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.