Benson's Economic & Market Trends

Money Created "Out of Thin Air"

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 it. (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". Central bank printing of new money is accomplished by purchasing government debt or other assets.

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 States.

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 flood's 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!

Richard Benson
Specialty Finance Group LLC

Richard Benson, SFGroup, is a widely published author on securitization and specialty finance, and a sought after speaker at financing conferences on raising equity for mid-market companies.

Prior to founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980's and started in the securitization business in 1983 at Bear Stearns, and helped build the early securitization businesses at Citibank and E.F. Hutton.

Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. Mr. Benson is a member of the Harvard Club of New York and Palm Beach.

The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.

In 1934 President Franklin Delano Roosevelt devalued the dollar by raising the price of gold to $35 per ounce.