For the Love of Money

I write this column for the love of money—literally.

Money as we know it is taking a beating at the hands of central bankers and pork-hungry politicians. It's time to remember what money is before we let them destroy it completely.

Money has two key characteristics:

1. Money is a medium of exchange
2. Money is store of value

Take away either of these attributes, and the item is no longer money. For instance, 5,000 acres of prime farmland is a good store of value, but it can't easily be exchanged or broken into smaller pieces. Likewise, colorful beads once served as a currency in the Americas because they were easy to interchange and transport. But when Europeans churned them out by the million and destroyed their scarcity, they ceased being a store of value.

More than any other piece of technology, money is the basis of civilization and progress. It allows people to interact and engage each other based on pure value and self-interest. Religion, ethnicity, social rank and even geographical location all melt into irrelevance when confronted with the pure abstracted value of money. Its free use lets people get the best goods and services at the lowest prices, freeing up real human energy to focus on more rewarding endeavors, which then enrich others.

This is why we all love money. Most people who understood Economics 101 would gladly defend these ideas against criticism from the socialist left. But the same principles are now under attack from our very own central bank.

The Fed has churned out our wampum with abandon while reducing its quality by lowering interest rates. They don't think about how millions of people depend on the dollar to save for retirement or to get paid. Bernanke & Co. don't consider the collateral economic damage that results when people lock up their capital in gold or send it abroad because they have so little confidence in their own currency.

Easy Money Killer

The Fed will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. - FOMC Nov. 4

Translation: The Fed will keep interest rates insultingly low to subsidize banks that made bad choices and politicians who made even worse choices. We continue to anticipate capital flight to gold and foreign jurisdictions as real unemployment climbs above 20%.

Even though it's recent history, our central bankers ignore the well-known case of Japanese housewives shipping their nest eggs to Australia or New Zealand rather than stomach their own country's disrespectfully low interest rates.

Just as happened to the yen, the U.S. dollar is losing its ability to serve as a store of value, attribute #2. This is a basic philosophical problem most economists miss: The Fed's low rates are destroying the "money-ness" of our currency.

Despite all their alleged wisdom, they don't seem to appreciate that money behaves differently at -1% real rates as at 5% real rates.

After all, the Fed enjoys the same kind of fiat power as the government when it mandates impossible costs on businesses and then wonders why jobs disappear. The underlying laws of supply and demand cannot change. Capital wants to survive and grow. If that's not possible here, it will go elsewhere, which means less job growth in the USA for the 15.7 million Americans seeking a job -- and for the growing number who've stopped looking.

(An additional 3 million people left the workforce in the past 12 months. And, this employment situation could actually get worse in the next year as states such as California and New York are forced to live up to their fiscal realities and finally start cutting state and local workers.)  

Despite its lofty ambitions, the Fed in isolation cannot create money. They can put more zeros on their balance sheet and increase the amount of currency in the system, but money is a social phenomenon that occurs between millions of real people, and has little to do with their egg-headed meetings and formulas.

(Treasuries + Agencies / Total Bank Credit) Average Since 1973 = 16.35%

Source: Fed H.8

One overlooked point is that the Fed has created bank reserves rather than handing people cash. But if lenders are still bleeding mortgage losses, that "money" won't reach the economy. Putting reserves into undercapitalized banks now is like trying to breathe with only half a lung. This chart shows banks' holdings of "non-risk" Treasuries and Agency paper versus their total credit portfolios. This proportion is still below the long-term average of 16.35%, and probably overstates lender health considering the amount of losses still in the system. The inevitable truth is banks still need to stockpile a lot more Treasuries before they're ready to start growing credit again.

If I think a house is going to be worth more, I borrow value from someone else to profit from this belief. Likewise, if I think my salary is going to rise 20% a year, I'll be more comfortable running up credit-card debt. In these cases, I have a real demand for value: Based on my situation and expectations for the economy, I borrow someone else's value today because I expect to have even more value tomorrow.
This is belief is the foundation of all investment.

Thanks to positive demographic trends and good economic fundamentals, Americans usually felt positive about the future in the post-WWII era, and wanted to own homes. That's one reason why the Fed successfully stimulated the economy with low rates in the past: The bigger "story" of houses, cars and granite countertops remained intact.

But that multi-decade trend is over because people owe too much while their assets and paychecks have shrunk. Americans feel they own too little value and don't want to borrow from anyone else.

 

3-month T-bill rates - Headline CPI (NSA) yoy Change
Source: BLS/Fed
It's not a coincidence that real interest rates were negative during the infamous 1970s, and then turned positive at the start of the booming 1980s. It should be noted that the final spike in real rates on the right should be disregarded because it's the result of negative CPI, not high interest rates. Expect it to drift back toward 0% as the year-over-year CPI declines slow.

The quickest way to restore financial balance is to raise interest rates and cut taxes, which would force distress on many institutions and allow stronger ones to thrive. That, in turn, would produce new investment, new businesses and new jobs.

Whether we live in igloos or the jungle, human beings can adapt to almost any environment. After some adjustment, we would survive and eventually prosper with Fed funds at 5-10%. Unfortunately, the two institutions running our economy cannot survive under those circumstances. More on them next time.