Sounds impossible but think it through!

Imagine all the banks in a country which we call Happy has $5 billion in fixed deposits. The bank keep 10% and loan out the balance of the $4.5billion. There is only $500million that is not lent out. There is a property market boom.There is a surge in property loans and $1.0 billion of new loans is needed. But the bank has only $500 million which it by law has to keep in reserves to maintain the Capital Adequacy Ratio. As all the available money has been loaned out, the banks has nothing to lend. All its $4.5 billion has already been loaned out. There is no money in the bank to lend to its new customers.

This is where the incredible magic occurs. Out of thin air, the Government provide a deposit of $1.0 billion to the bank. The bank then use this $1.0 billion deposit to lend to its new customers who needed the loans to buy property. Amazingly the bank has to pay interest to the Government for this $1.0 billion deposit which is an accounting entry created from nothing. Everyone is happy. The banks earn from the spread between what it pays the Government and what it collects in interest from its customers. Customers are happy since they are able to secure loans to buy their properties and the Government is smiling all the way to the bank earning interest from nothing!

When a recession occurs, there is too much money or liquidity and so the Government takes back its deposit and the $1.0 billion it created out of nothing is withdrawn from the market. So far so good as we are back to zero as far as money creation is concerned. This is one reason why recessions are good for they keep the money supply in balance.

But what happens if we have a boom year, year after year. In the second year, property prices rises and now customers want to borrow $2.0 billion. There is no money in the bank and so the Government repeats its miracle and deposit $2.0 billion into the banks .The banks used this money to loan to its customers. Now there is $3.0 billion of additional money in the market, money which never exists before.

If the boom continues for the third, fourth, fifth and sixth year, one can imagine how much new money is injected into the market. This huge supply of money creates inflation as with more money floating around, prices have nowhere to go but up. The money has depreciated simply because there is so much more money chasing after the same assets.

If initially in the country called Happy there is $100 billion of money. After six years, $20 billion of new money has been created. The total money supply increased from $100 billion to $120 billion. One dollar is now worth 83 cents of the one dollar six years ago. $120 billion times 0.833 is $100 billion. This is how our money gets smaller as the years go by. The main beneficiary is the Government who has created $20 billion from nothing and the citizens of Happy find after six years that their hard earned savings is now worth 17% less than before.

In a nut shell, that is how the modern economy works. The lesson is to put your money in hard assets such as gold, properties and stocks. Never leave your money in fixed deposits. The money will devalue year after year.

Where is the breakdown point?

The breakdown point is the percentage of national debt to GDP which is seen to be unacceptable by the financial community. To join the Euro, member states must show that their national debt has to be below 60% or fast approaching that level. This 60% is seen to be the sustainable ratio and Governments whose spending exceeds this ratio will be told to rein in thier spending. It would be interesting to see how many of the countries in Euro has national debts below the 60% level.

The same ratio in USA is 66%. The last time this level was reached was after World War 2 and money was needed for the rebuilding of Europe and Japan. After WW2, the only major developed country that was not bombed was the USA and so it was in a position to capitalise on the development of the bombed out countries. Today the world is competing on a global basis.

It seems governments throughout the world is in debt.The two Asian giants China and Japan has national debts . USA leads the charge followed by Europe and Asia. Only the oil rich countries have no national debts. China intends to spend $160 billion on the 2008 Olympics and need to spend even more to improve its infrastructure in the poorer provinces.

The problem is that there is no universal worldwide standard or agreement as to what level of debt is acceptable. Today banks have to have reserves that meet the capital adequacy ratio to protect them from potential financial crisis. Countries need to have a similiar capital adequacy ratio to protect them from over spending. The reserves would be kept in gold.

Indications of worry of excessive national debts can be seen in two indicators. Rising interest rates and gold prices. If investors see paper currencies as losing their value , they will want high interest rates to cover the risk of currency devaluations. The most obvious choice would be higher gold price . As national debts keep on rising, there will be a pulpable tension in the financial markets as everyone will be watching for the breakdown point. A lack of confidence in currencies could cause gold to spike to beyond the US$1,000 level.

What could cause this lack of confidence? A sudden disaster which would require billions to recover such as an earthquake in California or Tokyo. A tsunami in USA and Europe .Imagine Nice, Florida and the expensive resorts being hit be a tsunami. The cost of the tsunami in Asia is in human cost while the cost of the tsunami in Europe and USA will be more in economic costs. Imagine a tsunami several times more powerful than Hurricane Katrina.

Without a natural disaster, it will take another seven years for perhaps the national debt to exceed 100% of the GDP. No one can tell what this breakdown ratio is but perhaps 100% is a figure we can for now assume is the breakdown ratio. And when this happen buy gold and more gold!

Money from thin air?

My friends usually react with horror when I tell them that Government can and do print money out of thin air without zero asset or collateral to back what they have printed. A few still think that the good old Government must have an equivalent amount of gold to back the new money they have printed. Yes that was true, a few decades ago. We all know that the same one dollar buys much less than the same dollar twenty years ago. Assuming that the Government prints 6% more money each year, in twelve years, the amount of money would have doubled which has the effect of halving the value of money. Thus one dollar twenty years ago buys the same amount as what $2 buys today. This depreciation of our money is simply the result of Government printing money year after year.

This is great for the spending Government since twenty years later they effectively pay you less than what they borrowed from you after deducting the effect of inflation. If the inflation is larger than the interest, it means that the Government is paying a negative interest rate! China and Japan are the willing suckers buying the US bonds knowing full well that they may end up with less than what they paid. Who cares about the value twenty years from now on? What the politicians care is to keep exchange rates low , so their goods remain competitive, and jobs remain available.

Printing money is easy to understand. The Government just tell the printers to print x billions more cash and all it cost them is the printing cost. Government do have that right to just print cold hard cash. But an easier way will be to ask the central bank to add a figure to their ledger and hey presto , suddenly the Government has an extra billion to spend! Central banks in mnay parts of the world are literally forced by the USA to print money. Let us examine why.

The US Government borrows US$$413 billion in 2004 as this was the amount of the federal budget deficit. A large part of this borrowing is from other Central Banks who buys the US Treasury bonds with their local currency. The Central Banks do this to keep their exchange rate low vis a vis the US dollar. If US borrows, it sells US dollars which means there is a lot of US dollars in the market. If there are less Chinese Yuans available , then the exchange rate of Chinese Yuan to the US dollar will increase. One Yuan will buy more dollars since there are more dollars than yuan.

The Chinese Central Bank reverses this effect by buying US bonds which means it buys up the US dollar and releases more Yuan into the system. Now everything is in equilibrium. There are equal amounts of additional US dollars and Chinese Yuans and so the exchange rate remains stable. But wait a moment. The Chinese Government also has a budget deficit although it is much smaller than the US budget deficit. It means that the Chinese Government spends more than it has collected from taxes. If so where did the Chinese Central Bank get the Chinese Yuans to buy the US Treasury bonds? So the six million dollar is whether the Chinese Central bank and indeed other Central Banks print money to buy the US Treasury bonds?

The two biggest exporters to the USA are China and Japan and both these central banks buy huge amounts of US Treasury bonds to keep their exchange rates low. The total amount of money in the world is increasing leading to higher stock and property prices. The amount of stocks and properties in the world does not increase as fast as the increase in the supply of money. When you have more money chasing after the same goods, the price of these goods increases.

A stock is priced by what we call the PE or Price Earning Ratio. That is the price of the stock divided by the profit earned per share. In the US, the PE ratio has gone from 10 to 20. In other words, with exactly the same amount of profit, the price of the share has doubled! But the money does not get absorbed into the shares. The money goes into someone's pocket and he will use the gains from selling his shares to buy more shares , buy a bigger house, buy more goods, eat better and so forth. There is a wealth effect as the money goes around generating more profits and jobs for everyone. Money does not disappear but goes round and round and even from country to country.

After spinning around the USA, some of the money goes overseas inflating the oversea stock markets! The whole world is pumped with more and more money year in year out. The term for this is liquidity. The world is awash with liquidity. So when will the bubble end? The key to making a good investment lies in your understanding of money. Stay tuned.