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Kitchen Table Talk II
I received some very nice responses from my first Kitchen Table Talk last month. I would now like to continue with some more example discussions and ramblings about various topics. My goal here is to try to get people to think about and understand how our current world works. I am not an expert in banking or economics but just a guy trying to enjoy life and maybe pass along a little knowledge that I have picked up along the way. For many people these discussions are too basic. But if I can help open the eyes of one person than I will have accomplished my goal. Judging from the responses from my previous essay, I have so far been successful.

Fractional Reserve Banking

Let's go back to the kitchen table. We have 8 people sitting around and I am the central banker. I need to have some "reserves" in which to begin my loan and credit-money creation process. By some inexplicable reason, I have been able to accumulate all the known gold reserves on our island. Let's say I have 700 ounces of gold. This will form our monetary base. If I value 1 Dave Note (DN) at 1 ounce of gold, I have 700 DNs on reserve backed 100% by gold.

Using the principle of fractional reserve banking, I will make loans to our citizens using a 2% reserve amount. This means I need 2 DNs in reserve for every 100 DNs that I loan out. Therefore, I can loan up to 35,000 DNs using my reserves of 700 ounces of gold. (100 * 700 / 2)

So I make my initial loans of 700 DNs, 100 each to the other 7 people. I have committed only 14 DNs from my reserve, so I still have 686 DNs left. Our currency supply is 700 DNs and our reserves are 700 ounces of gold. Therefore, at this point, anyone could walk into my bank and redeem their DNs for gold.

Now, after 1 year everyone owes me 105 DNs. Since I only want the interest no one pays off his or her loan. Tony needs another loan. I have excess reserves so I loan Tony another 100 DNs.

We now have 800 DNs in circulation and only 700 ounces of gold in reserve. We have increased the money supply and DEVALUED our currency. The bank still has 686 DNs (I have not collected the interest yet).

Cristina, who had a good year, has 200 DNs in her possession. She walks into the bank and deposits 100 DNs in her savings account.

The bank's assets have just increased to 786 DNs! My bank, a wonderful invention if I do say so myself, now has more currency assets than it had in the beginning. Will wonders never cease?

I can now make 39,300 DNs in loans based on my 2% reserve requirement. Since no one is going to come in to redeem their gold (damn stuffs too heavy to carry around) I can confidently continue to make new loans.

The issues here are obvious: 1) as I loan more money, my ability to loan more money INCREASES and 2) what was used as my backing for currency, the gold, now has multiple claims on it. In other words, currency devaluation creates multiple claims on the original reserves (gold and silver).

Common sense should come in to play here. This type of system cannot sustain itself.

Debt Default

Inflation, Disinflation, Stagflation, Deflation. All words being used by scribes and economists to attempt to describe our past and current economic times and what the future holds. A friend of mine, William R. Sullivan, has coined a new phrase (new to me) which I think best describes what is happening in the world economy today: Defaultion.

Let's go back to the kitchen table. We have 8 people sitting around and I am the central banker. I loan everyone 100 Dave Notes (DNs) at 5% interest per annum.

One year goes by and Bruno has squandered all of his money. Bruno cannot pay me back and declares bankruptcy. Because his house backed up the original loan to him I now own his house. I have a house I need to get rid of.

What has happened here?

First, the original 700 DNs that my bank loaned out are still in circulation. There has been no deflation.

But Bruno has lost his home and I, the banker, need to sell the house. I can sell it to Cristina. My problem is that the market for houses is slow so Cristina, an intelligent businesswoman, offers me just 40 DNs for the house.

I, the banker, now have 40 DNs with which to make new loans. Since my reserve ratio requirement is only 2%, I required only 2 DNs of my money to loan 100 DNs to Bruno. So I lost 2 DN in my loan to Bruno and received 40 DNs for a net gain of 38 DNs for my bank's reserves.

The point of this simple scenario is to attempt to prove that Defaultion does not equal Deflation. The original credit-money is still in "circulation", which I put into quotes because so much of this currency is in electronic form, not paper form. We also only have something like $650 billion in actual paper currency floating around, with 2/3rds of this outside the US. But the total M's money supply is much larger than this.

What the world is now facing is Defaultion on a massive scale. Enron, Polaroid, TWA, Kmart, etc., are just some of the companies that have declared bankruptcy and are unable to pay their debts. Think Japan.

Now the banks are creditors to these corporations whom they have loaned money to. The banks are also debtors to the people and companies who have saving accounts, checking accounts and CDs with the bank. You and I are creditors of the bank. We LOAN our money to the bank when we make a savings account deposit. This stems from English common law and has been upheld by the US Supreme Court.

Now the bank needs to be able to come up with enough cold, hard cash to satisfy the needs of its creditors, you and I, especially in tumultuous times. Think Argentina and Russia. The bank needs to have enough assets to cover its liabilities. This is the real sticky part and where Defaultion leads to ruin in the banking system.

As Defaultion spreads, more and more people and companies are going to be requesting cold, hard cash from the banks. The banks will have to sell the assets they take in from the defaults to try and cover their liabilities to the deposit customers in electronic format. Accepting that the assets will be losing value in the market place at the same time as more and more people will be requesting their cash, the banks will find themselves short of funds.

We don't have the gold or silver to back the M's currency and we don't have the paper currency to be redeemed for the electronic currency. All of this is a prescription for disaster.

Inflationary Pressures

Another example in the Inflation vs. Deflation debate.

It is early in the year 2001 and I have US$100,000 and I want to buy a 90-day US Treasury bill. I know that Mr. Greenspan is going to be cutting rates for the next year or more. I could buy a 6-month, a 1-Year or a 2-Year also. All of these will go up in price as yields go down.

But I am not alone. Billions of dollars, maybe trillions, begins piling into the US Treasury markets because everyone knows that Mr. Greenspan is wielding Excalibur against fed funds rates.

What happens when Mr. Greenspan's arms get tired of wielding that heavy sword? (Oh, such a heavy burden it is managing the world's economy.)

Do I have to SELL my TBill? No. One day I just stop buying new TBills. One day soon many others and I will decide it is time to take our money and look for the next inflating investment. I do not have to find a seller. I do not have to do anything. I just take my original US$100,000 and my interest payments and move on.

This is what I call built up inflationary pressures. Some day soon this "liquidity" will begin looking for the next "moving target." Where will that be?

Tech stocks? They have had their run and their profits look a long ways away. The mass psychology has been damaged enough that this scam would not work a second time.

Blue chip stocks? With earnings in the S&P 500 down 50% and bankruptcies, layoffs, corruption in accounting, etc. still happening I do not think so. The mass psychology is beginning to crack here also.

Real Estate? Seems to have peaked and it is illiquid. The world's hot money needs liquidity.

Collectibles? Again, illiquid.

Commodities? Almost all commodities are at or just off of multi-year or multi-decade lows. Humans need basic resources to survive. China needs resources to continue to grow as the world's corporations beat down her door to move all of our manufacturing into the land of the dragon. We cannot just pick up the Ford Rouge plant and move it to China. We have to build a new one. This requires natural resources.

To me, this shows three things: 1) the built up inflationary pressures are out there lying idle, 2) the absolute idiocy of the US government to try to finance itself on increasingly short-term paper and 3) Mr. G has succeeded in moving the bubble from the NASDAQ to the bond market. Now the bond market is cracking. Where will it move to next?

"When we have eliminated everything else, whatever remains, no matter how incredible, must be the truth." Sherlock Holmes.



David M Champeau
champeaudavid@yahoo.com

January 30, 2002