debt dollar destruction 31711

8/6/2019 Debt Dollar Destruction 31711

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3/17/2011 Bryan Wisk

Debt Dollar Destruction

Understanding the role of

credit deflation in a balancesheet recession




Money For Nothing• All money (95-99%) comes into existence as an

interest bearing promise to pay.• The banking sector has the sole power to create

money by lending to the private and public sector.In aggregate, all deposits are simultaneous book entries to new loans.

• The system is limited on the supply side by theFederal Reserve System, a private bank consortium, that has the sole power to createreserves out of nothing as a liability onto itself.These new reserves are then expanded into newbank credit by the reciprocal of the fractionalreserve requirement.

• On the demand side, the expansion of new reservesis limited by the willingness and ability of private

and public sector to take on new debt.




Federal ReserveControl over thesupply of credit The following example is from theFederal Reserve of Chicago’spublication entitled Modern MoneyMechanics. This paper was takenout of circulation in 1994 but is stillavailable on the internet.

1. The trading desk at the FederalReserve Bank of New Yorkbuys $10,000 of Treasurybills from a dealer in USgovernment securities.

2. The Federal Reserve Bank paysfor the securities with an“electronic” check drawnon itself.

3. Via its “Fedwire” transfernetwork, the FederalReserve notifies thedealer’s designated bank(Bank A) that payment forthe securities should becredited to (deposited in)the dealers account atBank A.

4. At the same time, Bank A’sReserve account is creditedfor the amount of thesecurities purchase.

5. The Federal Reserve Systemhas added $10,000 of securities to its assets,which it has paid for, ineffect, by creating a liabilityon itself in the form of bank

Step 1:

Assets LiabilitiesUS Treasury Bills + 10,000 + 10,000

Assets Liabilities+ 10,000 Customer deposits + 10,000

Federal Reserve

Bank A

Reserve accounts:Bank A

Double entry bookeeping; The $10,000 iscreated as both a liability to the customer and a Bank asset as a re serve ba lance w ith

the Fed. The Federal Reserve is able topurchase the US Treasury bill by created aliability onto itself.

Reserves with FRBanks




“Multiple”Expansion of newlycreated reservesIf the process ended there, there would be no“multiple” expansion, i.e., deposits and bankreserves would have changed by the sameamount. However, banks are required tomaintain reserves equal to only a fraction of their deposits. Reserves in excess of thisamount may be used to increase earning assets– loans and investments…Assuming , forsimplicity, a uniform 10 percent reserverequirement against all transaction deposits, andfurther assuming that all banks attempt toremain fully invested, we can now trace theprocess of expansion in deposits which can takeplace on the basis of the additional reservesprovided by the Federal Reserve System’s

purchase of U.S. government securities.1. All banks together now have $10,000 of

deposits and reserves that they didnot have before.

2. Only $1,000 is required to be retained inreserve, the remaining $9,000 is“excess reserves”, and can beloaned or invested.

3. If business is active, the banks with excessreserves probably will haveopportunities to loan the $9,000. Of course, the do not really pay outloans from the money they receiveas deposits . If they did this, noadditional money would becreated .

4. What they do when they make loans isaccept promissory notes in exchangefor credits to the borrowers’transaction accounts. Loans (assets)and deposits (liabilities) both rise by$9,000. Thus the total deposits of the banking system are now$19,000.

5. Assuming that the banks holding the$9,000 of deposits created in Stage1 in turn make loans equal to theirexcess reserves, then loans anddeposits will rise by a further $8,100in the second stage of expansion.




P ≠ P + I• By design, our monetary system requires exponential credit growth in order to

avoid a deflationary collapse.• When a new loan is made by a bank, the principle is created but not the

interest. If no further credit is created, the borrower must earn that interest

from the existing supply of money.• If the banker spends this interest received on real goods and services, thenborrowers have the opportunity to earn the interest to service the debt.

• If however, the interest is saved rather than recycled, then this creates ascarcity situation where in aggregate, the only way the debt can be servicedis with new debt.

• Where I 2 = I 1 , then all interest can be earned, and all interest can be paid(100% interest recycled).

•

Overtime if I 2 < I 1 , then a condition of scarcity arises that is equal to theshortfall X = I 1 - I2 .• X, if no other savings exists, must also be borrowed into existence as P 2 + I 3 .

Producersankers

P0 P 0+

I 12 /o od s S er vi ce so od s Se rv ic es

* % .Sustainable usury where 100 interest is recycled and therefore available to be earned for debt service over time




For each added interest shortfall (I 2 , I 3, …, I n ),something extra is demanded of the system

as a whole

E Sector ( , - )Finance Insurance and Real Estate Productive Economy (Real Goods and Servic

(Σ I n )->n ∞

This becomes a positive feedback loop as the structural imbalance between FIRE sector and real economy:grows

.1 Led to the finacialization of US economy as the rise of the shadow banking system facilitated new.credit creation

.2 ,Fueled the shift in personal savings out of short term liquid assets and into capital markets.speculation

,In 1980 banks handled 58 percent of savings and investment transactions institutional investors held a . ,31 percent market share By 1994 banks proportion had fallen to 33 percent and that of institutions had

.jumped to 44 percent ( , Warburton Debt and Delusion , )1999.1 -Enabled by modern central bankers and neo classical economists who view the act of credit creation as

,matching existing savings with new borrowers thus maintaining the myth that all new loans come out.of deposits

, [ ] Provided that for every willing borrower there is a willing lender they central bankers would argue that the impact of burgeoning credit growth is at worst neutral and at best confers a benefit to market

. : efficiency But there is a colossal flaw in this argument what if the proportion of inadvisable

...borrowing rises as credit proliferates? The result is a credit pyramid which is effectively unsecured - . ( against property or other income earning economic assets and which will ultimately collapse , Warburton

Debt and Delusion , )1999




The End Result: Exponential Credit-Money Growth1. Ever-increasing demand for new loans2. De-regulation - gave rise to the shadow banking system which further increasedcompetition for new types of lending leading to an explosion in off-balance sheetoperations which were not subject to traditional capital adequacy requirements.

3. Artificial compression of risk spreads - traditional underwriting was replaced waswith an over emphasis on the value of the collateral against which a loan was made.4. Dependence on residential and commercial property as collateral - led toexaggerated demand for the property itself.5. Private sector debt saturation - resulted in a perceived victory over the stagflation of

the late 70s and early 80s (The Great Moderation) that collapsed with depreciation inthe value of the underlying collateral.




Producers: + Prices, + Revenues, - Spending 1. To sustain GDP growth, productivity has steadily increased (growth for the sakeof growth)2. Leads to structural misallocation of resources (building and construction) andexcess capacity3. This increases Σ(I n ) as over production saturates the market with unsoldinventory -S Labor Productivity 1972 Present

:Impact to




Consumers: +Wages, + Debt, - Savings1. Steadily increasing prices, productivity and excess capacity holds down real wagegrowth outside of FIRE Sector2. Low wage growth means that consumption must come out of savings or increaseddebt

3. This increases Σ(I n ) as future consumption is pulled forward to the present




Government: +Taxes, - Spending 1. Decreasing consumption puts pressure on government revenues2. Government becomes borrower of last resort and must increase taxes or cutspending to support deficit expansion.3. This increases Σ(I n ) to the extent that the government can continue to service itsdebt




Where are we today? Federal Reserve restores reserveratio of ~ 10% -The Federal Reserve System requires zero percent (0%) fractional reserves from depository institutionshaving net transactions accounts of up to $10.7 million, three percent (3%) over $10.7 million, and tenpercent (10%) over $55.2 million.- However, these numbers do not apply to time deposits from domestic corporations, or deposits fromforeign corporations or governments, called "non-personal time deposits" and "eurocurrency liabilities”

(Eurodollars), respectively. For these account classes, the fractional reserve requirement is one percent(1%) regardless of net account value.QE1- Starting in September of 2008 with thecollapse of FNM and FRE the Federal Reserveincreased the total reserve balances by $60B.By January of 2009, this amount had alreadyincreased $800B after the collapse of Lehmanand AIG.

While the Fed reports this balance as regulatory“excess”, the ratio of reserves held at the Fed andMZM increased to 10% after it became clear that thecommercial banks had been severelyundercapitalized, especially when you consider off-balance sheet entities.

. ,So urce Fed eralR eserve B an k of St Louis W ikipe dia

Wh d ? US G b




Where are we today? US Government becomesborrower of last resort

The Federal Government remains the only counter balance to continued private marketdeleveraging. The asset price speculation in the market is focused only on the public sidewithout acknowledging that since 2000 the private sector has added $20 Trillion in new debt.Furthermore, an almost $4.5 Trillion dollar increase in public sector debt has only been able tohold the aggregate level of US credit roughly constant. Taken together, its clear that deflation,

not inflation, is the greater risk especially with renewed emphasis on controlling Federal spendingand debt levels. How much deflation depends on what level of overall indebtedness we return to(i.e. what % of the debt written over the last 20 years is unproductive) versus what level of publicdebt expansion is politically feasible going forward.




. , ,on This indicates an entrenched belief in a successful effort albeit possibly short term by the United States Federal Reserve to prevent the

apita l Markets Cl ing To Hoped For Inf la t ion

. .sion Most continue to base their views on orthodox approaches and warn of inflation or the rising gold price The fact that a majority of ma.investors continue to buy gold in the expectation that the next round of easing will lead to inflation I find such behavior hard to understa




. ,long term sustainable effect during a balance sheet recession It was only when private domestic demand trade and fiscal conditions were showing signs of recovery together t- ( . . ) ,ut t urns out to be economica l ly no n viab le i e the t rue cos t exceeds th e economic bene f i t s households wi l l be forced to pay for the ne t reduc t ion i

. , “ ”ar bad assets off of the balance sheet The delay in recognizing the losses proved costly both in terms of taxpayer funds and in holding back a recovery as insolvent zombie




. ,used by excessive risk taking by the financial sector with respect to the housing market Therefore the current focus on restoring consumer confidence the supply of credit an. . ,years Now the private sector is forced to paying down debt at the expense of consumption and new loan creation Without federal support to fill in the gap the aggregate dem

.aging




- .d up as overcapacity especially as it becomes clear that developed world consumption will not return to anywhere near pre crisis levels The burden of this lack of real wealth. .l copper consumption This has put serious upward pressure on prices of all commodities In an effort to sustain its export driven model as the domestic investment boom fade




What Next?1) Outlook for the next 5-7 years: low to

negative real growth as the developedworld de-levers, shift in savingspreference away from capital marketsand outpacing inflation to liquidityand wealth preservation

2) Short term, painful and stubborntransition from expectations of inflation, to the realization of deflationcould lead to extreme gaps in assetprices

3) Long term, negative for all asset prices asgrowth expectations vanish withprivate investment

4) Debts will slowly be written down, termedout, or default as the market value of the underlying collateral continues todeteriorate, meaning 7-10 years of aneffectively insolvent banking system

5) Despite parallels to Japan in the 1990s,the “Great Recession” will be closer tothe Great Depression in terms of impact globally. Emerging marketswill not escape given continueddependence on western debt-fueledconsumption

6) G7 central bankers will use every tool toprevent the onset of the deflationholding on to monetarism even in theface of falling asset prices, as thesovereign debt markets will restrictfiscal stimulus

7) Without above trend GDP growth, theoutput gap in the US will remain highleading to persistent unemploymentand stagnant wages preventing anylasting recovery in US consumption

8) Politically, attempts will be made tocontrol the inevitable tides of populism by melding them into oneestablishment party or another (see

Tea Party in the US), but the successor failure of this bears carefulwatching. (i.e. protests in Greece,

“ ,conomies that generate high profits weak wage, -ains and low capital accumulation are like old style

-o no po li es t ha t c re at e a n e ve r w id eni ng d is tri bu ti on o f- .ncome but fail to produce long term prosperity or growth

o economy in the history of the world has tolerated that ort of situation for long without responding with

, ,r oh ib it ive ly h ig h t ax at io n re gu la to ry i nt er ve nti on or i n, .”o me c ou nt ri es r ev ol ut io n

John Hussman, July 12 th , 2010




References

, . . , ‘ . ’,Bernanke B S 2002 Remarks by Governor Ben S Bernanke paper presented to Conference to Honor, , , , , .Milton Friedman University of Chicago Chicago Illinois November 8 2002

, . . ,Dent H S 2008 :he Great Depression Ahead how to prosper in the crash following the reatest boom in history , , .Free Press New York

, . , ‘ - ’,Fisher I 1933 The Debt Deflation Theory of Great Depressions Econometrica , . , . ,vol 1 no 4 pp- .337 357

, . ,Garrett G 1932 Bubble That Broke the World , , , .Little Brown and Company New York

, . ,Keen S 2001 :ebunking Economics the naked emperor of the social sciences , ,Zed Books

.London

, . . ,Keynes J M 1936 ,he General Theory of Employment Interest and Money , , .Macmillan London

, . ,Koo R 2008 : ’he Holy Grail of Macroeconomics lessons from Japan s great recession , John& ( ), . Wiley Sons Asia Singapore

, . . ,Minsky H P 1986 t ab il iz in g a n U ns ta bi li zi ng E co no my , , .McGraw Hill New York

, . ,Morton W 1943 , -rit ish Finance 1930 1940 , , .The University of Wisconsin Madison

, . ,Phillips K 2008 : , ,ad Money reckless finance failed politics and the global crisis of merican capi t al i sm , , .Penguin New York

, . , Warburton P 1999 :ebt and Delusion central bank follies that threaten economic c on om ic d is as te r , , . World MetaView Press Princeton

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