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Author Archives: Dwayne

Stocks or BondsSuppose you think interest rates are going to go up, and you are trying to choose between alternative investments.  Of course, rising rates will reduce bond prices, and so you prudently decide to invest in stocks rather than bonds. 

But, if you expect rising rates, should you choose growth or dividend stocks?  From what I hear on business television, the obvious choice is growth stocks.  Dividend stocks, so the “experts” say, are similar to bonds because they are primarily bought for current income.  And, like a bond, when interest rates rise the dividend-paying stock’s price will decline.  This last part I fully understand.  Ceteris paribus the price of a dividend-paying stock will decline when interest rates go up.   Stock prices reflect the discounted value of expected future cash flows.  When interest rates go up the present value of a given cash flow stream will fall.

But what will happen to the price of growth stocks?  Growth stocks are generally those high-flyers that are not presently paying any dividends because the companies are reinvesting all their cash in new projects whose payoff will occur in the more distant future, if ever. Based on what I hear and read in the media, conventional wisdom is that when compared to dividend stocks, growth stocks prices will be less sensitive to rising rates.  And this is the part I don’t get.

Bond traders are usually pretty good with math.  And they understand that the “duration” of a bond determines how sensitive the bond’s price is to changes in interest rates.  A short-term bond whose duration is only one year will suffer a 1 percent decline in price for every 1 percent rise in rates.  A bond with a longer duration, say 10 years, will go down in price by 10 percent for every 1 percent rise in rates. 

Now, shouldn’t the logic be the same with stocks?  A dividend stock that is paying a known cash flow each and every quarter has a shorter duration than a growth stock that is paying nothing now, but offers the (faint) hope of large cash flows in the distant future.   Using duration as the guide, rising rates should drop the price of the short-duration dividend stock by a lesser amount than the long-duration growth stock; the talking heads have it backwards–in the face of rising rates I’ll bet on the dividend stock that is giving me cash now.

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WheelbarrowAn April 11, 2013 article in The Atlantic argued that bitcoins are not presently a currency, and that it “won’t be one until it has a central bank.”  According to the article, a serious problem with bitcoins as a currency is that an economy using bitcoins would be subject to a “massive deflationary bias.”  (See the article at http://www.theatlantic.com/business/archive/2013/04/bitcoin-is-no-longer-a-currency/274859/).

 Do bitcoins have a deflationary bias?  Let’s look at some numbers. 

 For starters, consider the 27-year period extending from now until 2040.  Presently there are roughly 11 million bitcoins in circulation.  By 2040 the amount in circulation will be 21 million.  With compounding, to get from here to there the average annual growth rate of bitcoins in circulation will be 2.4 percent.  Now, consider that growth in real GDP happens at a rate of roughly 3 to 3.5 percent per year.  If money (bitcoins) are growing at 2.4 percent and real GDP is growing at 3 percent, then one might expect prices (when measured in bitcoins) could be falling at 0.6 percent per year—hardly a “massive deflationary bias.” 

 Beyond 2040 the supply of bitcoins is fixed at 21 million.  If real GDP is growing at 3 percent, and the money supply is fixed, then prices might be expected to drop at an annual rate of 3 percent. 

 But there is a serious problem with the forgoing analysis.  That is, even though beyond 2040 the supply of bitcoins is fixed, the velocity certainly isn’t.  Bitcoins can be transferred between people at the speed of light.  The quantity of money in circulation may have been an important consideration back when currency had to be physically transported from point A to point B.  But when money can move at the speed of light, the physical quantity is circulation becomes a non-issue.  Whether prices when measured in bitcoins will ultimately rise or fall depends equally on the money supply AND its velocity, and nobody knows what the velocity will be.

 However, one thing is certain:  bitcoins cannot be printed up by central banks.  And, contrary to what appeared in The Atlantic, this is their biggest strength!  Governments working together with their central banks are able to steal real output from the private sector through running the printing presses.  Thankfully bitcoins are not controlled by self-interested politicians, central bankers, and greedy government bureaucrats, which is precisely why Capital as Money will soon be priced and sold in bitcoins.

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Red TapeA few nights ago I watched a John Stossel special on FOX news focused on government’s war against small business. The special started with Stossel surrounded by mountains of papers representing the federal rules and regulations imposed on businesses. To economists, the theme was a familiar one:  Guised as much-needed regulation, government’s myriad of rules and red tape often has the affect of suffocating small companies.  Discouraging entrepreneurs from pursuing new ideas ultimately benefits those larger companies having more lawyers, political ties and strong lobbies. 

Consider the recent problems of Bitcoin, which were first drawn to my attention in a comment on this website (see Adrian Alatorre’s comment posted on May 16th).  A Tokyo based company named Mt. Gox is the largest exchange involved with trading Bitcoins, and Mt. Gox has an account with Dwolla (a U.S. company that moves money online for a small fee.)   Information pertaining to the Mt. Gox account with Dwolla was seized last week by the Department of Homeland Security.

The alleged crime is a violation of Title 18 Section 1960 of the United States Code which prevents “Unlicensed Money Transmitting Businesses.”  If convicted of such a crime the penalty can be quite harsh.  As stated in the Code, “Whoever knowingly conducts, controls, manages, supervises, directs, or owns all or part of an unlicensed money transmitting business, shall be fined in accordance with this title or imprisoned not more than 5 years, or both.”

 Certainly the arguments against Bitcoin will be couched by government officials in lofty language and concerns about the “social welfare.”  The real motivation may have more to do with government’s worry that its central bank could face competition in the “money creation” business. 

 I have my own concerns about Bitcoins, but certainly the need for government regulation and scrutiny is not one of them.  My biggest issue with buying Bitcoins is that I am purchasing air.  Of course, if I buy them with dollars then I am buying air with air, so why not?  At least Bitcoins are limited to 21 million, whereas government-created money has no bounds.

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Capital as Money Cover Capital as Money is available as an E-book on Amazon. The price is $3.99.

Click the “Get the Book” button above to go to the E-book’s site on Amazon!

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BitcoinsThe free market is at work in attempting to come up with alternative solutions to government-controlled fiat money.  One interesting innovation is the development of “Bitcoins.”  A Bitcoin is simply a piece of information stored on a computer that is designed to be used as a medium of exchange and a store of value.  That is, Bitcoins represent a privately produced “money.”

The purpose of Bitcoins is stated as follows:

“Building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context, Bitcoin is designed around the idea of using cryptography to control the creation and transfer of money, rather than relying on central authorities.”  (https://en.bitcoin.it/wiki/Main_Page)

We greatly applaud the founders of Bitcoin.  Creating a new “money” that eliminates the government and central bank’s monopoly on currency manufacturing is a significant move towards economic freedom and transparency.  However, there is a drawback to Bitcoins:  Like fiat money, Bitcoins are not backed by anything real.  One way to obtain a Bitcoin is to purchase it with government-created fiat currency.  The other way to get a Bitcoin is to generate it through a process of computer “mining.”  Either way, there is nothing of real value behind it.

 Of course, there is nothing of real value behind government-created fiat money either.  And at least Bitcoins are designed to be of fixed quantity.  In these days of across-the-globe money printing by governments and central banks, the promise of a fixed quantity of Bitcoins is precisely what is giving the new money some appeal in the marketplace.

Better than a Bitcoin would be a privately-created medium of exchange that is actually backed by something having real value.  The evolution should be toward a money that is traded electronically, and when it is exchanged it represents the transfer of ownership of a small sliver of the economy’s productive capital.  

We believe Bitcoins are unlikely to be widely accepted as a medium of exchange for the simple reason that the public is rightly suspicious of a money that is backed by nothing other than a promise to not create too much of it.  However, Bitcoins represent an important first step in the development of a private money that does have real value:  Capital as Money.

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Capital as Money CoverAn interesting review of Capital as Money was posted on Amazon on April 11, 2013:

I hate to give banks TOO much credit, but understanding how the world we live in works isn’t possible without understanding banking.

To understand banking, of course, you must understand money. And, further, to understand money you must especially wrestle with the concepts of fiat money and fractional reserve banking.

And, finally, to wrestle with those slippery concepts YOU SHOULD DEFINITELY read Capital as Money.

After you get the concepts of fiat money and fractional reserve credit creation pinned down, you’ll begin to understand more about why there is so much volatility and excess in our financial system. Then you’ll want to look for alternatives to the present system we all rely on, which is exactly what the authors of Capital as Money have done.

The idea of our money being connected to something other than `thin air’ has an instinctive appeal to people. The problem is that most times people latch on to the idea of gold as the substitute for thin air. My conviction is that `out of the ground’ is no better, really, then `out of thin air’ as a source of money.

Gold has the appeal of seeming to be “God’s Currency”. Problem is, though, that gold is not currency, God’s or ours, and using it as currency (or to back currency) is also problematic.

What you have in Capital as Money is a genuine alternative to `thin air’ or `God’s currency’. Rather than basing our money on `air’ or `gold’ let’s base it on the fruits of our labor, our productive capacity, our hard earned and long term capital, and our ability to create more of the same.

That’s the genius of capital as money. The securitized ownership of our biggest corporations (the public ownership of the stocks issued by our largest corporations) is extremely deep and liquid, and yet it rests on something real (not thin air) and growing (not hidden under the ground). The idea presented by McGrath and Dwayne of using this very real corporate capital as the primary method of backing our money system deserves very serious consideration.

Capital as Money makes a very significant contribution to a very important conversation about what our money system is going to be based on; not air, not gold, but something much better suited to the creation of money.

Read the book and join the conversation.

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Businessman putting gas nozzle to his head, screaming.Sometimes it seems that we are examining inflation and its components with the same intensity and in the same absurd, uncomprehending way that Greek and Roman Oracles examined the innards of a chicken to discern the future.  “Include this item, exclude gasoline, assign more weight to IPADs, give zero weight to food.”  The numbers get massaged so that the in the final analysis it is difficult to find any meaning in what is reported.

To really get a handle on inflation, it is important to remember the distinction between inflation and relative price movements.  Inflation refers to the rate of increase of prices in general.  And inflation occurs or accelerates when governments or central banks are issuing worthless currency (fiat money) faster than their real economies are growing.  Hence, it is ironic for the government to wring its hands about inflation, its unfortunate impacts, or the nuances of its measurement.  The government and the central bank are responsible for creating the very inflation whose measurement is so carefully and selectively being fine tuned.

As was mentioned in last week’s blog, when measuring core CPI inflation the government tosses out food and energy, and last month energy prices shot up.  But since energy was removed from consideration, the reported core inflation number was unremarkable.

When reporting inflation, the government’s ignoring of those items whose price went up by the largest amount is absurd.  It is analogous to a guest coming into your home and bringing with them an un-housebroken dog.  After the guest’s dog fouls several of your rooms, the visitor commiserates with you on which rooms were fouled worst.    One can only imagine the conversation as the guest attempts to play down the damage.  “The dog had issues in both the kitchen and in the dining room, but it made an unusually bad disaster out the living room, so I am eliminating that one from our list..…”

In any economy, even an economy with stable prices on average, some individual prices go up and other prices go down.  Relative price movements are always part of economic life—and would continue to be even in an economy that used a private real money such as capital.  Relative price changes occur because of supply and demand for various goods and services and all the things that affect them—wars, droughts, new resource discoveries, fads, trade embargoes, etc.  Overall inflation happens only when fiat currency is rapidly created out of thin air.  And, the government should be reminded that the problem doesn’t disappear by reporting “core” inflation while closing its eyes to those prices that have gone up by the largest amount.

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prices

Today the government released the consumer price index.  The media largely downplayed signs of inflationary pressures, as the month-over-month core rate of inflation was a mere 0.2 percent.  The following quote taken from today’s Chicago Tribune is representative of the overall response to today’s inflation numbers:

“Excluding food and energy, consumer prices rose 0.2 percent slowing from January’s 0.3 percent advance.

The generally benign underlying price pressures should give the U.S. central bank scope to keep pumping money into the economy, despite signs of improvement in labor market conditions.”

 Before we break out the champagne, we think a further look at the numbers is warranted.

When it comes to measuring inflation, the government reports two numbers, one called “core” CPI inflation and the other called “headline” CPI inflation.  (Ironically, it is the “core” CPI inflation number that usually grabs all the headlines.) 

Headline CPI inflation is measured by considering all the items purchased by a typical household, and seeing how much the prices went up on average.  Makes sense, doesn’t it?  And when you examine today’s headline CPI inflation, prices went up month-over-month by an amount of 0.7 percent.    

By way of contrast, core CPI inflation is calculated by looking at a typical household’s purchases, but then tossing out food and energy.  So the core CPI inflation rate might be meaningful to a person who doesn’t use any gasoline, electricity, natural gas, or eat food.  For the rest of us, it is the headline CPI that matters. 

Naturally, lots of us wonder what the government’s rationale could possibly be for excluding two of the most important items in any household’s budget from the calculated “core” rate of inflation.  To skeptics, the reason is simple:  the inflation rate appears lower if you exclude those items whose prices are going up.  But perhaps we are being too harsh on the government by presenting only one side of the story. The government’s own economists would tell you that core inflation is more relevant than the headline number because food and energy prices are really quite volatile.  By excluding food and energy, they will argue, we get a better picture of underlying inflationary pressures in the overall economy. 

Well, OK, maybe food and energy prices are volatile. All that tells us is that the thing we are trying to measure, which is inflation, is volatile!  Putting your head in the sand and ignoring two of the largest items in any household’s budget may allow for bureaucrats and central bankers to conclude prices are rather stable, encouraging them to continue creating more money.  But for shoppers a low core rate of inflation means zilch.

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money changing handsMilton Friedman famously observed “inflation is always and everywhere a monetary phenomenon.”  This aligns with simple intuition—if money is printed too rapidly, then the prices of goods and services will surely rise.

The Federal Reserve is presently expanding the monetary base at an unprecedented pace.  But inflation, at least as reported by U.S. government statisticians, appears to be modest (more on reported inflation statistics in future blogs).   How do we explain this apparent anomaly?

As was previously discussed in our March 4, 2013 blog, one relevant factor pertains to the difference between the monetary base and the money supply.  It is the monetary base that is directly impacted by the Federal Reserve’s ongoing policy of purchasing boatloads of government bonds.  The monetary base consists of bank reserves and cash in the hands of the non-bank public.  But expanding the monetary base does not necessarily correspond to expanding the money supply.  The money supply (M-1) consists primarily of checking account balances and cash held by the non-bank public.  An expanding monetary base may not result in more checking account balances in an environment where commercial banks are reluctant to loan and are holding lots of excess reserves.  And the Fed’s policy of paying banks interest for clinging to reserves is having a negative impact on bank lending.   Thus, the money supply is not growing nearly as rapidly as the monetary base.

Still the money supply is growing.  For the 12-months from January 2012 to January 2013 the money supply (M-1) grew at an annual rate of 11.8 percent, while (M-2) grew at 7.5 percent (source:  http://www.federalreserve.gov/releases/h6/current/).  So, why is there little (reported) inflation?

The equation of exchange, explained fully in Capital as Money, provides us with an answer.  The equation of exchange relates the money supply (M), the velocity of money (V), the average price of a good or service (the price level, P), and the physical units of output produced in our economy (real GDP, Y).  The equation is a simple identity, and is shown below:

M V = P Y

At the present time our money supply, as measured by M-1, is growing at about 12 percent per year.  Meanwhile, real GDP (Y) is sputtering, with an annual growth rate of about 2 percent.  Likewise, reported inflation is somewhere in the neighborhood of 2 percent.  What is going on?  The answer is found in V, the velocity (or turnover) of money.  The velocity of money represents the number of times a dollar is spent on goods and services during a year.  And it has been declining.  A rapidly falling velocity of money can offset any increase in the money supply.  An examination of the equation of exchange suggests an economy will experience falling nominal GDP (which is P Y on the right-hand-side) whenever velocity (V) is going down more quickly than the money supply (M) is going up.

Now, here is the problem with velocity:  It always tends to go the wrong direction.  When an economy is entering recession prices tend to fall, and people are motivated to hoard their money.  Holding on to your cash makes a lot of sense if prices are going to be lower tomorrow than they are today.  This tendency can be seen in data provided by the Federal Reserve Bank of St. Louis (http://research.stlouisfed.org/fred2/categories/32242).  The velocity of money M-1 as of the fourth quarter of 2007 stood at 10.367.   By the fourth quarter of 2008 it fell to 9.202, and has steadily declined since.  As of the fourth quarter of 2012 the velocity of M-1 is a lowly 6.547.  The declining velocity has been sufficient to offset a growing money supply, resulting in rather tame reported inflation.

As was stated above, forces are at work to make velocity move in the wrong direction.  When inflation heats up, it entices people to spend money more quickly.  After all, who wants to hold cash when prices are rapidly rising?  Better to quickly spend your money on real goods and services; don’t wait until you have to pay more.

Right now inflationary expectations seem to be modest, and people are willing to hoard cash.  When inflation appears—and it will—the mindset will reverse.  Rising prices will trigger a rush to spend, and velocity will go up.  The rise in velocity further reinforces rising prices, which again increases velocity, and so on.  Such is the nature of an inflationary spiral.

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Vault with Safe-deposit Boxes InsideSince the fall 2008 financial meltdown the Federal Reserve has engaged in open-market purchases of the highest order.  Open market purchases refer to the buying of government bonds to keep bond prices high and interest rates low. 

At the present time the Fed’s program involves the monthly purchase of $85 billion of government and government-agency bonds.  This monthly amount, when multiplied by 12, gives an annual figure of just over $1 trillion, which is roughly the size of the federal government’s current budget deficit.  The implication is that the Fed is ultimately financing the budget deficit by creating new money, which is referred to as “monetization of the debt.”  And we have frequently argued that the end result of all this monetization is bound to be inflation.

But why is inflation not soaring right now?  With such a rapidly expanding monetary base, why are prices not also sky-rocketing?  The issue of inflation, and its measurement, is something we will take up this month in a series of blogs.  However, to begin our analysis, we note that there is a difference between the money supply and the monetary base (see Capital as Money for a thorough explanation).  The monetary base includes commercial bank reserves, and it has grown at a much more rapid rate than the money supply.  And it is the money supply that ultimately impacts on consumer spending and prices. 

Why isn’t the money supply soaring in the face of all the Fed’s aggressive bond purchases?  The answer is in part due to another Fed policy, enacted in October 2008, of paying interest to banks for holding excess reserves. 

Take a minute to digest what you just read:  Starting in the darkest days of the financial crisis, the Fed enacted a new policy of rewarding banks with interest payments for NOT making loans!  The Fed’s paying of commercial banks to hold excess reserves, while at the same time buying bonds at a feverish pace appear to be contradictory policies.  Bond purchases by the Fed are designed to increase the monetary base, which normally expands the money supply.  Paying banks to hold excess reserves discourages lending and works to decrease the money supply.   Why the contradictory policies? We are not exactly sure why the Fed would head down these two conflicting roads.  Perhaps it is because the Fed wants to finance reckless government spending through massive bond purchases, while at the same time keeping a bit of a lid on the growth in the money supply.  If and when banks do start making more loans there is ample fuel in the form of a gargantuan monetary base to cause a dramatic surge in the money supply and in consumer prices. 

The Fed suggests that increased inflationary pressure, when it manifests itself, will be readily subdued by increasing the interest rate the Fed pays on reserves.  When prices start to rise, the Fed will promptly increase the rate paid to banks from 0.25 percent to some higher number, stopping inflation dead in its tracks.  Time will tell.

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