{"id":61591,"date":"2017-03-20T00:50:00","date_gmt":"2017-03-19T23:50:00","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/show-me-the-money\/"},"modified":"2019-12-31T01:48:40","modified_gmt":"2019-12-31T00:48:40","slug":"show-me-the-money","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/show-me-the-money\/","title":{"rendered":"Show Me The Money"},"content":{"rendered":"

\u201cSchool days\u201d<\/em> inexorably continue at the Gross household, not just because of grandchildren,
\nbut because of the necessity to teach my own kids the complexities and pitfalls of investing.
\nAs I get older, I fear I may unduly introduce them to a 1930s Will Rogers warning about
\nlosing money: \u201cI\u2019m not so much concerned about the return on my money,\u201d<\/em> he wrote, \u201cbut the
\nreturn of my money.\u201d<\/em> \u201cDon\u2019t lose it\u201d<\/em> is my first and most important conceptual lesson for them
\ndespite the Trump bull market and the current \u201canimal spirits\u201d that encourage risk, as opposed
\nto the preservation of capital.<\/p>\n

Recently I also explored with them the concept of financial leverage \u2013 specifically that of
\nfractional reserve banking, which has been the basis of credit and real economic growth
\nsince the system was blessed by central banks over a century ago. \u201cIt still mystifies me,\u201d<\/em> I
\ntold them, \u201chow a banking system can create money out of thin air, but it does.\u201d<\/em> By rough
\nestimates, banks and their shadows have turned $3 trillion of \u201cbase\u201d<\/em> credit into $65 trillion +
\nof \u201cunreserved\u201d<\/em> credit in the United States alone \u2013 Treasuries, munis, bank loans, mortgages
\nand stocks too, although equities are not officially \u201ccredit\u201d<\/em> they are still dependent on the cash
\nflow that supports the system.<\/p>\n

But I jump ahead of myself. \u201cPretend,\u201d<\/em> I told the \u201cfam\u201d<\/em> huddled around the kitchen table, that
\nthere is only one dollar and that you own it and have it on deposit with the Bank of USA \u2013 the
\nonly bank in the country. The bank owes you a buck any time you want to withdraw it. But the
\nbank says to itself, \u201cshe probably won\u2019t need this buck for a while, so I\u2019ll lend it to Joe who
\nwants to start a pizza store.\u201d<\/em> Joe borrows the buck and pays for flour, pepperoni and a pizza
\noven from Sally\u2019s Pizza Supplies, who then deposits it back in the same bank in their checking
\naccount. Your one and only buck has now turned into two. You have a bank account with one
\nbuck and Sally\u2019s Pizza has a checking account with one buck. Both parties have confidence
\nthat their buck is actually theirs, even though there\u2019s really only one buck in the bank\u2019s vault. <\/p>\n

The bank itself has doubled its assets and liabilities. Its assets are the one buck in its vault
\nand the loan to Joe; its liabilities are the buck it owes to you \u2013 the original depositor \u2013 and
\nthe buck it owes to Sally\u2019s Pizza. The cycle goes on of course, lending and relending the
\nsimple solitary dollar bill (with regulatory reserve requirements) until like a magician with a
\nwand and a black hat, the fractional reserve system pulls five or six rabbits out of a single
\ntop hat. There still is only one dollar bill but fractional reserve banking has turned it into five
\nor six dollars of credit and engineered a capitalistic miracle of growth and job creation. And
\nimportantly, all lenders of credit believe that they can sell or liquidate their assets and receive
\nthe single solitary buck that rests in the bank\u2019s vault. Well . . . not really.<\/p>\n

\u201cAnd so,\u201d<\/em> my oldest son, Jeff, said as he stroked his beardless chin like a scientist just
\ndiscovering the mystery of black holes. \u201cThat sounds like a good thing. The problem I\u2019ll bet
\ncomes when there are too many pizza stores (think subprime mortgages) and the interest on
\nall of the loans couldn\u2019t be paid and everyone wants the dollar back that they think is theirs.
\nSounds like 2008 to me \u2013 something like Lehman Brothers.\u201d<\/em> \u201cYep,\u201d<\/em> I said, as I got up to get a
\nCoke from the refrigerator. \u201cSomething like Lehman Brothers.\u201d<\/em><\/p>\n

My lesson continued but the crux of it was that in 2017, the global economy has created more
\ncredit relative to GDP than that at the beginning of 2008\u2019s disaster.
\nIn the U.S., credit of $65
\ntrillion is roughly 350% of annual GDP and the ratio is rising. In China, the ratio has more
\nthan doubled in the past decade to nearly 300%.<\/quote>
\n Since 2007, China has added $24 trillion
\nworth of debt to its collective balance sheet. Over the same period, the U.S. and Europe
\nonly added $12 trillion each. Capitalism, with its adopted fractional reserve banking system,
\ndepends on credit expansion and the printing of additional reserves by central banks, which
\nin turn are re-lent by private banks to create pizza stores, cell phones and a myriad of other
\nproducts and business enterprises. But the credit creation has limits and the cost of credit
\n(interest rates) must be carefully monitored so that borrowers (think subprime) can pay back
\nthe monthly servicing costs. If rates are too high (and credit as a % of GDP too high as well),
\nthen potential Lehman black swans can occur. On the other hand, if rates are too low (and
\ncredit as a % of GDP declines), then the system breaks down, as savers, pension funds and
\ninsurance companies become unable to earn a rate of return high enough to match and
\nservice their liabilities.
\n\"u.s._total_credit_market_debt_as_a_percent_of_gdp.jpg\"<\/a>
\nCentral banks attempt to walk this fine line \u2013 generating mild credit growth that matches
\nnominal GDP growth \u2013 and keeping the cost of the credit at a yield that is not too high, nor
\ntoo low, but just right. Janet Yellen is a modern day Goldilocks.<\/p>\n

How is she doing? So far, so good, I suppose. While the recovery has been weak by historical
\nstandards, banks and corporations have recapitalized, job growth has been steady and
\nimportantly \u2013 at least to the Fed \u2013 markets are in record territory, suggesting happier days
\nahead. But our highly levered financial system is like a truckload of nitro glycerin on a bumpy
\nroad. One mistake can set off a credit implosion where holders of stocks, high yield bonds,
\nand yes, subprime mortgages all rush to the bank to claim its one and only dollar in the vault.<\/p>\n

It happened in 2008, and central banks were in a position to drastically lower yields and buy
\ntrillions of dollars via Quantitative Easing (QE) to prevent a run on the system. Today, central
\nbank flexibility is not what it was back then. Yields globally are near zero and in many cases,
\nnegative.<\/quote>
\n Continuing QE programs by central banks are approaching limits as they buy up
\nmore and more existing debt, threatening repo markets and the day to day functioning of
\nfinancial commerce.<\/p>\n

I\u2019m with Will Rogers. Don\u2019t be allured by the Trump mirage of 3-4% growth and the magical
\nbenefits of tax cuts and deregulation. The U.S. and indeed the global economy is walking a
\nfine line due to increasing leverage and the potential for too high (or too low) interest rates
\nto wreak havoc on an increasingly stressed financial system. Be more concerned about the
\nreturn of your money than the return on your money in 2017 and beyond.