Compass July 2012

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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The Mystery of Money (and Lettuce)

The system by which money is created and gets into the economy is perhaps the single greatest financial mystery to most of us. Ask a person, “Where does money come from?” and they most commonly answer, “From the government.” And since the Treasury Department does operate some printing presses, one might conclude that to be a reasonable answer.

But then we have to ask the follow-on question, “Who decides how much to print?” Somebody over at Treasury decides how fast to run the presses at any given time and create physical money. But then we notice that physical money is only about 10% of the total money. Where does the other 90% come from? And who decides how big it is?

Ah…right there we enter into the mystery. For there is no government official or committee or board or agency that makes such a decision. It “just happens.” Who decides how much lettuce there will be? The amount of lettuce circulating from farm to stores to homes is not the mandate of some central authority. Individual farmers and stores and households send signals to one another through their buying and selling decisions, and the invisible hand of the market decides how much lettuce there is.

In our current money and banking system (the one we’ve had since about 1913), the supply of money in circulation is decided by market forces, not by the government or the Federal Reserve.

In lettuce production, there is “base” of production. If the base supply of seed is enough to grow 1 million bushels, then the “lettuce base” is 1 million bushels. But that is not the total amount of lettuce available in a year — that merely represents the capability to produce lettuce. Quite literally, the seed capital. Let’s assume for a moment that lettuce is critical to the economy, and that we really need to consume 6 million heads per year to maintain our standard of living. Farmers can leverage that base of seed capital, taking seed from new lettuce as it grows in order to produce more lettuce. If they turn this cycle over 6 times a year, then there will be 6 million bushels of lettuce available. The “lettuce multiplier” would equal 6 and all is well and good.

The monetary “base” consists of actual currency sitting in bank vaults, plus the amounts that banks have in their accounts at the Federal Reserve. This base is like the farmers’ fields, tractors and seed — it is not actually spent out in the economy. It represents the capability to produce money. These total bank reserves are the modern-day equivalent of the gold and other valuables in the vault that old-time banks held.

Money then enters the economy when banks leverage that base capital to take deposits and make loans, which then become more deposits and more loans. Which comes first, deposits or loans? Same answer as for the lettuce and the seeds…neither, once the system is up and running. They create each other, in a circular process.

The total money in existence has long averaged about 10 times the size of the monetary base. The “money multiplier” has been about 10. Those 10 units of money out in the economy are created by the supply of and demand for loans and deposits. No government agency decides on “10” or any other figure.

Now, back to the lettuce market: Let’s imagine that conditions have changed. For reason beyond human control, farmers can no longer cycle 6 crops a year. Insects, drought, cold, whatever…something happened and the lettuce multiplier drops to 3. The base is the same, but the amount of lettuce in circulation collapses by half. Since the population is still the same size, they still want 6 million heads of lettuce in order to thrive. The price of lettuce, naturally, skyrockets.

Similarly, imagine if the money multiplier drops from 10 to 5. If the base is the same, and if the economy is still roughly the same size, there is a shortage of money. As with lettuce, the price of money goes up. The “price” of money can be thought of as the quantity of goods (or your time) that you will trade for a given amount of money. If money is scarce, you will trade more of your time for money. If you give more of your time for the same amount of money, that is known as a pay cut, and is a key — but often forgotten — component of deflation. If the total supply of money drops, there is strong downward pressure on prices: Deflation.

In the aftermath of the 2007-08 financial crisis, the money multiplier in the US did, in fact, collapse by about half. Lending and deposit volumes dropped dramatically, through market forces.

As said above, a drop in the multiplier can immediately result in falling prices. And falling prices might at first sound good — after all, it’s nice to have a cart full of groceries cost less. However, falling prices due to generalized deflation also mean falling incomes, falling house values, falling stock prices and falling wealth and overall business activity. Not good. Back to lettuce…what might the government do to solve the lettuce crisis when the multiplier drops by half? If the multiplier can be restored by, say, spraying for bugs, they will try that first. If that fails, they will seek to increase the size of the base — create more lettuce farms or supply more seed. They could do that by offering tax incentives to soybean farmers to switch to lettuce growing. They could perhaps fire up some sort of seed-making process and ship seed out to farmers.

Similarly, money-system policymakers (the Fed and the Treasury) will respond to a collapse in the money multiplier. They first try to restore the multiplier — reducing interest rates so that businesses and consumers borrow more money. Remember: Loans create deposits, which provide money to make more loans, etc.

If that doesn’t work (and it didn’t in 2008), the Fed will intervene directly and increase the base. They will do this by buying up bonds in the open market and replacing them with newly-created money deposited to the banks’ reserves at the Fed. Like soybean farms converted to lettuce farms, bonds were converted to money.

The last two charts go hand-in-hand. A collapse in the multiplier was met with an explosion in the base, in an effort to keep the total money supply from falling. Many pundits (particularly those hawking gold) only look at the chart above, ignoring the chart to the left, and conclude that the sharp rise in the monetary base will lead directly to hyperinflation. It didn’t, and it won’t.

There is no historical example of hyperinflation arising from our type of banking system, operating in a developed democracy.

What all this means is that policymakers can quickly become nearly powerless to increase the money supply and, in turn, keep prices stable or stimulate the real economy. The money multiplier (the spirals in the chart far left) is not controlled the government or the Fed. It is determined by the mysterious invisible hand of the free markets and the people that participate in it. The Fed can push up the base of money, but it can’t push up the market’s appetite for loans and deposits.

Keynes likened these policy limitations to the futility of “pushing on a string.” The Fed can’t push on a string. The stock market seems to react quite favorably to suspicions that the Fed might engage in more stimulus. Never mind the reason that the stimulus is required (weak economy). They can increase bank reserves, but if the economy isn’t borrowing more, the money supply won’t grow and wages won’t go up. A true generalized inflation is highly unlikely in a soft labor market. You can’t push on a string.

There is another path open to the Fed — one that circumvents the multiplier problem. The Fed could begin to buy bonds directly from the government, handing over newly-created cash. The government spends that cash and directly increases the money supply. We will be watching carefully for the Fed to do this, as it will be a harbinger of an uptick of inflation. Likewise, should the money multiplier rise back to higher levels, the Fed will have to act quickly and decisively to pull those excess reserves out of the system.

The most recent data available on GDP, prices and employment — together with the Fed’s growing impotence — have made us less concerned about buying longer-term bonds. We are now willing to buy safe bonds that pay above our expected rate of inflation (after tax) out to 7-10 year maturities rather than the 3-5 year target we have maintained for the past two years. Reaching this “yield hurdle” is becoming harder to accomplish in the taxable bond market, but the municipal market still provides great opportunities.

For the true longer-term investor — a person that can ignore the quarterly fluctuations of market value — high dividend stocks continue to merit a prominent place in portfolios. With dividend yields of 4-5%, those stocks offer returns that will grow with any inflation. They are not bought with the intention of selling out at a profit in the short-term, and we encourage investors that own dividend stocks to watch the dividend stream, not the stock price.

These are trying times. The recovery hasn’t been much of one, and we can think of little the government can do about it at the moment. This is a political year, and the usual debates about policy choices will rage on. But presidents don’t affect economies the way their respective backers would like to believe. A hangover from 30 years of too much private and public debt — and the associated over-consumption — takes time to fade away.

Tech IPOs

First, let’s talk about the acronym IPO. It actually stands for “It’s Probably Overpriced” not “Initial Public Offering.” As we saw with the recent Facebook IPO, this new acronym is more appropriate. With the launch of Facebook into the public stock market, we saw that the hype machine known as Wall Street is alive and well. Understanding the motivations behind a stock offering is critical for an investor. Was Facebook going public because they required the capital to build a new complex to enhance their product? Of course not. They went public because the venture capitalist investors and employees were focused on cashing out. Unfortunately this has become the norm with many of the recent technology-related public companies.

Historically, a company would bring their stock to the market to raise capital for capital intensive projects which they could not self-finance. A company like Caterpillar required large sums of money to build factories and actually produce physical items to improve our quality of life. Today’s technology IPO’s like Zynga and Facebook are not about producing items which add to our GDP. They go public to make a small group of people very wealthy.

Microsoft is a public technology company and has added a gigantic amount of productivity improvement to our society over the last 25 years. Facebook, on the other hand, does just the opposite: It is a productivity detractor. We need a shift back to building companies that improve GDP rather than detract from productivity. Facebook is a great way to stay in touch with people, but we need more productivity-enhancing companies and fewer time-wasting companies.

As always, beware of the motivations of someone trying to sell you something.

2011 Calendar Year Index Returns

Total Market U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds

Inflation
(year-over-year May 31)

9.30%

8.98%

3.89%

4.37%

3.46%

2.38%

1.7%

Wherever possible, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at info@creeksidepartners.com.