November 24, 2009

What “Money” Means Now

It’s almost Thanksgiving, and the sun-splashed snow along Denver’s South Pearl Street is festive! Groping for reflective thoughts this holiday season we found humorist Dave Barry’s mother, who told him these immortal words long ago: “Son, it’s better to be rich and happy than poor and sick.” As Dave Barry observed, “That makes sense, even in these troubled times.”

What doesn’t make sense is a sentence from the Fed Open Market Committee minutes  from November 4, out today. IR professionals and execs, this is crucial, so stay with us here. It gets to the meaning of “money” and why we have a serious problem, despite markets up 23% since November 24, 2008, and 60% since March. The Fed said: “The low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.”

How does the absence of resource utilization cause prices to go down? Prices decline when production is high, resulting in more goods being chased by the same dollars. And for that matter, why does the Federal Reserve keep interest rates low? In free markets, low interest rates mean that investment capital is plentiful and entrepreneurs should take chances. But if we’re saving no money, unemployment is over 10%, and profits are up almost entirely on cost-cutting…where is this widely available capital coming from?

Enter the prime brokers. All are now regulated as commercial banks by the Federal Reserve. This means they can create money under “fractional reserve” rules. Banks must keep a certain amount of assets to lend money. Most people think that means they keep back 10% of their assets and lend out the rest. In fact it means that if they’ve got $1,000 of assets in savings accounts, the Federal Reserve writes onto their asset ledger $12,000, for lending. That $12,000 did not come from productive investment activity. It came from thin air.

The Fed calls this “keeping interest rates low.” But it’s really the provision of synthetic money. This is what happened with the housing bubble. Interest rates were low. Banks like BofA had money created by the Federal Reserve on their books. That was free, riskless money. Any use of it produced returns, so they gave it out by the armload for mortgages and lines of credit – exactly as the Fed intended. Then other banks packaged these debt instruments into securities that could sit on, say, JP Morgan’s balance sheet to serve as that 8% reserve requirement, giving JP Morgan the ability to create Fed money on its ledgers and lend it out too.

Fake money was chasing fake money. When one mortgage in one collateralized debt obligation came apart, the whole house of synthetic cards came down. This was our first Madoff Moment – the veneer of prosperity peeled back to reveal nothing underneath.

We have another much bigger such veneer now in equity markets. Little new capital from investment is behind market appreciation of 23% year-on-year and 60% year-to-date. It’s Federal Reserve currency deployed by Prime brokers. It is synthetic money.

This is what we mean. This is why we continue to clang the claxon. This is why executives and IR professionals need to take a personal interest in the actions of the Federal Reserve and the government. They are behaving exactly the opposite of free markets, telling everyone that capital is widely available when it is not, and providing explanations that defy basic rules of economics.

It’s inflating equities and threatening us with another huge bubble. Mark our words: this bubble will pop. And we dance around as though the world has been healed.

And with that happy thought – hey, these machinations need to STOP if we’re ever to restore lasting value to our capital markets – it’s a grand and glorious day in Denver, and we are glad to live in a country where we can still petition our government for redress of these ridiculous grievances that ought not be happening in the land of the free.

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