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Banks Keep Marching On

The previous two parts of this lesson we made one critical assumption: Banks were lending and people were borrowing. This is what usually happens. Companies need to borrow money to expand or fix problems or simply to bridge a bad quarter. Banks are there and happy to loan.

People usually also borrow. People borrow for many reasons but the largest personal loan most people take is a mortgage. Who does not have the dream to own its very own house or apartment?

In normal economic circumstances, companies and people borrow because they are confident they will be able to pay the loan back.

There is chain of transactions which begins with CBs creating money out of thin air. This money is then multiplied roughly by 10 again, out of thin air, but this time by the Banks. This money is then lend to companies and people who use it to purchase goods and services. The sellers of these goods and services receive this money and they deposit it in Banks, which, consider these deposits “new” reserves and happily proceed to multiply them out of thin air and lend them to more companies and people. And so the cycle begins again.

The calculation explaining how exactly this happens is complicated and not intuitive. If you have the stomach, you can take a look at Wikipedia Money Multiplier.  For our purposes, suffice to say that there is a limit to how much money can be created by the Banks out of thin air for each unit of money that the CB originally created out of thin air.

That’s why it is called a Money Multiplier and not a Money Generator (only CB’s can do the latter).

This process is the only one that can place sufficient new money in the marketplace to create inflation and with it Interest Rate havoc. If for some reason this process does not work, there simply is no inflation or Interest Rate crisis. Until this process is restarted again, this is. Then it chaos comes back with a vengeance.


Dirty Float

If I live and work in France, my salary is paid to me in EUR. I can go to a supermarket and buy a bottle of French wine for 10 EUR. In the very same supermarket, I can also buy a Japanese bottle of wine (yes, Japan produces wines) for about 12 EUR. Both wines are of about the same quality. So I buy French. The question is now, why one bottle costs 12 EUR versus 10 EUR if they are about the same? Simple. The importer of Japanese wines has to buy it in Japan. For that, this person needs to take Euros, buy Yens and purchase the wine. How much he will have pay for each bottle depends of the exchange rate between EUR and YEN. If the YEN is expensive, he will get less Yens for each EUR. This is the same as saying that he will have to spend more Euros for each bottle of wine. This means that in order to make a profit, he will have to sell that very same bottle for more Euros in France. Hence, the bottle of Japanese wine is more expensive.

The problem with this is that this difference in price is not produced by manufacturing or transportation costs. It is an artificial difference created entirely by the Foreign Exchange Market (Forex). In this market, people buy and sell currency with currency. Since no currency is attached to anything (CBs do not peg the value of their currencies to the amount of precious metals they have in their volts), the relationship (exchange rate) of one currency to the other is anybody’s guess. It’s what’s called a “dirty float”.

Because of this dirty float, the market is subjected to variations in costs that have nothing to do with actual manufacturing costs.

CBs and governments may attempt to control or modify this exchange rate to their advantage (or so they say).


Japan Melts Down

Around 1985 the Japanese Yen had appreciated considerably and was causing problems with the export sector. Japan is mostly an exporting nation (Mercantilist) and depends of a cheap Yen to be able to sell their goods and services abroad.

This requires a brief explanation. Let’s take an industry we can compare, for example car manufacturing. The amount of time, raw materials and labor required to make a care in Japan is roughly the same it takes to make a similar model in USA or France. Therefore, the prices of any of those cars should be about the same. Emphasis on “should”.  However, they are not. This is due to the “dirty float”. If the value of the YEN against the EUR is low, French people will buy Japanese cars because in terms of Euros, they are cheap. Japanese manufacturers will be happy to sell cars to French people, because French people pay in Euros and through the favorable exchange rate, they receive more Yens than if they would sell them in the Japanese market.

And so, for an export-oriented economy, it is convenient to have relatively cheap currency. For a more current example, think China and its Renminbi (RMB) against the USD.

The opposite is also true. If the YEN becomes more expensive against the USD or other hard currencies, Japanese goods and services simply become too expensive for other people to buy.

Thanks to this “dirty float”, around 1985 the YEN was becoming very expensive and Japanese exporters begun to suffer. The government intervene. They started created money out of thin air (i.e. credit) by the truck load. The idea was to devaluate the YEN against other currencies, hence forcing the exchange rate down and thus recover its “competitive advantage” against other nations.

It did work. Throughout 1985 through 1990 the YEN dropped from about 250 per USD to about 133. A drop of about 50%.  It all worked out… more or less.

The “technical” problem with this process is that in order to force the Forex market to notice the devaluation of the YEN, astronomical amounts of YEN had to be generated. All these Yens had to go somewhere. They ended up in Bank’s digital volts. Banks promptly lent as much as they could. But, eventually, they started to run out of borrowers, even considering that interest rates dropped by more than 50%. All that funny money had to go somewhere. And somewhere it went. To Real Estate and Securities. People but mostly companies borrowed tons of money at ridiculously low Interest Rates and purchased commercial real estate or stocks and bonds. Voila!  Enter the Japanese economic boom.

This boom fed on itself. The higher the prices of land and securities went, the more people and companies could borrow against the to purchase, you guessed it, more land  and securities! The whole scheme was based on the principle that you could always borrow more at cheap Interest Rates and invest the proceeds in rapidly (and artificially) appreciating lands and securities.

The Japanese CB, recognizing that they have screwed-up, decided to “correct” the situation by… wait for it… crashing the entire Japanese economy! What they did is to raise Interest Rates abruptly in 1989. Since by then the entire Japanese economy was dependent upon fresh and cheap new credit, when this became unavailable, it collapsed.

Prices of land and securities dropped overnight and all those speculative loans on which this raise was dependent, went insolvent. People and companies could not pay back the loans and they could not liquidate their land or securities because even the proceeds of such sale would not cover the loans. They went bankrupt "en mass".

Hardest hit were the Banks, since now most of their loans were worthless. They were effectively bankrupt.

Then, the Japanese CB, understanding that it had screwed-up, intervened. They started to pump new credit into the Banks and allowing them to “delay” (forever) the accounting of unsound (unrecoverable) loans.

Banks were now flush with cash… that they could not use since they had to maintain a level of capitalization (i.e. Banks need to keep 10% of all the cash they loaned in their volts). Worse. Even if they could loan that cash to somebody, there were no takers. Banks looked alive but in reality, they were dead. They were labeled as “zombie banks”. Eventually, many Banks consolidated (went bankrupt and were purchased by other Banks).  

The Japanese CB did what all CBs do: they printed more money. Or equivalently, they lowered the interest rate to 0.1%. There was only one problem. There were no Banks willing to take more money they could not loan to anybody.  The economy simply wasn’t turning enough profit.

And so, we have what’s called “Liquidity Trap”. There is plenty of money to be borrowed, but there are no borrowers. The concept that lowering Interest Rates will stimulate the economy is no longer valid, because Interest Rates cannot be lowered beyond zero!

As there is no new money entering the system, the money is trapped in Bank’s digital volts, there is no inflation.

And so we arrive at the strange situation where there is no inflation, there is plenty of credit but no takers and the economy remains flat or enters into a crisis.

Japan lost a minimum of 20 years because the Japanese CB decided to “do something” to fix a recession caused by the “dirty float” they themselves created in the first place.

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to Senseless Inflation and Interest Rates - Part 4


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