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Benson’s Eco­nomic & Mar­ket Trends
Money is cre­ated out of thin air

Richard Ben­son

July 30, 2004

We hope this brief essay stim­u­lates your thoughts with
respect to how money is cre­ated — a secret all investors should know

Money is cre­ated in two ways:

First, money cre­ation comes from bor­row­ing it and spend­ing . (Money is lit­er­ally bor­rowed  and spent into existence.)

Sec­ond, it can sim­ply be printed up “out of thin air“by a cen­tral bank. The U.S. econ­omy and other mod­ern economies have cen­tral  banks and fiat cur­ren­cies. Cen­tral banks have two major pow­ers. They can

1) “peg” the nom­i­nal level of short-term inter­est rates, and

2) pur­chase assets such as gov­ern­ment debt, with newly printed money. When the cen­tral bank pegs short-term inter­est rates at a low level, it greatly encour­ages cor­po­rate and  indi­vid­ual bor­row­ing and spend­ing. For the past decade, most money has been cre­ated through pri­vate sec­tor bor­row­ing and spend­ing. How­ever, the day is fast approach­ing when the pri­vate sector’s new bor­row­ing will not cre­ate enough new money to keep ser­vic­ing the already mas­sive level of old debt. Cen­tral  banks will need to step up their efforts to “print money out of thin air.” (QE1 &QE2)
Cen­tral bank print­ing of new money is accom­plished by pur­chas­ing gov­ern­ment debt or other assets.

The Broad Mea­sure of Money:

(In Bil­lions of Dollars)

Clearly, there has been sub­stan­tial money growth since 2000. More­over, nei­ther the crash of the NASDAQ stock mar­ket, or the last reces­sion, has slowed down money growth. The fact that the Fed cut inter­est rates 13 times since 2000 — reduc­ing them to a 46 year low — has a lot to do with the mas­sive amount of bor­row­ing that has taken place in the United

Total Net Bor­row­ing in the U.S.

(In Bil­lions of Dollars)

The amount of net bor­row­ing in the United States is quite impres­sive, par­tic­u­larly when you con­sider the old eco­nomic model when bor­row­ing was lim­ited to sim­ply recy­cling sav­ings. In 2003, the sav­ings rate was 2 per­cent of GDP, while net credit mar­ket bor­row­ing was well in excess of 20 per­cent of GDP. There has been a whole lot of bor­row­ing and spend­ing of new money going on!

Cer­tain asset classes, such as finan­cial assets and hous­ing, have ben­e­fited the most by this credit and money cre­ation. For instance, because the mort­gage mar­ket has been will­ing to finance any and all mort­gages, the credit cre­ation process has allowed both new mort­gage debt and the abil­ity to pay for higher hous­ing prices. These higher hous­ing prices have, in turn, allowed for the fund­ing of larger mort­gages. Money cre­ation in the pri­vate sec­tor tends to con­cen­trate in cer­tain asset classes that facil­i­tate the cre­ation of new credit. This new credit lends itself to new spend­ing, leav­ing behind new money as the resid­ual, and a grow­ing moun­tain of debt.

To say that this process has been left to run wild is an under­state­ment. Indeed, it’s time to think “Bub­ble” in stocks, bonds and hous­ing. A ratio­nal investor under­stand­ing the credit cre­ation process would have played the result­ing upward momen­tum in asset prices for all they were worth!

How­ever, the world is chang­ing. The cen­tral banks are already  print­ing vast quan­ti­ties of new money, mak­ing 2004 a “water­shed” year. In the gen­eral price level, due to the cre­ation of new money bor­rowed into exis­tence, infla­tion is start­ing to leak through.

If one exam­ines indi­vid­ual incomes and cor­po­rate cash flows, you will real­ize the U.S. eco­nomic sys­tem can not ser­vice the moun­tain of pri­vate debt that has already been cre­ated at higher nom­i­nal inter­est rates. This water­shed year could turn into a cliff side
water­fall unless money growth keeps increas­ing to encour­age the growth in per­sonal and cor­po­rate incomes. Infla­tion is needed to push up cash flows to ser­vice old debt.

With­out infla­tion, there remains a mas­sive risk of defla­tion. If old debt is paid down, or for­given in bank­ruptcy, money that has been pre­vi­ously cre­ated will van­ish from whence it came. If the money and debt goes, asset prices will crum­ble. Many intel­lec­tual writ­ers have log­i­cally con­cluded that ris­ing inter­est rates will cause a “defla­tion­ary debt col­lapse” as inter­est rates rise. Cer­tainly, a rise in inter­est rates to more nor­mal lev­els will be painful and will cause some finan­cial dis­tress. More­over, a rise in inter­est rates tends to slow the pri­vate money cre­ation process. So, some ques­tions remain unan­swered. Where will enough money come from to keep the U.S.
econ­omy liq­uid and sol­vent? Where will the mas­sive amounts of new money come  from to ser­vice the debt mountain?

Let’s not for­get that cen­tral banks  can cre­ate new money with a few strokes at a com­puter key­board to pur­chase
what­ever assets they wish. The Fed­eral Reserve can cre­ate any vol­ume of money  it needs to keep the econ­omy ser­vic­ing both old and new debts. It seems vir­tu­ally  cer­tain that the Fed, and other friendly cen­tral banks, will print as much new  money as they need to because “infla­tion tomor­row is bet­ter than a col­lapse of  the finan­cial sys­tem today.”

Since the U.S. Trea­sury is run­ning a $450 Bil­lion deficit and a 5  per­cent trade deficit, cen­tral banks have actu­ally begun the “Great Money  Print­ing.” In the past 12 months, global cen­tral banks have cre­ated about $800 Bil­lion worth of new money (as mea­sured by the increase in world cen­tral bank  reserves). This is what the Fed­eral Reserve Gov­er­nor, Ben S. Bernanke, lov­ingly  calls “Heli­copter Money.”

For­eign­ers already hold almost 40 per­cent of mar­ketable U.S. Trea­sury debt. The Asian cen­tral banks have increased their hold­ings of U.S. assets to about $1 Tril­lion. In the relay race of money cre­ation, 2004 is the year when the baton of money cre­ation has already been handed from the pri­vate sec­tor to the world’s cen­tral banks!

Wide open money spig­ots in the pri­vate econ­omy have a habit of financ­ing “asset  price bub­bles.” Since the prices of bub­ble assets (stocks, bonds and hous­ing)  are not included in the price indexes that mea­sure infla­tion, the infla­tion­ary  con­se­quences of new money growth can be ignored. As cen­tral banks inject money  growth directly into their respec­tive economies by buy­ing assets such as United
States trea­sury bonds with Heli­copter Money, it is impos­si­ble to totally  con­ceal the fact that there is more money chas­ing the same num­ber of goods. Infla­tion  happens!

The mas­sive trade and bud­get deficits in our coun­try have acted  as an “excuse” for friendly for­eign cen­tral banks to do much of the needed money  print­ing that would nor­mally be done by the Fed­eral Reserve. Our trade deficit gives com­pa­nies in for­eign coun­tries dol­lars in exchange for their exports. Our trea­sury deficit gives for­eign­ers the oppor­tu­nity to buy our U.S. trea­sury debt with the dol­lars. Any for­eign cen­tral bank can then swap their local cur­rency with com­pa­nies hold­ing dol­lars and buy U.S. trea­sury debt! It’s all so simple!

New money has been cre­ated, just not in our country!

For instance, the Cen­tral Bank of China is cre­at­ing new money by buy­ing U.S. trea­suries with our trade deficit. This has helped to drive up their domes­tic infla­tion rate to 5 per­cent a year!

Until just recently, even the Japan­ese have been suf­fer­ing from mild defla­tion and may not have the eco­nomic capac­ity to buy unlim­ited quan­ti­ties of our trea­suries. Japan is already flood­ing their econ­omy with fresh Yen out of thin air, as they finance their own gov­ern­ment deficit. Japan is cur­rently run­ning a 7–8 per­cent fis­cal deficit and their sav­ings rate has been drop­ping. Japan’s national debt is 140% of GDP and is ris­ing rapidly.

The Japan­ese bond mar­ket faces a seri­ous risk of price col­lapse as their inter­est rates start to rise. There­fore, Japan can not be counted on to finance both their gov­ern­ment deficit and our deficit for much longer.

Very soon it will be incum­bent on our Fed­eral Reserve to crank up the domes­tic U.S.  print­ing press. It is one thing when your neighbor’s cen­tral bank floods their  coun­try with newly printed money buy­ing U.S. Trea­sury debt. It is quite another  when the Fed­eral Reserve floods Amer­ica with Heli­copter Money by buy­ing  mas­sive amounts of U.S. Treasuries.

As infla­tion comes, inter­est rates will be forced up. Ris­ing inter­est rates cer­tainly hurt the own­ers of old low-coupon bonds. More­over, ris­ing inter­est rates have never been the stock  market’s friend. Ris­ing inter­est rates are the declared enemy of hous­ing prices.

Indeed, ris­ing infla­tion in the gen­eral price level is the enemy of all those  won­der­ful bub­ble mar­kets. Ris­ing infla­tion and falling asset prices will  turn the world of invest­ing upside down!

In other words he just described the Gen­tri­fi­ca­tion of the United States of Amer­ica.  Did you send the Let­ter Yet?

July 30, 2004

Richard Ben­son
Spe­cialty Finance Group,

2505 S. Ocean Boule­vard -
Suite 212
Palm Beach, Florida 33480
1 800–860-2907
eMail: rbenson@sfgroup.org



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