Less than a year ago, crude oil was $145 and everyone was wondering how fast the dollar would inflate into worthlessness. Could it be that today there’s a shortage of dollars? The usual discussion centers around the supply of money, defined as the quantity (M1 or M2) times the velocity (how quickly a dollar gets passed around the economy). Over the last year the fed has roughly doubled the supply of money while the velocity has roughly fallen in half, keeping the real supply stable. But what about the demand for dollars?
First let’s look at the domestic demand for dollars. For 5 years, homeowners have used their homes as piggy banks. When they wanted cash to buy something, they just took out a home equity loan. Stocks looked like an attractive investment, so people generally had little desire for money, everyone preferred to own stuff like houses and stocks. Companies held as little cash as possible because cash doesn’t generate the aggressive growth that’s so attractive to investors. As asset prices collapse, every seller demands money. After a foreclosure, banks try to sell the foreclosed home as quickly as possible; during bankruptcy, the court or debtors liquidate the company’s holdings. Any potential buyers of homes or corporate assets need to sell other assets to free up money.
What about the international demand for dollars? Over the last decade, investors and banks rushed to send money to emerging markets for higher rates of return. For example, Eastern Europe had net foreign borrowings of $1.6 trillion at the end of 2008. Any foreign loan or investment requires a purchase of the foreign country’s currency and a sale of your own (there are exceptions, but debt denominated in foreign currencies is relatively insignificant). As the world economy comes under pressure, we’ve had a flight to quality. Investors sought to sell their subprime loans to emerging markets and buy top rated US debt. So investors are selling their zlots and forints and even euros to buy dollar denominated assets.
As asset prices continue falling, inflation concerns wane, general economic conditions deteriorate, people hoard cash. Individuals fear unemployment and increase their savings. Companies find fewer attractive investments and financing costs rise, so they hold more cash. Investors worldwide flee all currencies but the safest. As people hoard cash, the velocity of money drops further and asset prices drop further, deepening the cycle. The fed can mitigate this by printing more money, but just about everyone consistently underestimates the deflationary effects of deleveraging, so the fed is too slow and the dollar shortage deepens. Eventually the cycle ends when there are fewer new foreclosures and new bankruptcies and enough debt is liquidated that companies and individuals start spending more.
Where does the deleveraging end? It’s hard to predict in advance, but we can at least identify when asset prices have further to fall. Real Estate is stagnant in most of the country as sellers remain anchored to old prices and refuse to hit the “too low” bids of the buyers. California is the exception. After a 40% drop in median prices, the real estate market is starting to look healthy with plenty of transactions. Californian real estate may have reached equilibrium while most of the country obviously hasn’t. Prices keep falling until sellers and buyers agree on prices. Another example is mortgage derivatives. With some derivatives, buyers are bidding $0.20 on the dollar while the banks that hold the derivatives are refusing to sell at less than $.80. Without massive subsidies, the result would be that eventually the banks would become realistic and lower their offers or go bankrupt and be forced to sell. The government and the banks are hoping that special programs can subsidize buyers to pay closer to $.80 or that the economy will improve enough for the buyers to pay $.80. History suggests that eventually it is the sellers who must compromise and lower their offers.