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Wednesday, June 10, 2009


In January 1981 I began my second semester of college. In the fall semester I had taken, and passed, Macroeconomics to fulfill part of the required course list for my major; now in the spring semester I would be taking Microeconomics. Both courses were taught by on campus legend Harvey Botwin who leaned on a text book written by economist Paul Samuelson. While Samuelson himself has become somewhat famous in economic circles for wildly missing on his macroeconomic predictions, his textbook, and Professor Botwin's lectures, provided a solid foundation of economic understanding and tools for economic analysis.

A significant portion of our Microeconomics class was spent on money. The exchange ones goods or services of greater value than the goods or services being offered in trade led most cultures to develop a system of currency so economic activity could occur. For currency to be effective it must be universally recognized as valid currency, its value must be universally accepted and it must be portable--one must be able to transfer the currency in order to complete a transaction.

Of great interest to me was the development of the currency system on the Island of Yap. Located in Micronesia, Yap is famous among college students for the term, "the stone money of Yap." The people of Yap, isolated from Western culture, economy and trade developed their own currency. The currency was easily recognized and accepted, the value was easily apparent and it was portable, as can be seen in the picture at the top of this post. In Yap the money was made of stone, hewn into circles with a hole in the middle. In Yap the larger the stone the more value the unit of exchange and units ranged from the size of our quarters and half dollars to the huge wheels seen in the picture. The holes allowed a pole to be placed through the "coin" and transported from payor to payee. It was effective as its value was recognized and accepted and it was portable. Did the people of Yap experience inflation? Certainly scarcity and over supply impacted the island economy, but to what extent I do not know.

Further exploring money in my college career I learned about inflation, the increase in prices in an economy not through scarcity of products but as a result of over-supply of money in the economy. With more money available to consumers more money can be bid on the goods and services for sale, resulting in inflation. If there is an extreme over supply of money in the economy then "hyper-inflation" occurs, think the Weimar Republic in the 1920s, Argentina in the 1980s and early 1990s, Zimbabwe recently. Hyper-inflation is when prices are rising over 50% per year, in many cases it runs away to inflation rates of 100-200% per year. The cost of a loaf of bread in the morning is $1.00, at the end of the day the same loaf of bread is selling for $1.20. Currency becomes almost worthless in hyperinflated economies because instead of $1.00 for a loaf of bread it is $100 or even $1000.

The amount of money in an economy is controlled by the government--it has the printing presses to create currency. By printing more money the government adds currency to the economy and devalues the currency currently in circulation--the $100 bill you have in your pocket is worth less if the government prints puts more $100 into circulation than are taken out of circulation. To much printing and the government is creating inflation in the economy as each $100 has less value, more than $100 is needed to purchase the goods or services that used to cost $100.

Monetary supply by printing is not the only way the government impacts the economy. The other way is the taking on of debt and issuing debt obligations--called bonds. Bonds are sold to investors and investors expect a rate of return on their investment--interest payments. The rate of return, or interest, is dependant on the amount of bonds that are available for investors to purchase. In order to get investors to buy their bonds a rate of interest must be offered by the issuer that is attractive to the investor who must balance the risk of not being repaid the bond, the other investment opportunities available and the rate of return being offered. The more bonds that are available on the market the higher the rate of return that must be offered to investors to entice them to purchase the investment. If there are only 100 bonds available from a really strong company that almost certainly will pay off the bond when it is due, then the scarcity of the bonds will create a high price--and subsequently a low rate of return. Conversely if the company were to issue 1000 bonds more investors would be able to purchase the bonds, there is not scarcity so the company would need to offer a higher rate of return to sell the 1000th bond. More bonds on the market higher interest rates.

If I said you could invest in a company for $1000.00 and it was somewhat risky if you would get your money back, and also when the bond is to pay off in five years there would be significant inflation in the economy--making your $1000.00 today worth only $900.00 then--would you demand a lower or higher rate of return on your $1000? Of course you would demand a rate of return at least as high as the expected inflation, plus a premium for the risk involved in the investment. Instead of a 5% rate, you would probably factor in a 10% rate of inflation, plus the risk that the investment may not be paid off in five years so you would want a higher return early on to make up for that risk, so to invest you may require 15%, 17%, 20% return on your $1000 to be paid in five years.

Yesterday the United States Supreme Court upheld the Obama Administration's orchestration of thetake over of Chrysler by the United States government, giving some of the company to the United Auto Workers and some of the company to Italian automaker Fiat. In the process investors who held millions of dollars of bonds issued by Chrysler saw their investments wiped out--zero return.

General Motors was restructued through bankruptcy by the Obama Administration. In the restructuring tier one investors in General Motors who had invested in hundreds of millions of dollars of bonds issued by the company were given less than thirty cents on the dollar--a discount of 70% of their investment; while the Federal government was given 60% of the company and the United Auto Workers approximately 20% of the company.

In the past five and one half months the Obama Administration and Congress have passed spending bills and budgets that surpass $2 trillion. Which means that the United States government will put two trillion additional dollars into the economy and put over two trillion dollars of bonds into the investment market.

Economies depend on investment to grow. Investors depend on risk-reward scenarios that will ensure a reasonable expectation that their investments will pay-off, the less reasonable the expectation the higher the rate of return they will demand. Financing high interest debt to grow a company is very risky and most companies are not willing to take on the risk and the high debt payments, along with salaries, rent, cost of goods, etc. that are rising in an inflationary economy.

With the wiping out of Chrysler and GM bond holders investments the Obama Administration has signalled to all investors in the U.S. economy that their investments in American corporations are at significant risk, not because of economic factors but because of political whim and power. This risk of government taking your investment and giving it to another entity, such as a labor union or a foreign company, adds considerably to the rate of return companies raising capital for growth and expansion will to pay to attract investors; i.e. higher interest rates.

With the addition of trillions of dollars into the United States economy the government is putting a huge supply of currency into the economy, making the currency in your pocketbook worth a little less every day. With the addition of trillions of dollars of debt into the capital markets, the government is creating a huge oversupply of bonds, in order to attract investments those bonds will have to have higher and higher rates of return, i.e. higher interest rates.

With the knowledge that corporate debt is riskier due to government intervention, that there will be an oversupply of currency in the economy and that there will be an oversupply of debt in the capital markets, investors are already demanding higher rates of return on their investments to account for inflation that will erode their returns.

Money, we all have it, we all need it. How much we have and how much we need are the results of many factors, including the actions of the United States President and Congress. Given their actions the last five months we will need a lot more it in the near future just to buy what we are able to buy today--that is what inflation is all about, look for it at your neighborhood grocery store soon. If we lived in Yap we would all be out in the yard looking for bigger stones to buy a carton of eggs.


Anonymous said...

When is America going to wake up?

poolman said...

I wish the New York Times would publish as clear of a description of the country's current economic policies as you just did. I think it should be a requirement of anyone who holds public office and is involved in policy decisions to take courses in economics.

I just received notice from the state board of equalization that sales tax rates in LA county are going up to 9.75% as of July 1st. At a time when we should be creating incentives to increase consumer spending to create growth and jobs, we do just the opposite. This is insanity.

Taking our money and money we do not have and creating government jobs is not job creation. It merely transfers money from the private sector to the public sector where economic growth is not stimulated but is actually stunted.

The best way to help the environment and health care is to create a healthy economy so that we can afford the programs that make us feel good. We have gotten the cart before the horse.

Haiku Frank (D) said...

Wage and price plummets!
Unemployment increases!
It’s called “Phillips Curve.”