Understanding creation of money and credit.

[WinstonWolfe]

Over the last 10 years, house prices have inflated at a greater rate than general price inflation. I find most property investors are fuzzy on the cause of this. Most relate it back to supply demand imbalances.

I am interested in people's understanding of how money and credit is created.
Personally, I think it is something not well explained and understood by most, and I have prioritized trying to understand it better over the last few years myself. But it can get very technical and there are varying views on flow on effects so it is hard to visualize the process clearly.

I think controlling the risks inherent in asset investment is very much dependent on understanding the forces that cause asset price inflation.....and the primary forces are money and credit creation.

Some might be surprised to learn that Australia has been expanding broad money and credit at approximately 3-4x the rate of GDP growth for 20 years.

I'd be interested in others' interpretation and opinions of this topic.
Essentially, what criteria do you think the govt uses to expand or contract money supply and credit, and what mechanisms do they use?

 

[WinstonWolfe]

Anyone wishing to devote a bit of time to understanding this topic might familiarize themselves with Richard Werner, a highly respected authority on Japanese deflation, the originator of the term "quantitative easing", who has evolved a "Credit Theory of Money" (after Joseph Schumpeter) which splits the use of credit into productive and non productive use, the latter of which causes asset bubbles and deeper recessions.

Here's a ppt he presented last year that isn't too hard going.

Here's a 20 minute interview with him re Central Bank Policy.
Part 1
Part 2

 

[ScottAppleby]

I haven't looked at your links but I assume if it explains the reasons for the increase of money supply through the increase in debt then it should mention the fractional banking system.
Once you read about fractional banking you can understand why alot of money doesn't exist and why it is good to be a bank.
Do a web search for"Money as debt" there is an awesome clip out there for any who haven't seen it.

 

[WinstonWolfe]

I haven't looked at your links but I assume if it explains the reasons for the increase of money supply through the increase in debt then it should mention the fractional banking system.
Once you read about fractional banking you can understand why alot of money doesn't exist and why it is good to be a bank.

Yes, am aware of fractional reserve banking....but there's some detail I still need to clarify in my own mind. i.e.

- when an Aussie Big 4 bank secures foreign wholesale funds, do fractional reserve banking rules apply?

- how are Bank corporate bonds treated? (I presume foreign wholesale funding is in part corporate bonds or notes)

Aussie banks are 25% reliant on foreign funds to keep Aussie property at current levels.

Out of interest, here's a chart of credit expansion over the last 15 years.
I can't get my head around how a central bank can allow credit expansion to grow at 3-4x gdp growth for 15 years. It seems totally irrational.

 

[Mandy Mac]

Lordy, been a while since I heard Schumpeter discussed. I was in a cab once in Singapore and all the driver wanted to chat about was Joseph Schumpeter - I think he considered himself an entrepeneur - LOL Maybe he though I said "Austrian economist" when I told him what I was - I'd had two sleeping tablets and was totally out of it.

Anyway, back to the question.

Are you asking SHOULD the govt take measure to control the supply of money or are you asking HOW does the govt try to control the supply of money?

 

[WinstonWolfe]

Are you asking SHOULD the govt take measure to control the supply of money or are you asking HOW does the govt try to control the supply of money?

Am happy to hear people's understanding of the control and mechanics of money and credit supply.

Most more knowledgeable people I've discussed this with have heard of fractional reserve banking and commercial bank reserve accounts, but are fuzzy on the mechanics and reasoning the RBA use to govern credit expansion. Some say the RBA is happy to let credit expand as long as it doesn't elevate cpi above the target band. However, I don't understand why they don't monitor credit's effect on asset prices more carefully when most credit is used to purchase assets.

 

[Mandy Mac]

Am happy to hear people's understanding of the control and mechanics of money and credit supply.

Most more knowledgeable people I've discussed this with have heard of fractional reserve banking and commercial bank reserve accounts, but are fuzzy on the mechanics and reasoning the RBA use to govern credit expansion. Some say the RBA is happy to let credit expand as long as it doesn't elevate cpi above the target band. However, I don't understand why they don't monitor credit's effect on asset prices more carefully when most credit is used to purchase assets.

OK - the first bit is way too clever for me. And since Al Greenspan who was governor of the Fed for 100 years doesn't understand it either, I don't feel too guilty.

However, I do think that de-regulation is a good thing, even though we don't yet know where it is leading us. We can just sit back and watch as financial institutions do their thing and eventually hope that we'll get an understanding.

Second part - Thanks for clarifying you meant RBA, not govt.

I think that the RBA can't actually control credit - as they have no control over what happens "out there" in the big bad banking world and when all these clever people are inventing clever new products that multiply money many times over.

So why didn't they tighten monetary policy when it became clear that loose money supply was resulting in an increase in property prices?

Coz the RBA has a charter to look after inflation, growth and employment. Now you might look at it and think "Well hang on, propery prices went up at ridiculous rates, surely that's inflation" but since wages didn't, then it considers its job done.

So that's just my humble opinion on it all.

 

[WinstonWolfe]

However, I do think that de-regulation is a good thing, even though we don't yet know where it is leading us. We can just sit back and watch as financial institutions do their thing and eventually hope that we'll get an understanding.

well it is partial de-regulation, otherwise banks could lend 45x their reserves, like Lehmans.

Second part - Thanks for clarifying you meant RBA, not govt.

I appreciate the RBA acts independently of govt, but taxpayers still pay RBA staff wages.

I think that the RBA can't actually control credit - as they have no control over what happens "out there" in the big bad banking world and when all these clever people are inventing clever new products that multiply money many times over.

Well, their control is compared to pushing and pulling on a piece of string. They can certainly tighten credit by reducing commercial bank reserve balances, upping the fractional reserve ratio, and increasing cash rate (pulling the string), but no matter how much they increase bank reserves, lower the fractional ratio and cash rate (pushing the string), banks don't have to take the risk of lending.

So why didn't they tighten monetary policy when it became clear that loose money supply was resulting in an increase in property prices?

Coz the RBA has a charter to look after inflation, growth and employment. Now you might look at it and think "Well hang on, propery prices went up at ridiculous rates, surely that's inflation" but since wages didn't, then it considers its job done.

So that's just my humble opinion on it all.

Appreciate your opinion.

The RBA's charter is to maintain the stability of the currency and full employment, and ensure the economic prosperity and welfare of us Aussies. Therefore they are to prevent economic cycles from swinging wildly (causing loose credit, asset bubbles, deep recessions, and credit freezes), which they currently attempt to achieve by controlling interest rates, bank reserves, and fractional ratio.... Considering loose credit caused the Great Depression and most recessions, one would think they watched credit supply more carefully.

Richard Werner makes a compelling case that measures of cash and money (M0-M4), broad money, high powered money, monetary base, reserve money are not good predictors of inflation because they don't actually tell how much credit is b3ing utilized.

 

[Dazz]

Hi WW,

Cannot comment on all that high level stuff - way over my head, and I haven't seen a way of making a $ out of it, so I don't apply myself in that area.

I think controlling the risks inherent in asset investment is very much dependent on understanding the forces that cause asset price inflation.....

What I can comment on is that bit.

The force that dictates asset price inflation for the assets I buy is rental growth. Everything is tied back to what the joint can either potentially deliver (vacant block waiting to be built on, or a market review just around the corner), or what it is delivering right now.

No one falls in love or gets dreamy eyed about a cold concrete box up in the air, or a set of rusty old sheds.

What drives rental growth then comes into play. I've found it to be a many and varied grab bag of things ;

• Couldn't fit his truck in the other shed (height clearance), so he's happy to pay more for mine.
• Wanted to drive around, not reverse out.
• Had a loading dock, others didn't.
• Office had views, the other one didn't
• Office close to law courts
• They've been there for 30 years....and they are "rusted on" Tenants
• Smart Leasing terms - most Tenants don't even look at the review schedule
• Factory was big enough, others weren't, captive Tenant
• Too many IT servers to shift - easier to pay higher rent than move them

I work on these things every day, which drives the rental growth, which drives the asset growth. It puts rental $ in the pocket, and extra zero's on the asset tables.

 

[cu@thetop]

Good post thanks Dazz.

 

[Piston Broke]

I work on these things every day, which drives the rental growth, which drives the asset growth. It puts rental $ in the pocket, and extra zero's on the asset tables.

It's all paid for with borrowed money.
And where does that borrowed $$ come from? The Central Bank.
So in effect the central bank is what controls the demand for rusty sheds and more trucks.
Knowing where they're at can be beneficial at times.
But what they say is generally the opposite of what they do.

As for IT, I can host servers & support with Amazon or Engineyard for 1/3 of the price it costs here with no need for to rent buildings & hire people. It will soon be cheaper to throw out at least half those servers (and staff) imo.
The only consideration may be that some storage of data may have to be held locally.

WW 99% of the population does not care and has absolutely no interest.
Who won the footy or the lotto draw is way more important.
Both of which contend with the latest horoscope and who's doing who on days of our lives & home & away.
On a scale of 1-100 the central bank and any interest in what it does is ZERO.
And most of the 1% believe whatever the RBA says, which on most occasions is not what it does.
But the RBA discloses what it does, it's just that it's much easier to hear what they say and not watch what they do.
Specially if your a news reporter or financially illiterate finance commentator.
And then of course there's those who have vested interests.

I raised the issue here before about money supply being 16%, but I would've got much more response posting about reading tea leaves or using the horoscope as a method of picking the best growth suburb.

I think that the RBA can't actually control credit - as they have no control over what happens "out there" in the big bad banking world

I think you net to re-asses your thinking of central banks.

 

[Dazz]

It's all paid for with borrowed money.

On the contrary PnB, many of the potential purchasers are very very cashed up Owner Operators. They have been screwed by Landlords previously, or had to share with another business and don't like it one little bit.

There are oodles of gentlemen in their 50's with lazy millions in their accounts ready to snap up something if it fits their business needs and gets them autonomy of their premises to operate out of. Banks aren't involved.

Fortunately, there is no graph published for that that the ABS or RBA pumps out to confirm it.

That's a level down from the macro stuff that the Govt agencies track, but that is where the money is.

 

[Mandy Mac]

I think you net to re-asses your thinking of central banks.

Why?

A central bank trying to control credit in a deregulated market is as absurd as the government trying to control imports after abolishing tariffs.

 

[Mandy Mac]

Appreciate your opinion.

The RBA's charter is to maintain the stability of the currency and full employment, and ensure the economic prosperity and welfare of us Aussies. Therefore they are to prevent economic cycles from swinging wildly (causing loose credit, asset bubbles, deep recessions, and credit freezes), which they currently attempt to achieve by controlling interest rates, bank reserves, and fractional ratio.... Considering loose credit caused the Great Depression and most recessions, one would think they watched credit supply more carefully.

Richard Werner makes a compelling case that measures of cash and money (M0-M4), broad money, high powered money, monetary base, reserve money are not good predictors of inflation because they don't actually tell how much credit is b3ing utilized.

Yeah, maintaining the stability of the currency means keeping inflation under control so the integrity of the dollars remains stable. They would also consider "maintenance" to prevent wild fluctuations in the value of the dollar compared to other currencies which is why you'll occassionally see them step in and buy money if they think the dollar has fallen too low.

I actually think they've done a good job. If you look at growth and inflation over the Howard/Costello years, even with the blip of the Asian financial crisis, we had steady growth, low inflation, full employment. Now some might say that's due to Govt policies, not RBA policies, or even that it's due to other worldwide factors, and there is never going to be a definitive answer.

But I think you are saying they have failed, or perhaps not achieved an optimum outcome, because housing prices have risen so much more than wages and this is due to credit and how banks make money.

I don't have the answers - but I hope you find them. One day my grandchildren might be learning the Winston Wolf Graph of credit creation in 2nd year macroeconomics.

 

[Mandy Mac]

There are oodles of gentlemen in their 50's with lazy millions in their accounts ready to snap up something if it fits their business needs and gets them autonomy of their premises to operate out of. Banks aren't involved.

But what he means is that gentlemen are paying the price they pay because of the existence of credit. If credit didn't exist, then you would only be competing against other other gentlemen.

But since credit exists, you may need to pay 5 million and 1 dollar because a lady has been given credit for 5 million dollars.

Thus even if gentlemen use banks or not, it's the ladies and the not-so-gentle men that use banks that have driven up prices.

 

[tom32]

There are oodles of gentlemen in their 50's with lazy millions in their accounts ready to snap up something if it fits their business needs and gets them autonomy of their premises to operate out of. Banks aren't involved.

Fortunately, there is no graph published for that that the ABS or RBA pumps out to confirm it.

That is what the graph of broad money is showing, there are lots of these people with lazy millions in bank accounts. Broad money is not a measure of loans it is a measure of deposits.

i.e. it is "money"in peoples deposits. How do we have this money increasing, well as people who are familiar with monetisation they will know if assets are increasing in price and people have access to credit to buy these high priced assets then a whole lot of new money is going to be created along the way.

Take a house valued at 500k an owner occupier (Bob) with no debt can increase the money supply by 500k.

Peter a first home buyer with steady employment and other assets approaches a bank to get finance for 500k. The bank loans peter the money and credits bob's bank account with 500k.

Bobs deposit counts toward M3, Peters loan does not.

Bob is one of these monied people now who have sold out of their home. Asset price rises drive deposits as well as loans. This is why asset price movements can gather momentum the monetisation of assets create more funding; that is the high valuation of the assets in question allows further increases in the asset in question.

I think as clear as night comes after day this will present issues down the line as we are reliant now not only on the deposits created by the asset price rises internally the usual feedback loop in asset price inflation, but now we are also reliant on external funding into certain asset classes in Australia.

The government buying 4bn of RMBS for example has a more profound impact on the assets price than you might at first think. i.e. a 4bn external funding source into an asset class from another allows banks to loan out this 4bn, which also creates new deposits see multiplier effect for an explanation of this.

 

[Player]

Some interesting perspectives so far. Enjoying reading the different standpoints in this thread

I am no economist and do not have deep enough knowledge or understanding of how the alchemists create currency ad infinitum.

Who are these alcehmists? The US govt (and all the mini-me US govt's around the globe)asking ever so politely for the Central Banks to print more currency. Sure they say.........here's the interest bill.

That's OK we'll capitalise it and raise taxes to pay for the sugar rush created from these rescue packages; at least until the patient falls into a diabetic coma.

We aren't free of the apron strings of the US however fortunately more tied to Asia and not to the US or Europe.

I wonder if this current rally on the DOW and S&P 500 and the ASX is the bears napping. For how long can the US stick their head in the sand and dish out trillions and trillions in stimulus having the effect of a garden hose fighting a rampant bush fire?

I'm not a pessimist however realistically a part of me is a little concerned about all this expansion. What further smoke and mirrors are to be revealed?

 

[WinstonWolfe]

I think as clear as night comes after day this will present issues down the line as we are reliant now not only on the deposits created by the asset price rises internally the usual feedback loop in asset price inflation, but now we are also reliant on external funding into certain asset classes in Australia.

I agree. I just cannot see this ending well. To me, Australia as a nation is becoming more like Skase, Bond, Connell, Judge, Elliot....who all went on a reckless credit binge in the 80s with the deregulation. I read "Bold Riders" recently and the noughties' similarities to the 80s are striking.

Excessive credit is destructive, and the stuff I have read that makes the most sense is based in the Austrian School paradigm, and Richard Werner.

You just cannot keep pumping credit into a nation if that credit is not going to increase productivity. Eventually, debt saturation in non productive assets deprives the nation of the ability to invest in production related enterprise. This will deepen our reliance on foreign investment to own and operate our most profitable businesses and previously public infrastructure, and borrow for housing.

Mandy Mac, are you doing a PhD? What's the field? I have no wish to develop a theory, just to clearly understand what vested interests do not seem to want Joe Average to understand, but effects everyone's wealth so profoundly it is scarey. When I was at uni I was a senior tutor in neuroscience, and myself and one other dumbed down a lot of the 101 content and text book into a palatable format via congregating all the best images, flow charts, acronyms, and learning aids we were exposed to. This was developed into a course handbook which increased exam performance dramatically. I have a passion for the power of well communicated information/education....and money/credit creation is too important a topic not to be understood better by anyone concerned about their children's future and preservation of wealth.

 

[tom32]

Excessive credit is destructive, and the stuff I have read that makes the most sense is based in the Austrian School paradigm, and Richard Werner.

You just cannot keep pumping credit into a nation if that credit is not going to increase productivity. Eventually, debt saturation in non productive assets deprives the nation of the ability to invest in production related enterprise. This will deepen our reliance on foreign investment to own and operate our most profitable businesses and previously public infrastructure, and borrow for housing.

Absolutely!

If I could indulge in an analogy;

A smart business owner who upon seeing his profit margins erode looks to invest in the productive parts of his business to claw himself back to a profitable business model. He may even take on greater debt if he can be assured it will provide him with a marginal return greater than the interest payments on that debt associated with teh specific capital expenditure.

A stupid business man seeing his margins eroding would say well this business is over I am about to go into the red, lets put on a brave face and make the most out of the next few years. Promptly goes out and buys his staff sports cars, boozy lunches and flashy nights out.

Think about Australia in the above context. Think about our GFC1 fiscal stimulous, supposedly Keynesian. Think the two rounds of $1000.00 cash handouts, School Buildings, Free insulation etc. Then ask yourself is Australia really the smart country. What did our Federal government invest in when we stared into the abyss of a global financial crisis?

Australias stimulous is the most short sighted in the entire developed world from what I can tell. Of course we avoided a recession because our " ïnvestment" was short term but produced very little. It was chiefly designed to keep broad money levels from shrinking in my opinion. In stead build snowy schemes, harbour bridges and irrigation schemes while we might have seen a recession we would have built something for the future, not got out of a recession on a technicality.

 

[WinstonWolfe]

In stead build snowy schemes, harbour bridges and irrigation schemes while we might have seen a recession we would have built something for the future, not got out of a recession on a technicality.

I agree with Werner who says neither public or private debt is necessarily bad if it is invested more directly in the means of production.

Indeed, if every household ran itself more like a business, where it must pay for all that it consumes over its life span, and use debt wisely to increase income, then Australia would be more like Germany in economic strength.

If every household invested moreso in education, health, and entrepreneurial nous, then what a difference.


Dazz, re the forces that dictate cip cg, it is not only rents, but govt regulation of supply of sheds.....and govt regulation of water supply and other infrastructure that could see more cities across Australia.

One of the reasons Austalia concentrates into the capitals in my view is that we are too poor a nation to spread out into more cities. Some would say that it is more cost efficient that we huddle into caps....but the reverse argument applies that we are too capital and entrepreneur poor to go start a few new cities.

If the Chinese shifted all Aussies off to NZ, and brought down 22.5 million of their own, I bet your bottom dollar GDP would double within 10 years in addition to the number of new cities. But sheds wouldn't necessarily go up if supply was allowed to expand with demand.

In many respects, your shed cg is a function of market inefficiencies introduced by govt (in supply demand equilibruim), and permissive govt attitude towards credit creation.

Though in my view, cip inflation is not as damaging as rip inflation. At least cips are used in the production process.

Anyway, this isn't a dump on property investing. It is the system we are in and to preserve or create wealth we all have to strive to get as much of the new credit money as we can, without burning our fingers.