Monday, April 27, 2009

Shortage of Dollars? - Ari Paul

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.


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  3. Dear Vega,

    thank you for your stimulating article.
    I just want to point to two sources, apparently not so far from your position.

    In a newspaper article Norbert Walter, chief political economist of Deutsche Bank, wrote on March 05:

    “… central banks worldwide are boosting the money supply. This expansionary monetary policy increases inflation worries. But it is as easy to reduce money supply as it is to increase it – if central banks are empowered and willing to do this.
    … at present only the monetary base is seeing rapid expansion. But as the multiplier is not working and there is no creation of commercial bank money because of the lack of trust between banks, the M1 monetary aggregate – so important for purchases – is only growing very slowly. The immediate danger of price increases should therefore be very small. I consider it very likely that 2009 – and the second quarter in particular – will see price levels in a number of countries fall below the respective pre-year readings.
    … As I am certain that the ECB is taking its inflation target very seriously and as the world knows that there is competition for the US dollar from the euro, the risk that the Fed will pursue an inflationary monetary policy is limited thanks to competition from the ECB.”


    The RGE Analyst Team wrote in a collective article on April 29:

    “… So far, despite several months of hot money capital outflows, China seems to have increased its share of the safest U.S. assets especially treasury bills. Given the global export weakness, China may be forced to maintain its quasi dollar peg, which will likely involve a resumption of U.S. dollar asset purchases. …”


    Finally I have two questions:

    1.) It is often said that the Fed prints money. Does it print paper money literally or is this loose talk meaning that the Fed increases the monetary basis exclusively by entitling commercial banks to book a certain amount of fiat money as their asset on their current accounts in their electronic data processing? If it were not the latter I could not understand Norbert Walter’s thesis that central banks can easily reduce excessive money supply.

    2.) Could you explain why banks as sellers of derivates are probably in the weaker position so that they will lower their offers? Commercial banks are hoarding liquidity. What should banks bring to sell derivatives at low prices?

    Best wishes
    Mr. Deep Pocket

  4. Hi Deep Pocket,

    My thoughts on the shortage of dollars are definitely not unique. I'd also count Eclectica manager Hugh Hendry among the vocal supporters of the idea.
    To answer your questions:
    1. The fed prints very few physical dollars. They're "printing money" via open market operations where they electronically credit banks' accounts at the fed in exchange for treasury securities.
    2. The seller is in the weaker position because metaphorically, you can't eat financial assets. As a potential buyer I always have the option of just walking away and holding cash. Warren Buffett was sitting on about $50 billion of cash for a few years because he didn't see any investments he liked. The sellers may be forced to sell by regulators to meet capital requirements, or just to free up cash to pay their employees. Homeowners may be forced to sell because they can't afford their mortgage payments or need cash to buy food.