Saturday, February 09, 2008

The Money Supply Game

Imagine a rich relative dies and leaves you 100K and you deposit it in your bank. Along comes Mr. I-want-to-be-rich who borrows the 100K from your bank and buys Mr. I-want-to-retire’s home. Mr. I-want-to-retire puts the money in his bank. Figure that housing prices plunge and Mr. I-want-to-be-rich walks away from the house.

You put 100K in the bank and Mr. I-want-to-retire put 100k in the bank. The reality is, there is only 100k of cash in the system. The other 100K is what the house was valued at when bought. Note I could be shot again for over simplification with this example.

With 3 transactions, the money supply doubled. We didn’t have to stop at three transactions. Another loan and deposit would have created another 100k. Suppose you and Mr. I-want-to-retire decide to “Stuff the Mattress” and cash out both accounts today. The money isn’t there, so one or both banks will borrow from the Federal Reserve. The system works very well if the asset can be converted to cash with no loss of value. Right now, that just doesn't happen to be the case.

In very simple terms, it is easy to see how the money supply can expand in good times and contract in bad times. Two people have claims of 100K against the banking system. The money in a bank is insured and most probably is not at risk because of that fact.

The banks learned their lesson from the 1990’s savings and loan debacle. That doesn’t mean that they are off the hook. Everyone who ever wanted a credit card, now has one. That problem is another story for later.

Whose money was spent on this whole mess? It wasn’t the foreclosed homeowner’s money, now was it! The only money left is OUR money (retirement funds come to mind). The baby boomers are just starting to retire, so there is no real problem ---Yet!

One to three trillion dollars of real estate value will vaporize in the coming years. It’s so comforting to know that this was all someone else’s money. It’s kind of like selling 5 million tickets to the next Super Bowl, there is no problem until the day of the game. Surprisingly there would probably be empty seats. Most ticket holders (4.7 million) would be stuck in a massive traffic jam trying to get to the game. Sometimes things do work out alright, for all of the wrong reasons (our government functions a lot like that).

Copyright 2008 All rights reserved


Anonymous said...

When learning about Fractional Reserves, I had to diagram a handful of imaginary transactions to grasp it. And then I was agog - the government doesn't need printing presses; we all carry little plastic Visa and Mastercard printing presses in our wallets.

Jim in San Marcos said...

Hi Anon 2:31

I skipped the fractional reserves to keep it simple. It just slows the process down a little.

Once you understand the concept, it's easy to see how it could really take off with a big ticket item like real estate.