Hoa Trinh

How banks have set a trap for the U.S. Fed by creating money: U of T expert

noreen.rasbach — Wed, 29 Aug 2018 16:38:28 +0000

How banks have set a trap for the U.S. Fed by creating money: U of T expert

noreen.rasbach Wed, 08/29/2018 - 12:38

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The financial system is awash with money, which is why interest rates have been so low for so long (photo by Shutterstock)

Hoa Trinh

Topic

Global Lens

The Conversation

The 10-year anniversary of the 2008 financial crisis is upon us.

A decade ago, former U.S. president George W. Bush signed into law the money-printing scheme called the Troubled Asset Relief Program (TARP), aimed at purchasing toxic assets and equity from financial institutions to strengthen the country’s shell-shocked financial sector amid the sub-prime mortgage crisis.

In this 2014 photo, vines cover the front of a boarded-up home in East Cleveland, Ohio. Ohio was one of the Midwest states hardest hit by the sub-prime mortgage crisis that began in 2007 (photo by Mark Duncan/AP)

How do banks, treasury departments and central banks create money anyway? And does it work to buoy economies teetering on the brink of collapse?

In the U.S., banks are required to set aside, depending on the total amount, up to 10 per cent of their deposits to be held at the Federal Reserve.

Here’s how the reserve system works. Let’s say you deposit $10,000 at Bank A. The bank sets aside $1,000 as reserve. It will loan out the remaining $9,000 and charge interest, enabling it to make interest payments to depositors and earn interest income. So Bank A becomes a financial intermediary between savers and borrowers, and money keeps getting created.

How? Because there are many banks in the financial system, and they are required to hold only a fraction (10 per cent) of their deposits. Loans end up deposited in other banks, which increases reserves, deposits – and the money supply.

Money multiplies

In the U.S., the Treasury Department can sell IOU papers via the Fed to the open market in order to finance government deficits instead of raising taxes. The Fed itself, domestic and foreign banks and investors, and foreign governments will buy and pay for them with American dollars. When the government spends these dollars, they get channelled into the commercial banking system as deposits.

Big corporations and commercial banks can also sell their own bonds. Today, U.S. non-financial corporate bonds stand at $4.8 trillion. And so the system’s money multiplier gets even larger.

When the Fed buys financial assets from financial institutions, it pays for them by making bookkeeping entries into their reserve accounts. Banks can create up to $10 in new loans for every one dollar increase in the commercial banks’ reserves.

During the financial crisis of 2007-2008, the Fed engineered what’s called quantitative easing, or QE, by buying many billions of bad assets from endangered banks.

The banks’ damaged assets became safe because the Fed had bought them. And it also allowed banks to extend more credits to, supposedly, stimulate the economy.

This financial injection multiplied, and money flooded the system.

Here’s how and why.

Bank assets versus liabilities

Mortgage loans are bank assets because banks can call in the loans and the borrower must pay. Deposits, on the other hand, are bank liabilities because customers can withdraw their money at any time, so banks owe that money to them.

If people start defaulting on their mortgage payments and house prices plummet, it can create fears among depositors; they will rush to take their money out of the bank before it collapses and they lose their savings. So in 2008, the Fed stepped in to nip this fear in the bud to prevent a possible system-wide bank run leading to the collapse of banks.

When house prices fall and people are worried the economy is on the brink of collapse, they tend to withdraw their money from the bank (photo by Shutterstock)

Today, the cumulative balance of the Fed’s financial assets over a 10-year period from 2008 to 2018 has risen to $4.3 trillion from $872 billion, an increase of about 400 per cent. Money keeps multiplying.

Why? Recall that each time the Fed buys financial assets from banks, it pays for them by making bookkeeping entries to banks’ reserve accounts, and for every one dollar increase in their reserve accounts, banks can lend out up to $10.

Where has all the money gone?

The financial system is therefore awash with money. That’s why interest rates have been so low for so long. Interest rates, essentially, are the price of money. When the Fed makes it easy for banks to create money, banks must lower the price of money in order to move it into the hands of borrowers. Banks, after all, are in the business of making money by selling money.

And this does not even include Eurodollars. These are U.S. dollar-denominated deposits at foreign banks or at American bank branches abroad, the amounts of which are hard to estimate. And they are not subject to the Fed’s regulations on required reserves. The world is simply flooded with American dollars, with the Euro, the yen, the yuan and pound sterling all operating under similar QE policy.

Traders work on the floor of the New York Stock Exchange in July (photo by Richard Drew/AP)

Within the U.S. and major developed and developing economies, part of this flood of cheap money has created significant increases in the world’s selected real estate markets and in stock markets. By 2017, 16 of the 20 largest stock exchanges in the world have a market capitalization ranging from US$1.2 trillion to $19 trillion.

Key lesson: The Fed can create money, but it’s hard to predict where that money will go.

Why scant inflation?

Over the period of 2008 to 2018, the U.S. economy has not experienced noticeable inflation, despite the flood of money into the system. The broadest measure of inflation shows it’s increasing at about 1.55 per cent a year. America does not have a problem of too much money chasing too few goods, because there is plenty of money around for imports. That’s where trade deficits came from.

Meantime, while American after-tax corporate profits have grown at a compounded rate of 6.44 per cent per year, workers’ average hourly earnings before tax and before inflation is 2.29 per cent per year, which is practically zero in real terms.

The gigantic money-printing scheme, therefore, appears to have benefited banks, corporations and those who can afford to play in real estate markets, in stock markets and in the broader financial world. Broad-based personal consumption, however, remains unimpressive compared to pre-2008 periods.

The Fed is trapped

The Fed has increased its own federal funds rate over the past couple of years from zero to 1.91 per cent to spur rate hikes in the financial sector. This is the rate that short-term commercial interest rates are pegged to. And it has also started to sell off some of its assets back to the market. When it sells assets, the multiplier works in reverse, resulting in less money available and higher interest rates.

The rationale for this strategy is that the real economy seems to have picked up some momentum as unemployment rates are down and inflation is ticking up. The QE money that has been circulating on and on within the financial and real estate sectors may finally be going somewhere in real sectors.

But facing a total government debt of $21 trillion and climbing, the Fed is trapped – higher interest rates mean bigger interest payments on government debt.

The Congressional Budget Office (CBO) has projected that the government’s net interest costs alone will triple over the next 10 years, rising to be the third largest expenditure item after Social Security and Medicare.

U.S. President Donald Trump’s tax cuts may produce some short-term economic growth, but at the expense of even bigger budget deficits, rising to exceed $1 trillion annually by 2020. That’s two years ahead of CBO’s previous projection.

Ending easy money is not easy

While the Fed has pushed interest rates up, rates in the Eurozone and in Japan remain at or below zero, and QE is still ongoing there. More money will flow into the U.S. to earn higher rates. Adding to the ongoing trade wars, this global uncertainty will, paradoxically, result in higher demand for the dollar. The higher dollar will make American exports more expensive and reduce the effects of tariffs on imports.

A silver bullet has yet to be found to break through this vicious circle of debt, the dollar and trade deficit. But interest rates will have to rise to their normal level soon or pension funds will come under enormous stress to hit the eight per cent required returns in order to meet their obligations.

This is going to be a test case of the Fed’s independence.

Hoa Trinh is an instructor of business management at the �ؿ�ζSM.

This article was originally published on The Conversation. Read the original article.

Donald Trump's misguided aversion to trade deficits: U of T expert

Christopher.Sorensen — Thu, 28 Jun 2018 20:16:07 +0000

Donald Trump's misguided aversion to trade deficits: U of T expert

Christopher.Sorensen Thu, 06/28/2018 - 16:16

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U.S. President Donald Trump speaks during a groundbreaking ceremony for the $10 billion Foxconn factory complex on June 28 in Mt. Pleasant, Wis. (photo by Scott Olson/Getty Images)

Hoa Trinh

Topic

Global Lens

Global

School of Continuing Studies

The Conversation

Trade

United States

If political power grows out of the barrel of a gun, as Mao Zedong once proclaimed, the same can be said about the United States’ trade deficit in general.

In this instance, the gun is American and being wielded by U.S. President Donald Trump, who has a puzzling aversion to trade deficits despite the fact they’ve helped fuel the U.S. economy for decades.

If we were to take a little walk down the memory lane, we all know that the U.S. won the Cold War with the collapse of the Soviet Union. But America paid a price by losing its consumer industrial base and more than 58,000 lives.

Following the Vietnam War, the U.S. expanded its military industrial complex and has since engaged in several military conflicts, big and small.

To understand the connection between war and the trade deficit, we must understand four major historical markers in contemporary American history.

The first is the Vietnam conflict (1954-1975), a proxy war that pitted siblings against each other – North and South Vietnam – and resulted in more than three million deaths on both sides. The north was supported by China and the Soviet Union, and the south was supported by the U.S. and its smaller military allies, notably South Korea and Australia.

A crowd of American soldiers swarm around U.S. President Lyndon Johnson in October 1966 shortly after his arrival at Cam Rahn Bay in South Vietnam visiting troops during the war (photo by AP)

While that was going on, President Lyndon Johnson in 1964 waged a very costly second front at home – the Great Society program aimed at ending poverty, reducing crime, abolishing inequality and improving the environment.

Not to be outdone, President Ronald Reagan’s 1981 tax cut partly contributed to recharging the American economy in the midst of a recession, but it also created massive government deficits.

But the most important historical event of the four is the fact that America abandoned what’s known as the Gold Standard in 1933. The policy banned creditors from demanding payments in gold. It then fixed the exchange rate between gold and the dollar at US$20.67 per ounce, and then increased it to $35 per ounce.

In 1971, President Richard Nixon announced that the U.S. would no longer convert dollars to gold at a fixed rate of $35 per ounce. And that freed the U.S. government to issue more money. And issue they did.

In this February 1972 photo, Chinese communist party leader Mao Zedong is seen with U.S. President Richard Nixon in Beijing (photo by AP)

Connecting the dots among these four historical events requires examining them through the prism of three American undertakings – winning the Cold War from a defence perspective, increasing civilian consumption and finding a way to finance the two.

The U.S. opted to take care of its defence requirements domestically in order to protect, strengthen and sustain its vast military industrial complex.

Outsourcing manufacturing to Asia

To spur consumption, the Americans found it more efficient to outsource a significant part of that task to its allies, notably Japan and other Asian Tigers at the time (Taiwan, Singapore, Hong Kong, South Korea) and, later on, China, among others.

The U.S. outsourced a lot of manufacturing to Asian countries, including China in recent years, to spur consumption and spending domestically (photo via Shutterstock)

This marked the beginning of a prolonged track of American trade deficits.

The remaining task was to find a way to finance these two enterprises. In normal circumstances, a country can run trade deficits for a while, and if it continues, the price of its currency must go down.

The country buying goods from other nations must sell its own currency in order to buy the currencies of the countries from where it imports, or to buy U.S. dollars to pay for those goods since the American greenback is considered a secure global currency.

This cannot go on for very long before the local currency collapses in value as a basic consequence of supply and demand. But it’s different for the U.S. – the American dollars at home are the same dollars needed to pay for imports, and the U.S. simply supplies more of them when needed.

Because countries buy U.S. dollars to trade their goods, the ones that earned money thanks to American outsourcing reinvested their dollars back into the U.S. in financial and other investments.

Oil-producing countries in the Middle East, for example, do that by reinvesting their U.S. dollars from selling oil back to the U.S. and via American dollar-denominated investments elsewhere.

The Japanese do so as well, and did so massively in the heyday of the Rising Sun, and the Chinese have been doing the same with their trade surplus with the U.S..

The dollar remains strong

Today, the two biggest sources of U.S. foreign debt are recycled dollars from the Chinese and Japanese. The shrinking of the American consumer industrial base has been offset by this incredible expansion of its financial industry thanks in part to China and Japan investments.

In short, U.S. consumers acquire many of their goods from these countries. These importing nations then invest the money made from selling those goods to the Americans into U.S. treasury bills and bonds, which helps fuel the American economy.

But the real question is why do these countries have such confidence and trust in the U.S. dollar?

The answer: America has a secure geography with two big oceans on the east and the west that form a natural security barrier. A friendly Canada lies to the north and relatively weak countries lie to the south. Geographically, the U.S. is secure, militarily it is the strongest, and economically it is among the most capitalistic countries.

And so given Americans have had it so good for so long, why is Trump complaining about trade deficits? Trade deficits, after all, have allowed Americans to consume and spend more, to save less, to grow American company profits, and to save itself from having to endure additional and enormous environmental damages due to manufacturing and production.

America’s real deficit

A final point that’s often lost in trade deficit debates: In terms of accounting, America’s trade deficit with China is China’s trade surplus. But much of China’s trade surplus with the U.S. is owned by American companies given so many Chinese goods contain components from U.S. firms, including Apple, and are simply assembled in China.

By one estimation, the U.S. trade deficit with China last year was 36 per cent lower than commonly reported when all factors are taken into account.

And so America’s trade “war” with China will hurt the sectors in which the U.S. is doing relatively well – in semiconductors (a crucial component in electronic products), commercial aircraft, automobiles and products within the food and energy supply chains.

And it will eventually cause hardships for low-income Americans who must buy everyday household consumer goods. In China, low-income Chinese will also be hurt the most by higher food and energy costs.

The U.S. recently announced tariffs on 1,102 Chinese products. China promptly retaliated by announcing tariffs on 659 American imports, including soybeans and automobiles. Trump fired back, using a bigger gun, by asking his administration to identify an additional $200 billion worth of Chinese products for a 10 per cent tariff.

If nothing changes in the interim, the announced measures will come into effect soon.

If Americans truly want to reduce the trade deficit and increase real income in the long run, they must increase personal savings, lower government deficits by reining in military spending and perform major surgery on health-care costs.

These changes hold the keys to freeing up necessary resources for rebuilding America's consumer industrial base, its crumbling infrastructure and its decaying public education system.

Low-skill industrial jobs are not going to come back to the U.S.. Even China has slowly started the process of moving some low skill and low value-added jobs elsewhere.

America has an income and opportunity distribution problem, and Trump’s obsession with trade deficits and his subsequent wielding of the tariff big guns, is the wrong approach.

Hoa Trinh is an instructor of business management at the �ؿ�ζSM.

This article was originally published on The Conversation. Read the original article.