at once." And what, he asked, should be done when this happens?

"We must look first to the foreign drain, and raise the rate of interest as high as may be necessary. Unless you can stop the foreign export, you cannot allay the domestic alarm. . . . And at the rate of interest so raised, the holders – one or more – of the final bank reserve must lend freely.

"Very large (domestic) loans at very high rates," Bagehot advised, "are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness. But though the rule is clear, the greatest delicacy, the finest and best skilled judgment, are needed to deal at once with such great and contrary evils."

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A good name sliced, diced and traded

The UBS fiasco is more than the story of a failed acquisition spree. It also embodies the rise and (current) fall of credit derivatives - the instruments that were intended to transform the humdrum but risky business of bank lending.

I can vouch for this because I remember going to see Mr Ospel in London after the Warburg deal closed in 1995, to find him fretting over the layout of its headquarters. The chief executive's office was on the seventh floor and he wanted to get closer to the traders two floors below.

After him, I met David Solo, the then 30-year-old head of fixed income who had previously worked at O'Connor Associates, a Chicago options trading firm that SBC had bought. Mr Solo was figuring out how not only to revamp Warburg but also to revolutionise lending.

He told me about the credit default swaps market, which had just started emerging in London. Mr Solo got out a piece of paper and drew a diagram of how loans might be priced like swaps and options and be traded by banks and investors. With hindsight, I wish I had kept that document.

Without knowing it, I was present at the creation of the new model UBS. Mr Ospel was cooking up a bank that could take on Goldman Sachs and others with the special ingredient of derivatives. An organisation that was not making enough money from domestic banking would take on the world with options....

....They are not happy now. For these pioneers eventually created a market that grew so big and complex that Mr Ospel no longer had any grasp of the risks UBS was running. His traders - now in the US while he was in Switzerland - came to use the instruments more to game the system than to pass on risk to others.

I am indebted to UBS for making this fact plain in its fascinating report to shareholders, which it published under pressure this week in time for the annual general meeting. I recommend it to anyone wanting to find out how, over a 13-year course, beneficial financial innovation turned into deceptive financial alchemy.

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Credit Suisse Posts SF2.15 Billion Loss on Writedowns

Credit Suisse Group, Switzerland's second-biggest bank, reported its first loss in almost five years on 5.3 billion Swiss francs ($5.2 billion) of writedowns linked to deteriorating credit markets.

Credit Suisse rose in Swiss trading after Chief Executive Officer Brady Dougan said the capital position is ``strong,'' quelling speculation the bank may have to sell shares. The first- quarter loss was 2.15 billion francs, compared with a 2.73 billion-franc profit a year ago, the Zurich-based bank said today.

While Dougan said the results were ``clearly unsatisfactory,'' the company's losses have been dwarfed by UBS AG, its larger Swiss rival, which is seeking 15 billion francs from investors to repair its balance sheet. Royal Bank of Scotland Group Plc, Britain's second-largest bank, plans to raise 12 billion pounds ($23.70 billion) selling stock after writedowns.

For Credit Suisse, ``the only positive thing is that they are not announcing a capital increase, at least not yet,'' said Joerg de Vries-Hippen, who oversees about $26 billion, including the Swiss bank's shares, as chief investment officer for European equities at Allianz Global Investors in Frankfurt....

....The world's biggest banks and securities firms have reported credit losses and writedowns of about $290 billion linked to the collapse of the U.S. subprime mortgage market. Credit Suisse marked down loans for leveraged buyouts and mortgage-related securities.

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Bondholders Lucky to Get 10 Cents in Looming Defaults

Bondholder recovery rates are becoming more crucial as the U.S. economy slows. Chapter 11 business bankruptcies rose 16 percent in the first quarter, according to court records compiled by Jupiter eSources LLC, and Moody's Investors Service said last week that the number of companies at risk of running out of cash is the highest since at least October 2002.

``When leverage was so ample, private equity firms were able to buy companies at multiples that didn't make sense,'' said James Keenan, who oversees $20 billion of high-yield debt as co- head of leveraged finance at BlackRock Inc. in New York. ``Most people use the assumption senior unsecured bonds are going to recover 40 percent. I don't think you're going to see that.''

The amount of debt in Merrill Lynch & Co.'s U.S. High Yield Distressed Index has swelled to $206 billion from $4.8 billion a year ago. The index contains non-defaulted bonds with yields of 10 percentage points or more above Treasuries.

Moody's anticipates defaults will quadruple to 5.9 percent in 12 months. That assumes a ``mild'' recession. Judging by the amount of distressed debt, investors expect an 8 percent default rate, said Martin Fridson, head of high-yield research firm FridsonVision LLC in New York.

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Foreclosures to affect 6.5 mln loans by 2012-report

Falling U.S. home prices and a lack of available credit may result in foreclosures on 6.5 million loans by the end of 2012, according to a Credit Suisse research report on Tuesday.

The foreclosures could put 12.7 percent of all residential borrowers out of their homes, Credit Suisse analysts, led by Rod Dubitsky, said in the report. That compares with a foreclosure rate of 2.04 percent in the last quarter of 2007, they said, citing Mortgage Bankers Association data.

The new forecast includes 2.7 million subprime loans whose risky characteristics sparked the worst housing market since the Great Depression. Subprime foreclosures, on top of the 676,000 already in or through the process, will hit 1.39 million in the next two years alone, an upward revision from the 730,000 predicted by Credit Suisse in October.

Falling home prices have made an increasing number of U.S. homeowners more vulnerable to default, they said. Nearly a third of subprime borrowers owed more than their home was worth at the end of last year, and that figure will double to 63 percent in 2009, they said.

The shutdown of mortgage bond markets that financed many risky borrowers during the housing boom has also made it harder to refinance into affordable loans, they added.

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Fannie and Freddie portfolios, delinquencies rise

Mortgage financiers Fannie Mae and Freddie Mac said separately Friday that their mortgage portfolios rose in March as delinquencies inched higher.

McLean, Virginia-based Freddie Mac saw its total mortgage portfolio increase at an annualized rate of 8.9 percent year-to-date and 9.9 percent in March to $2.15 trillion.

The company’s retained portfolio increased to $712.5 billion as mortgage purchase and sales agreements entered into during the month of March totaled $43.5 billion, up from $14.8 billion in February.

Mortgage delinquencies continued to inch up as well, as the single-family delinquency rate (90+ days) climbed three basis points to 0.74 percent in February, nearly double the 0.40 percent rate in March 2007.

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Stoneleigh: The hierarchy of government will determine access to decreasing tax revenues. If states or provinces are having a hard time, municipalities will be squeezed even harder, and they in turn will squeeze you.

U.S. States `Deteriorating' Amid Slump, Lawmakers Say

U.S. states expect to have at least $26 billion less than they need to pay their bills during the next budget year as a slumping economy erodes tax receipts, according to a national survey.

The study by the National Conference of State Legislatures shows that pressure is mounting in almost half of the states. Payrolls declined in March by the most five years, crude oil prices are 79 percent higher in the last year and consumer confidence reached a 26-year low in April. States rely on income and sales taxes to pay for schools, health care and criminal justice.

``With a few exceptions, state finances are deteriorating, in some cases considerably,'' according to the survey, based on data from legislative fiscal directors collected in April. The group said that ``if the national economy continues to struggle and indeed falls into recession, the state fiscal situation will worsen.''

The widening budget shortfalls for fiscal years that in most cases are three-quarters completed are forcing officials from Maine to California to consider tax increases, spending cuts or selling state assets. Others, including Nevada and Arizona, are tapping reserves built during the housing boom.

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Stoneleigh: As municipal finances are increasingly stressed, they will try to raise taxes of all kinds in any way that they can. This will push more people and businesses underwater, and will lead to unrest. War in the labour markets is also a given, since wages and benefits will be cut as bills rise. Even those currently able to cover their debts will find it increasingly difficult to do so in a depressed economic environment where costs are rising and income is not secure. There is no safe level of debt to be carrying.

Rising Property Taxes Fill Gaps, Pinch Homeowners

Faced with revenue shortfalls, local governments across the U.S. are raising property-tax rates, angering homeowners already hit by the housing slump and economic slowdown.

Spring Valley, N.Y., approved a 9.7% increase in the property-tax rate to balance its budget. A number of fast-growing suburbs around Washington, D.C., have raised rates, while Memphis Mayor Willie Herenton has proposed a 17% increase in the property-tax rate to close a budget gap.

"Everyone is feeling this pinch and we are not immune," he told the Memphis City Council last week.

Increasing property taxes is especially sensitive when housing prices are falling, the labor market is weakening and household budgets are strained by the rising cost of food and gasoline.

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UK buyers rush for mortgages as drought worsens

The number of mortgages taken out slumped by nearly 50 per cent last month as the mortgage drought left buyers scrambling to secure home loans in the wake of the credit crunch.

Mortgage lenders approved 35,417 loans for house purchases in March, down by 46.2 per cent compared with March last year, according to figures from the British Bankers’ Association. This came as additional evidence emerged of a slowdown in the housing market, heightening fears that house prices may tumble further.

Estate agents said activity in the market halved in the past year. Agents sold an average of seven properties each during March, compared with 14 per agent during the same month last year. They said that first-time buyers accounted for only 8.3 per cent of sales last month, down from 11.7 per cent in February.

The cost of an average property slipped by nearly £5,000 to £191,556 last month, according to Halifax. But experts gave warning that the lack of new entrants to the market could cause further price falls.

Lenders are still dragging their heels about passing on April’s rate cut to existing borrowers. Only 38 out of 100 lenders have so far said they will be reducing their standard variable rate nearly two weeks after the rate cut, according to Moneyfacts.co.uk.

Mortgage rates have also soared as lenders pass on the increased cost of wholesale funding. The difference between base rate and three-month sterling Libor, the rate at which UK banks lend to one another, widened fractionally to 0.886 per cent yesterday, indicating growing stress. This spread, which had narrowed in the previous six sessions, is seen as a key indidator of the intensity of the credit crunch and is an important factor in the pricing of new mortgages. Lenders signalled that the unprecendented bailout by the Bank of England announced earlier this week was unlikely to lead to a fall in mortgage rates.

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Stoneleigh: This article touches on the importance of psychology as it interacts with supply and demand. Once people fear price rises, or reduced availability, they stock up, which increases demand. If supply is tight, that drives prices up very quickly, which feeds back into an even greater perceived need to hoard supplies. Speculation feeds into this as well through momentum and expectations of further price increases. Speculative flows of money can disrupt the physical trading systems.

Hoarding can only go so far though, as storage can quickly become an issue. Once storage has been maxed out, demand drops quickly and drives prices down, which causes problems for those who had tried to met increased demand with increased supply. This kind of volatility, which is typical of markets transitioning to tight supply conditions, reduces economic visibility to the point where conducting normal business can be very difficult.

Of course speculators feed on the destabilizing volatility they help to created, although they are really only a symptom of the way our globalized economy functions. When capital is completely free to respond rapidly to changing circumstances - far more rapidly than the physical systems it interacts with - boom and bust volatility is inevitable, as is economic wreakage.

Fears mount as rice prices soar

He's been in the business of importing foreign foods to canada for 30 years, but never has Kkanti Shah seen one of his staples - rice - so expensive and hard to supply as now.

American long-grain and short-grain white rice, Indian basmati rice, Thai jasmine rice - the wholesale price of those popular varieties has risen by double or almost double in the last five months because of shortages overseas, said Shah, co-owner of Shah Trading Co.

"Right now, the scenario is: 'Where can I get my rice?' " said Shah, a Kenyan-born Indian immigrant whose St. Laurent firm supplies Loblaws, Wal-Mart, Costco and other big chains.

"It's definitely a crisis. I don't think it will get so bad that rice won't be available here, but the price will be high. You know, the Asian crowd in North America are major consumers of rice - breakfast, lunch and dinner - so they've been stocking up."

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Wheat Crop Failures Could be Total, Experts Warn

On top of record-breaking rice prices and corn through the roof on ethanol demand, wheat is now rusting in the fields across Africa. Officials fear near total crop losses, and the fungus, known as Ug99, is spreading.

Wheat prices have been soaring this week on top of already high prices, and futures contracts spiked, too, on panic buying. Experts fear the cost of bread could soon follow the path of rice, the price of which has triggered riots in some countries and prompted countries to cut off exports.

David Kotok, chairman and chief investment officer of Cumberland Advisors, said the deadly fungus, Puccinia graminis, is now spreading through some areas of the globe where "crop losses are expected to reach 100 percent.” Losses in Africa are already at 70 percent of the crop, Kotok said.

"The economic losses expected from this fungus are now in the many billions and growing. Worse, there is an intensifying fear of exacerbated food shortages in poor and emerging countries of the world,” Kotok told investors in a research note. "The ramifications are serious. Food rioting continues to expand around the world. We saw the most recent in Johannesburg. "So far this unrest has been directed at rising prices. Actual shortages are still to come.”

Last month, scientists met in the Middle East to determine measures to track the progress of "Ug99,” which was first discovered in 1999 in Uganda. The fungus has spread from its initial outbreak site in Africa to Asia, including Iran and Pakistan. Spores of the fungus spread with the winds, according science journal reports. According to the Food and Agriculture Office (FAO) of the United Nations, approximately a quarter of the world’s global wheat harvest is currently threatened by the fungus.

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Prison Nation

Americans, perhaps like all people, have a remarkable capacity for tuning out unpleasantries that do not directly affect them. I'm thinking here of wars on foreign lands, but also the astonishing fact that the United States has become the world's most jail-loving country, with well over 1 in 100 adults living as slaves in a prison. Building and managing prisons, and locking people up, has become a major facet of government power in our time, and it is long past time for those who love liberty to start to care.

Before we get to the reasons why, look at the facts as reported by the New York Times. The United States leads the world in prisoner production. There are 2.3 million people behind bars. China, with four times as many people, has 1.6 million in prison.

In terms of population, the United States has 751 people in prison for every 100,000, while the closest competitor in this regard is Russia with 627. I'm struck by this figure: 531 in Cuba. The median global rate is 125.

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