Part I: What is it?
by Mark Lawrence
Mark's Market Blog
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Portfolios & Risk
What is money?
Interest and Growth
Money Utility and Risk
Trade Deficits and Inflation
Distribution of Income
Distribution of Wealth
Zero Coupon Bonds
Reading Bond Pages
Risk & Volatility
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What is money? If I asked this question of 100 people on the street, I'm confident that at least 80 of them would show me a $20 bill and ask me what country I was from. It may surprise you to hear that money is difficult to define. The Fed and the Treasury are charged with controlling the supply of something that they can neither define nor measure accurately.
The word "money" comes from the Latin word "monere," to remind, warn, or instruct. This is the primary function of money in a capitalist economy, to instruct you what to do (go to college, be a doctor or lawyer), remind you (bills, financial statements), and warn you (getting your electricity or insurance turned off). Money is currently broken. It's been doing a very poor job for the last three years or so when it instructed us to build a lot of houses that no one lives in, to revere the wisdom and knowledge of a bunch of creeps on Wall Street, and to plan on retiring early 'cause of the huge stock market gains in our 401ks.
The Fed currently has three working definitions of money, creatively called "M0, M1, M2." M0 is the man-on- the-street definition: currency, $20 bills, quarters, that sort of thing. No one pays attention to M0 except the guys who print the stuff (the Treasury, and certain people in Russia and North Korea).
M0: Currency in circulation, currently about $800 billion.
Suppose you go to a store and buy $120 worth of groceries. You write a check. Where is the money? M1 is currency plus checking account balances. But let's consider this transaction more carefully: you write the check, the store lets you leave. The check doesn't clear for three to five days. During that period the $120 is in their checking account because they deposited the check, and also in your checking account because the check hasn't cleared yet. Is the money really there? If the checking accounts pay interest, both of you are earning interest on this money at the same time - that's about as real as money can be. When you write a check, for a few days you have created new money. But no one writes checks anymore (except the little old lady ahead of me in line at the checkout who inscribes her checks with painfully intense calligraphy).
At this instant you could complain, "but I buy everything with my VISA or ATM card, what about that?" ATM cards are just a fancy new magnetic type of checks, they don't change anything. VISA cards are a bit different: the money you spend shows up in WalMart's checking account right away, but you don't pay your balance for another few weeks, and your VISA balance doesn't show up in these calculations at all. VISA cards let you create even more money for even longer than checks do. Your VISA credit limit is how much money you're allowed to create.
Most of us have a savings account linked to our checking account. We get higher interest on the savings account. We can log in and move money 24/7, or in many cases the accounts are linked and the money transfers automagically. So the distinction between checking account balances and savings account balances is a bit blurred. M2 includes savings account and money market account balances. There is about ten times as much M2 money as there is M0 currency.
M2: Currency plus bank deposits, currently about $8 trillion.
When you go into a bank and borrow $10,000, the bank puts the money into your checking account. Where did the money come from? The bank wrote you a check, which means the bank created it. The bank has a new asset: you owe them $10,000 as evidenced by the loan documents you signed. The bank also has a new liability: they owe you $10,000 as evidenced by the balance in your checking account. In the bank's double-entry bookkeeping system the asset and liability cancel each other out, there's no change in the bank's worth. By the way, this means when a bank advertises "Assets over Ten Billion Dollars" this means that people owe them $10B and they hope to get it paid back someday. Today our major problem is that banks aren't creating money. Less money chasing the same goods means lower prices, deflation, layoffs, recession, bad stuff. The government is urging, pleading, threatening, begging banks to loan money, but the banks are currently thinking we're all sub-prime flakes.
Just as you have a limit on your VISA card, the FED puts a limit on the amount of money a bank can create. The FED requires that banks keep money in an account at one of the Federal Reserve Banks. Banks are only allowed to deposit currency or treasury notes (shown above) in this account - no checks. The total loans that the bank is allowed to write is ten times the money they have on deposit with the FED. Interestingly, in these days of bank failures and questions about bank solvency and liquidity, it appears that although the FED is satisfied with a 10% reserve, investors seem to be requiring a 15% reserve or the bank's stock price and deposits suffer greatly. Today because of losses on mortgage based bonds, banks find themselves under- capitalized. They can get their reserve ratio up by attracting more deposits, calling in loans, selling loans for cash, selling stock, or borrowing currency or treasury notes. This is why the Treasury is buying loans and bank stocks and the FED is loaning $700 billion to banks: to increase reserves and get the banks loaning again. It's not working.
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Revised Sunday, 08-Mar-2009 15:26:06 PDT