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Global recession – where did all the money go?

worldponzischemeGuardian UK: Before the credit crisis, the world was awash with money. Now central banks are pumping in more than ever before and still everyone is short. Dan Roberts explains the illusion of wealth.

Central Bank Gold Reserves – $845 Billion:
Ever since central banks stopped pegging their currencies to the price of gold, money has been a nebulous concept: a promise to pay the bearer, or “cheque” from the central bank, rather than a permanent store of wealth. Nevertheless most central banks do still hold substantial reserves of gold and foreign currency as a buffer against financial turbulence. The size of these gold reserves (just $845bn of gold in the central bank vaults) is a sobering reminder how much the value of money is an expression of confidence, or perhaps even a confidence trick. Central banks do not need to hold gold on a bigger scale because their ultimate response to a severe crisis would be to print more money. The process is about to get under way in the UK and US through an intervention called quantitative easing. Critics say the crisis has exposed the inherent weakness with paper, or “flat” money. (Source: GFMS)

Cash in Circulation – $3.9 Trillion: The narrowest measure of money is known by economists as M0 and count all the notes and coils in circulation plus reserves which commercial banks are required to hold with central banks. Because of the process of loan formation described in the next paragraph , this way of counting money can produce a much lower number than the amount  of theoretical cash flying around the world electronically. Global M0 was roughly $3.9 trillion in October 2008. This too has been growing though, particularly led by increases to the money supply in China and the US. Attempts to avoid economic recession after the last investment bubble burst at the turn of the century also led central banks to slash interest rates to historically low levels. Since interest rates effectively measure the “price” of money, this corrective action to avoid the last bust contributed to the explosion of cheap debt that caused the current one.many skeptics now believe we are experiencing  a super-slump caused by the failure to address problems building up during previous slumps.

Traditional Banking System – $39 Trillion: Ever since the queues formed outside Northern Rock, it has been  slowly dawning on people that all banks are inherently unstable. Under a system called fractional reserve banking, they are allowed to lend many times the amount they take in as deposits – on the assumption that not all depositors will ever want their money back at once. Instead, they are required to hold small core reserves with the central bank, for example $1 in reserve for every $4 they loan out. You put $100 in, they can lend $80 back out to someone wanting a car. The car company puts that $80 back into the banking systems, and its bank gets to lend out another $64 and so – creating up to $360 of new money if taken to the extreme. As commercial banks found ever more sophisticated ways to encourage us to borrow and interest rates were kept at historically low levels, this process saw the assets (or loans due to be paid back) of the world’s big commercial banks balloon to $39 Trillion according to the Bank for International Settlements.

Shadow Banking System – $62 Trillion: Bank regulation has been heavily criticized during the crash, but the rules governing commercial bank lending were stringent compared with the so-called “shadow banking system”. Led by investment banks and hedge funds, traders found ever more exotic ways to escape limits on how much they  could borrow to increase their returns. One financial instrument in particular, the credit derivative, grew to dwarf the value of the underlying debt on which is was based – parking at $62 Trillion according to the INternational Swaps and Derivatives Association. Ostensibly, credit default swaps (CDSs) and collateralized debt obligations (CDOs) allowed lenders to insure themselves against the risk of any one borrower going bust. INstead, traders lost touch of who owned what and products like CDO squared took financial engineering into fantasy land. The notional value of all derivatives reached $62 Trillion – many times the value of all economic activity on the planet. (this is the system that is currently being bailed out – NOT commercial banking)

The Great Asset Bubble – $290 Trillion: Easy money fueled a series of gigantic bubbles on the price of key assets such as property. These bubbles are now bursting with violent consequences. Working out how much the world is worth is tricky, but the Economist made a stab at $115 Trillion for developed economies in 2002 – including property, shares and bonds.  In the subsequent boom, shares alone soared to a peak of $51 Trillion. Applying the same multiple to other assets bubbles suggests the total asset value of developed economies peaked at $290 Trillion, compared with global GDP of around $55 Trillion. Since then, residential property has fallen by a fifth in the UK and global stock markets are off 81%. asset prices matter more than usual because loose credit conditions previously meant that consumers were able to borrow against the values of their homes or share portfolios to spend yet more money. We all felt wealthier, so we spent more.

An Unstable Pyramid?:  Viewed from the bottom up, the explosion in debt and asset prices that occurred during the boom years looks unstable and top-heavy. In even bears similarity to the pyramid, or ‘Ponzi’. schemes carried out by fund managers like Bernie Madoff: all the time all the participants believed in the inexorable growth of the economy, rising debt level were sustainable. When the music stopped. the whole edifice began to wobble.

Why the Bail Outs are Ineffectual – $1.9 Trillion: Attempts to restore stability by pumping in PUBLIC money have had some effect but the sums of money are tiny relative to the problem. The total value of state assistance to the banking system – either through direct spending or guarantees is estimated at $1.9 Trillion. The next stage is seeing central banks attempt to re-inflate the bubble be injecting new money into the system through a process known as quantitative easing.

Velocity of Money: mv=pq : As they dust down their economics textbooks, one equation is enjoying a revival among bankers trying to understand why the credit crunch is so powerful. The quantity theory of money can be expressed in just four letters: m, v, p and q. Put crudely, the first stands for the amount of money in circulation, the second for the velocity with which it zips around the financial system, the third for the price of goods and the fourth for the quantity of economic output. During the boom, financial innovations sped up the flow of money through the system. Now as banks stop lending to each other and nervous consumers stop spending, velocity is tumbling. Even though the money supply is being increased by central banks it is not enough to prevent steep falls in prices and the output, of GDP, of the world economy.

Graphic slide version available here.


Written by mattliving

February 1, 2009 at 12:39 pm

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