Pretend Money and the Economic Recovery


Although the data isn’t updated, the economic conversation currently in the air suggests that it might be a good time to revive Scary Economic Chart #1,275:

U.S. Stock Market Growth Compared with National Debt, Consumer Credit, and GDP, 1943 to 2010


The green line is an estimate of the total capitalization of the U.S. stock market, and although it’s true of the first spike, the focus of this post is the green line’s second big spike, which (not to put too fine a point on it) isn’t real money.  It’s pretend money.  The financial imagination is diverse, so there are many figments, but the most prominent in the second spike was the debt that risky borrowers were never really going to be able to pay back.

The thing with imaginary money is that somebody is eventually left holding a half-empty briefcase.  In this case, it wasn’t the folks who couldn’t pay their mortgages because, well, they couldn’t pay their mortgages.  Instead, it was the banks and pension funds and other investors who had somewhere along the line produced something real (like cash to lend) or debts they couldn’t divest so easily (like pension promises).

So the United States issued bailouts, although liberal economists have a point when they say that the bailouts and stimulus weren’t enough to do what they were ostensibly meant to do.  In part, that was because a full bailout would have been politically impossible, but in part, it was because (as pensions illustrate spectacularly) the empty space in the briefcase was not just its balance at the crash, but where its holders had expected it to be at any given time if the crash had never happened… and where they expected it to go in the future.

So what’s a debt-addicted society governed by a ruling elite to do?

Well, it changes the measure.  It fills the briefcase up with newly printed dollars.  None of those dollars are representative of anything that has actual economic value, so they don’t really indicate a growth of wealth.  And once they’re in the briefcase, you can’t differentiate between the new and the old, so twice as much cash is representing the same amount of value, meaning that each dollar is worth half as much.

“Half” is just an illustration, in this post, but the underlying principle is where the debt, spending, and quantitative easing policies of the Obama Administration and the Federal Reserve have gotten us.  As happens whenever one blows air into a closed, flexible space, it creates a bubble.

The stock market has rebounded during a time of stagnant GDP and stagnant or declining absolute human work. Meanwhile, policies designed to hold inflation low have kept the bubble in the stock market — that is, in the speculative economy of pretend wealth, where a promissory note is suddenly worth more because somebody is willing to add a fake dollar to a real one in order to buy it.

That can’t last.  Eventually, people will need to withdraw actual value from the game.  Eventually, the dealers will start to cut themselves some tangible assets with real value.  And when they do, that’s when the inflation will seep out into the marketplace.

Thus, the folks who rode that green line down during the crash will simply spread their pain to the entire economy, leaving themselves relatively better off from the privatized gains and socialized losses.  That may be the whispers heard between the lines of Nathaniel Popper’s New York Times article, “Behind the Rise in House Prices, Wall Street Buyers“:

Large investment firms have spent billions of dollars over the last year buying homes in some of the nation’s most depressed markets. The influx has been so great, and the resulting price gains so big, that ordinary buyers are feeling squeezed out. Some are already wondering if prices will slump anew if the big money stops flowing. …

While these investors have not touched many healthy real estate markets, they are among the biggest buyers in struggling areas of the country where housing prices have been increasing the fastest. Those gains, in turn, have been at the leading edge of rising home prices nationwide. …

Nationwide, 68 percent of the damaged homes sold in April went to investors, and only 19 percent to first-time home buyers, according to Campbell HousingPulse. That is helping to shore up prices and create confidence in the broader markets.

While real estate is arguably a risky investment where the objective is to make a profit, its buyers have actual things.  Western civilization would essentially have to collapse before legal ownership of land and structures could be as worthless as speculative air can be.  And as the bubble moves into actual things, it will cause inflation felt by that broad population for whom money is not just a bunch of numbers.

Of course, the “spreading the pain” future may be averted in a negative way, with another crash, which some are predicting in the near future with near certainty. In that circumstance, only a portion of the pain would have been spread.

The tragedy is that boom and crash cycle of financial speculation on economic dreams isn’t necessarily something to be feared, if investment is limited to status as tool by which to move resources quickly around the economy.  But the problem that America now faces is that, gradually, the incentive to actually do anything to create new wealth is dissipating for a diverse set of reasons.

And as that happens, eventually, even a house will be worthless, although probably the office building next door will become worthless first.

  • Mario

    The Federal Reserve doesn't just print money and shove it into the economy, they use that "new" money to purchase assets (always, but not necessarily, bonds). So, in that regard, it does represent something of actual value. When they eventually decide to unwind their balance sheet, they will have to effectively un-print that money to do so. The overall effect is not to create anything, it's to maintain the balance between assets and the medium of exchange. Even if you wanted to keep the value of the dollar stable, you would still have to print money every month to account for population growth, and increase or decrease that amount depending on the relative desire to hold liquid assets.

    If there is any entity that creates money out of nothing, it is commercial banks via the allowed leverage ratio (30-1, I think?). Since people are able to also create assets out of nothing, it has a generally effective balancing impact on the economy (intertemporally), but that is also where the imaginary wealth finally disappears when people can't find real assets to pay off the debt. Overall, monetary policy really isn't as loose as people think, and I would doubt there are any bubbles brewing at the moment (besides, perhaps, unauthorized government debt, which little RI may finally pop all on its own).

    So, anyway, I don't think its fair to say that the Fed is creating money out of nothing, they are really just changing the asset balance (and, if anything, insufficiently). That's not to say that I don't think a crash is coming (I've been working on a very simple model that says that a recession should be starting this month, though I don't have any idea what the mechanism would be, besides possible premature Fed tightening (?)), but not every drop in the market is a bubble popping.

  • I’m not sure why you present your comment in contradiction of the post. If the Federal Reserve did just “shove [money] into the economy,” you’d get broad inflation, not just (as I argue) inflation of the stock market. What you describe is what I characterize as placing fake money into the briefcase.

    Where we may differ some is that I think the tendency to elide financial assets and things that have value irrespective of the cash that they may signify… like a place to live, food to eat, a contract to do work, and so on… is one of the larger problem with current economic thinking. Macroeconomically, money is just a measure of value, so if policy determines that the measure of value for any given thing (say, food) must remain the same even though its actual value in the world of tangible assets goes up or down, then it’s necessarily distorting the value of something else, disallowing the economy from adjusting where it needs to adjust. I fear the result when financial assets are distorted overly high, as they are now.

    For that reason, I mark the beginning of the end of our economic system with the Fed’s gaining the mandate of price stability. One could make the case that what we’re seeing right now is the Fed stabilizing the price of the total investment market, thereby preventing wealth from flowing where it needs to go in the economy on a massive scale.

    On that scale, it isn’t just capital resources that have distorted values, but human resources and the decisions that actual people make. You can inflate the market to make people think that the price of something hasn’t changed, but it’s theoretical actual value doesn’t change

    • Mario

      I don't think you can say that the stock market is inflated. There has been a big run-up of late, but if stocks were overvalued you'd see high PE ratios, and they aren't there. The entire rally just about put stock values where they should be, considering corporate earnings.

      Now, I do think I have figured out the mechanism you are talking about. The Fed buys bonds > banks end up with extra cash and no safe harbor > banks don't need extra cash so interest rates drop > people invest in the stock market instead of saving (chasing yield) > IF financial collapse, widespread pain.

      I can't really argue with that, except to say that those same interest rate changes should also encourage businesses to expand. In that case, the extra money sloshing around in financial assets would be absorbed by the increased value of the companies. So we have a verifiable claim, and I think the PE ratios tell the truth. As long as those stay close to historical averages, we should be safe.

      For my money (of which there is little), there is no bubble or financial misallocation… yet. I'd say the Fed's actions have been generally the right ones, albeit insufficient, and if your fears are ever realized I would have to say the main culprit is not the policies themselves, but the actions of the political overlords, stymieing the opportunity for the new money to make it out into the real economy by making it too difficult or too risky for businesses to expand. And, make no mistake, there has been a lot of that, more than ever, but the main economic risk is still that the Fed will tighten (or has already tightened, I fear) too soon, not that they have been too loose.

      • I think our entire system has become so distorted, with so many conduits from conduits to conduits, that measures like PE ratios don't capture what they once may have done. If I'm understanding you, I think you give one example when you say "the extra money sloshing around in financial assets would be absorbed by the increased value of the companies." Price, value, earnings, I'm not so sure these can be teased apart for a holistic view of the market.

        So step back and look at the chart above and see that national debt has been going dollar for dollar into the stock market. The mechanisms are probably multitudinous. Some is pure inflation of stock prices. Some is corporate value based on assets. Some is new demand from debt. But if earnings are climbing to match stock prices, why is GDP stagnant?

        Turning to the mechanism: Part of my argument is that the banks and other financiers DO need the cash (or did)… in order to get the stock market back up to where it was in nominal terms. Whether that was done through pure inflation, as defined in the financial world (as with PE ratios), or through other mechanisms to drive up the market total is immaterial.

        Another part of my argument is that "IF financial collapse, widespread pain" has another path: if NO financial collapse, widespread inflation as all that sloshing money works its way into general circulation. This is where you rely on the Fed's unwinding its balance sheet to maintain stability. But inflation and other financial manipulations don't fall on the economy like dew; they flow in and out through points, so a successful landing, so to speak, ultimately socializes the fiscal collapse. The money world collapses; debt and easing prop it back up to where it had been; tightening the money supply keeps prices in check, and the hit goes to slowed GDP growth, leaving the money world where it was pre-collapse relative to everything else.

        But then, I'm not sure you can ever get off the ride. It will always be too soon for the Fed to tighten, because the economy is not growing quickly enough to disguise the hit of payback for financial maneuvering. There's no devastated Europe to rebuild. There's no new world of people to find and exploit. And growth through innovation arguably resembles inflation more than population growth.

        Even where Reagan kept borrowing but helped the money flow into productive uses, the economy never took off enough to painlessly unwind the debt back into the economy, and every year the proportion of non-debt GDP growth fell. Nobody wants to be the person/sector/investment that eventually has to go into recession because it is no longer as valuable as something else.

        • Mario

          GDP isn't really stagnant, its been growing at the normal annual rate for a while now, the problem is that we never made back the ground lost during the last recession, so while the rate of growth is fine, the level is far too low.

          None of what you are saying is wrong, so I don't have much to add, except that unwinding the balance sheet may be easier than people think. Bonds eventually mature, and the Fed owns a ton of mortgage-backed securities, which will also, eventually, mature. So even if they are never able to see them back to the public, they will eventually turn into cash anyway. The assets will eventually cease to exist, although, if it gets to that point, presumably the Fed will take a pretty large loss (and I don't know what happens then).

          The real problem will be slowing down the asset purchases in the first place, but even there the Fed's inflation target is only 2% (although I get the feeling they are really shooting for 1.5% or so), which, while far too low to make up the lost ground mentioned above, should be achievable even in a relatively stagnant economy. [You say that it will always be too soon for the Fed to tighten, although I would argue that by most measures the Fed has already started tightening, which is why the stock market has had such a bad week.] I would love it if they were willing to wait for real growth before pulling back, or, even better, showed a willingness to not kill real growth if it appeared, but they seem satisfied with unemployment where it is.

          Incidentally, the Fed was able to intentionally slow the economy down without causing a recession in 1995, so I'm not as pessimistic as you are about the prospects of a pullback. If we ever get that crazy hot 2.5% inflation rate, they will have a guide for how to bring us back to earth.

          • I'm very glad to not be wrong. I was worried that you were about to force me to reevaluate everything I thought I'd figured out!

            The only thing I can think to note, at this point, is that 1995 is the year banking policy and risky mortgage lending decoupled stock market growth from national debt. Prior to that, the new money in the economy was as real as the government's ability to tax people in the future. So I'm not confident in that period as a model for government control of the economy.

  • Warrington Faust

    Mario does a very good job in his post concerning the creation of money. In our system most is "created" by bank loans. When I studied such things there were different leverage ratios for "demand deposits" (checking accounts) and "term deposits" (savings accounts), I think "term deposits" can now be ignored, other than for "money market" accounts. As he points out, the issue is "balance" between assets and cash. The alternative is inflation/deflation. Ultimately, chaos as our money has no intrinsic value.
    -Required split-

  • Anthony

    Also…the GM bailout worked just fine.
    "The Treasury sold nearly 20 percent of its remaining shares in General Motors Co. in the first three months of the year, the Detroit automaker disclosed Thursday, as well as 200 million shares sold to GM for $5.5 billion in December.
    In total, Treasury has recouped $30.6 billion. At current trading prices, Treasury would lose around $10 billion on its GM bailout.

    You see it's the TREASURY that lost the money…not the US taxpayers. Pay no attention to that Commisar behind the curtain.

  • Warrington Faust

    Whatever criticism might be made of the Fed, it is certainly much better than our prior system. America has a strange relationship with banking. Until recently, conversations with loan officers were at desks in open areas. It was not sensible to be in a private office, you wanted witnesses. Google "Andrew Jackson and the National Bank", or "wildcat banking". This may seem like ancient history, but consider the wisdom of the Greek philosophers and ask if human nature really changes..

  • Warrington Faust

    Justin writes "1995 is the year banking policy and risky mortgage lending decoupled stock market growth from national debt." I think it is a mistake to attempt to decouple the "economic history" of that year from the "popular history" which has not yet been written. As well as I remember those days, popular psychology overwhelmed good economic thinking. I doubt there is room here for complete analysis, although one might liken it to the "tulip mania". Little noted today is that in 1995 foreclosures initiated matched or exceeded those initiated in the "bubble" of the middle 2000's. I pulled a list of all such filings in Massachusetts weekly, 450-500 filings was ordinary. The difference in the two decades was that in the 90's there was money and "belief" available. An owner being foreclosed could usually sell, sometimes at a profit. In the latter decade more foreclosures went to auction, the "belief" wasn't there.
    -required split-

  • Warrington Faust

    The most popular, and almost uniformly accepted, explanation of sleepy New England values suddenly rising was "we are catching up with California". As with "global warming", "deniers" of the California theory were decried and defamed. No one wanted to hear it. Politics and banking policies followed. When the end neared, I noted a switch at developers seminars and conferences. All the talk was of "value created", as opposed to "profits made". It was "value" that couldn't be sold.

  • Warrington Faust

    When discussing economic and banking policy it is easy to become lost in the belief that "Macro economics" (with measureable data) can control events. Those who support this view, even though they lack economic training, for instance Robert Reich, are lionized. Those who suggest that a multiplicity of "micro economic" decisions can overwhelm "macro economic" decisions, such as Steven Levitt,, are dismissed as humorists with immeasurable anecdotal evidence. How many people know that Arnold Greenspan was captain of Ayn Rand's softball team? Would this have effected his credibility? I have seen the photographs of him in his softball uniform.

  • D.A.

    Operation: Monetary Blowout.