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If I take money out of the economy (by withdrawing cash and stuffing it into my mattress, say) is that deflationary? I don't think so. Potentially it reduces the opportunity for my bank to use to lend in future. But I do not regard it as deflationary. Unless it happens to get burnt in a fire or something, it's likely it will be spent some time in the future.

This is rather a moot point at the moment is it not?

The dollar's role as a reserve currency means that many of its dollars are held overseas (the equivalent of being withdrawn from circulation by being hidden under the mattress) where it has had little impact on driving up domestic prices over the years. This has allowed the us to have lower interest rates and higher money supply growth than normal inflation targeting would allow.

It is over simplistic to look at only one loan transaction, you need to look at a series of the same transaction. In the series of the same transaction (over and over again) the money supply must grow or contract. It cannot stay the same.

 

These are 2 simplified extreme examples.

 

In an inflationary scenario, there has to be an increase in the money supply and it must keep growing. Otherwise we would not be able to repay our debts + interest. So the money supply keeps growing and you or somebody borrows more and more money to keep repaying debt + interest.

 

In the deflationary scenario, the money supply has not increased (or somebody defaults to cause the money supply to reduce). There is now not enough money for repayment of debt + interest, not for everyone. More people default because there simply isn’t the money to repay the loan (for everyone) and the situation keeps getting worse.

 

Both situations are balanced, slowed down a bit by default / new loans

On the whole I agree ziknik. I'm just not sure about the point in bold which is widely quoted.

There are two provisos I would make...there is always enough money as long as that money continues to circulate quickly enough to run ahead of the growth of interest liabilities so that they don't become unmanageable i.e if you have a healthy economy people can earn their way out of their debts. It shows up as affordability I suppose. So the velocity of money is as important as the money supply itself in terms of meeting debt/interest obligations. (EDIT: effectively the money supply growth simply makes debts more manageable by devaluing them through inflation - but it is the 'velocity' or 'earnings' that makes them payable)

Secondly, the interest that gets paid to the bank ends up (assuming it has lent and run its business well) as profits. Those profits may well be used to grow lending and future profits even further. Alternatively those profits are paid out as tax to the government who may spend it or indeed to the shareholders who may spend it. So the interest doesn't necessarily just get stuck at the bank doing nothing...it circulates in the economy earning profits and repaying other debts.

Make that three points. Deposits are in a sense a loan to a bank and earn interest themselves which may also go out into the economy. The bank has to find the money to pay its depositors in much the same way that a borrower has to find the money to pay the bank. As you know the depositors' interest is largely paid by the bank from its lending. So the net liabilities may not be as big as we think...the effective liabilities between depositors and borrowers is far bigger than that between the borrower and the bank. And we know in both cases that the money comes out into the economy again anyway (unless something drastic happens).

ziknik is my thinking right? I'm not sure. Just doing it from scratch.

3 ) Interest payed -> no net effect on the money supply, just existing money changing hands

Couple of points - don't forget the effect of default wiping out capital which results in a multiple of that reduction in lending capacity. In extremis this can cause the calling in of loans and/or reduction in lending going forward.

Secondly re interest. Interest is added to the loan held at the bank. The effect of paying interest reduces this balance but causes money to be removed from the system in much the same way as a repayment of principal. There is no effect on notes and coins in circulation but would impact deposit holdings where the customer's earnings may otherwise go. So it is deflationary. (unless and until it tops up the banks capital via the profit and loss account, increasing its lending capacity and it is used for additional loans as a multiple of the additional amount of capital).

I think we're going to get the chance to see whether default results in inflation or deflation....

http://www.moneymarketing.co.uk/cgi-bin/it...;h=24&f=254

Moneymarketing report HBOS prime rmbs mortgages with an incredible arrears rate of 4.1% ( we haven't even stated a recession yet!).

If you think of the interest rate differential between a borrower's prime mortgage and the funding costs (south of 1%) you can see what damage default will wreak.

It is inflationary the maximum extent because all the banks that lent money to NRK got their money back in one day rather than receiving it over years.

I'm sorry ziknik, I don't understand that. Correction. I see what you mean...the government stepped in to provide funding when investors (banks, ordinary depositors, hedge funds etc) disappeared. But you argued earlier that repayment of loans is deflationary. Is it different here? The effect of the repayment of a bank's loan is in itself deflationary - but of course if they then go straight ahead and lend it out again, then it has no effect. It rather depends on whether the government's money is 'new' money or re-deployed (and where re-deployed from).

It could be deflationary if people paid back their loans within a few years but they are not going to do so. They are going to move their loans to another bank so it will make no/little difference.

Given all the banks are having trouble increasing lending to support house prices, this extra requirement at this time would be difficult for them to support. In normal times, I would agree with you. The NR situation of reducing the book has the effect of reducing the lending capacity in the overall banking system.

If you take the SLS as an example: It is designed to stop the deflation. The BofE have put a lot of time in to the design of the scheme to ensure it is not inflationary. If it runs as per design, it will probably be a bit inflationary. It’s a difficult balance and it cannot be 100% right.

 

The chances are that the SLS loans will run for several years and halt the deflation that is needed and cause some (a little) inflation.

 

But, on top of the SLS, we have Northern Rock. NRK was a 100% bail out. The money will be unrecoverable and is very inflationary.

 

If another bank on the SLS goes bust we have more of the same. Especially if it is 100% bailed out like NRK.

 

Remember, there’s already enough money in existence to create a devastating inflation scenario (if not hyperinflation). We need some deflation

The SLS provides liquidity not capital. So whilst it stops deflation as a result of a market shortage of liquidity, it does not solve the issue of default wiping out capital and the consequential effect on lending capacity.

Re Northern Rock - the capital injection is 'inflationary' to the extent that it is expected to replace capital that is expected to be wiped out. However, the plan is to shrink the book to about one third I think over the next few years which is very deflationary.

Repaying a loan is deflationary in terms of prices because money is being used to repay loans rather than chasing goods.

 

In terms of money supply, repayment is inflationary because the money is paid back with interest. This allows the bank to lend even more.

Or, strictly speaking - repaying a loan is deflationary as money is removed from the system...but as ziknik says, if the bank makes a profit (of which interest is one of the revenue streams) then the bank has more capital against which it can lend a multiple of money (assuming it doesn't pay it all out as dividends and taxes).

I would argue - but I've not had this confirmed anywhere - that the charging of interest itself may in fact be deflationary as it creates additional liabilities which need to be paid out of the existing money supply...i.e. the velocity of money has to rise. But this is contentious. Lending also brings forward consumption from the future and raises effective prices for goods and services - so in effect borrowing is short term inflationary and longer term deflationary in terms of demand.

Exactly

Yes. But not exactly, exactly.

Because the bank's capital is wiped out by having to pay off the customers' loan for him in the event of default, it means the bank's capacity to lend is constrained by the appropriate regulatory capital requirement (c.10x average for on balance sheet lending). They either have to raise additional capital (which is effectively a transfer from elsewhere) or they have to either call in their loans or not grow the book so quickly as they rebuild their capital ratios out of profits.

QUOTE (bigtbigt @ Sep 5 2008, 02:59 PM)

"why did the PoG and PoS just do what they just did this last hour?"

 

QUOTE (wrongmove @ Sep 5 2008, 03:00 PM)

"US employment numbers worse that expected."

 

Eeerrrr... OK??

 

You're probably right. But I'd have thought that in most peoples minds bad employment => implied recession => implied deflation => drop in gold price

 

Perhaps the reaction is instead therefore one of growing panick (as I spkoe of a few posts back). If so great! People are getting nervous and likley to be increasingly easily pannicked. Good time for a black swan as far as gold bulls are concerned.

 

This marks a very clear divergence from price of oil!!!

You're good.

I wrote this on another thread at 3.15pm

http://www.greenenergyinvestors.com/index.php?showtopic=4166

Interesting.

 

Higher than expected unemployment figures leads to dollar weakness and according result on commodities etc.

 

Now commodities (esp. oil) falling again....because of counter effect of expected fall in demand...which then causes the dollar to strengthen?

 

My brain hurts.

I wouldn't bet on the divergence lasting.

FT article re demand surge:

http://www.ft.com/cms/s/0/89cfe296-7aba-11...0077b07658.html

Gold demand in India is booming as retail consumers in the yellow metal’s biggest importer return to the market after a 20 per cent fall in the price of bullion.

The arrival of the festival season in India – when it is traditional to buy the precious metal – is helping demand rebound sharply after a lacklustre start to the year, but traders said a similar trend was emerging in Turkey and Abu Dhabi, supported by the fall in prices.

The surge, after global retail demand fell 18 per cent in the first six months of 2008, is helping to sustain gold prices at about $800 an ounce in spite of the strength of the dollar, which traditionally hurts precious metal prices.

Traders said that bullion imports in Abu Dhabi – a key Middle East gold hub – surged 300 per cent in August compared with the same month last year. Turkey saw the highest ever monthly imports last month, while the past five weeks have seen the busiest gold demand from India in 20 years.

Ashok Minawala, chairman of All India Gems and Jewellery Trade Federation, a trade body in Mumbai, says he has witnessed a “tremendous” increase in consumption.

“The buying period usually starts in August and September, for the festival of Divali in October, but this has been unprecedented,” Mr Minawala says.

UBS, one of the largest gold exporters to India, says it has seen a spike in sales. John Reade, UBS metals strategist, says that the near-absence of jewellery demand in India between August 2007 and July left the local market largely de-stocked, “hence the tremendous pick-up in demand over the past five weeks”.

As a result, prices in India have moved up to $5 above London quotes.

etc

From FTAlphaville's Markets Live today...

House price declines and subsequent increases in unemployment

Our Gilt strategists have examined the lags between the start of past housing crises and the first

significant increases in unemployment. They found that large increases in unemployment have

typically emerged about 16 months after the onset of a housing decline. UK prices started falling

a year ago, which means that the first significant rise in unemployment could appear in spring

2009.

Reuters video: "Japan firm serves China gold bug."

Enjoy.

http://uk.reuters.com/news/video?videoId=9...;videoChannel=5

I hold by the view that until gold regains its role as money as opposed to its commodityness, it will always be the tail wagged by the $ dog. And the commodity of preference for $ buyers and sellers is clearly oil - with gold a distant second.

If this is the case as I suspect, then articles like the one below which I received by email from uSwitch simply has to have some effect on peoples' behaviours this coming winter.

A new report by uSwitch has revealed that disposable income has dropped for the first time since 1997 in cash terms. UK households are £2,500 worse off this year compared to 2007.

Driving this drop is the huge increases in essential living costs which has left households being forced to find an extra £145 a month to cover rising bills.

LOOK HOW Gold (GLD) continues to follow the same path as Oil (USO)

and Oil Service stocks (OIH): ... update

Is gold 'following' oil, or is it a simultaneous $ phenomenon? Outcome similar right now but the distinction could be important.

But take your point about 'unless oil is also money, gold is behaving no differently and is therefore not money right now'.

Reuters video on gold.

http://uk.reuters.com/news/video?videoId=8...;videoChannel=5

Yes, which brings to mind what they say about gold being the anti-dollar. People have to doubt fiat first before they can believe in gold. This psychology will be central to the gold bull in my mind.

I would add that I think the run up in the gold price we have seen is down to it 'commoditiness'. i.e. its perception as an inflation hedge, a protector of wealth - but no different to other commodities at this stage. However, I do believe this is a necessary first stage if it is to be followed by a repudiation (or partial repudiation) of the $ - indeed this will be a process where it will be difficult to discern when it is one thing or another - and will only become clear when it has happened i.e. people finally don't want to accept your dollars any more.

EDIT: but it also assumes that people will choose gold instead of other forms of exchange - such as the Euro say. Such a decision may be based on confidence, ease of use, availability etc.

I think the only time it makes sense to compare the price level of gold with its previous peak is when similar circumstances occur. i.e. when there is a repudiation or even a partial repudiation of the $ and gold assumes its money role. Until enough people look at it that way, the price will simply be largely based on its gold use or commodity role.

Of course, if you think the $ is on its last legs as successive waves of default occur in the US housing market requiring wholesale bailout of the banking, mortgage, investment, insurance and housing industries (at the same time as dealing with a general recession) - then gold could be a good substitute for $.

I don't think it is as straightforward to look at the ratio of fiat to gold either.

Gold has to compete with all sorts of other goods and services for that fiat and they may have changed price and/or volume over time.

I know you know but it's worth remembering that the fiat merely facilitates all those transactions...it doesn't actually reside in the goods or services themselves.

You can lend your gold out for interest you know. But of course, you then have some credit risk.