Basic Economics We All Need To Understand

Reading what follows may be of help if you are one who would like to have a better understanding of what the recent and future actions of our government may have on our economic future.

Those who took Economics 101 in school may recall the following basic formula:

M x V = P x T = gross income

M = invested money

V = velocity (the number of times this money is turned over per unit time)

P = price

T = number of transactions per unit time

Business people apply this formula regularly whether they know it or not. The more times they can rollover their investment, the more gross income they derive. However, the gross income is also dependent on having an optimum price on a product that will cause an optimum number of transactions to occur. Businesses like a super-market can operate with a small margin of profit because there are a large number of transactions that occur every day. Conversely, a clothing merchant would have to set prices with a higher profit margin because they would not have as many number of transactions to optimize their gross income. This same analogies applies to our government's business.

M x V = P x T = GDP (gross domestic product)

M = money supply

V = velocity (the number of times this money is turned over per unit time)

P = price (reflected by cost of goods/services indices's relating to inflation or deflation)

T = number of transactions for goods and services per unit time

Since the great depression years, circa 1930's, velocity has stayed relatively constant until the present period, except for a slight increase in the 1990's,. The degradation of credit, due to the housing market collapse, has caused velocity to decrease markedly. As a result GDP has fallen accordingly. The FED (Federal Reserve Bank) has attempted to offset this by increasing the money supply. However, in order for an increase in GDP to take place the other side of the equation (P x T) must increase. This requires that the increase in the money supply be used effectively to bring back velocity to what it previously was. Milton Friedman supplied me with graphs to show that there is a two year delay between a change in the money supply and an attendant reaction in GDP. Therefore corrections do not take place instantly.

There are also actions by the legislative and executive branches of government that fiscally address economic problems with various spending programs. The Treasury is called on to fund them by issuing bonds that are purchased by foreign banks and the FED. Thus besides increasing the money supply the government hopes to kick start the economy, increasing P x T and thus GDP. However, unless GDP is increased sufficiently to offset the debt generated by the funding of the spending plus interest, it may very well fail.

In the past it has been the private sector with its inventiveness and private investment capital to nurture it that has been the catalyst for economic growth leading to marked increases in GDP. All one has to do is look at the companies that sprouted up and matured into large enterprises employing thousands of people. Among these many firms the names that come to mind are Hewlett Packard, Intel, Microsoft, Dell, Cisco Systems, Oracle, Yahoo and Google.

It would rationally appear that the government, at some point, should consider incentivizing the private sector. This could be done by harnessing the private sector's ability to leverage capital to create new products, as has been done in the past . The seed capital could be provided by cutting corporate income taxes that are presently the highest in the world and completely eliminating the capital gains tax. Able to keep more of their derived revenue these companies would be able to retain and/or hire new employees and plan for expanding their activity. Without the necessity to plan investments based on the effect of capital gains taxes, investors whether they be stock market types or venture capitalists, would likely be incentivized to buy into the future of American enterprise as has previously occurred.

Of course, when and if the increase in the money supply (M) finally takes hold and velocity (V) accordingly starts to increase, prices (P) will tend to increase creating inflationary pressure. To counteract this the FED will surely start to cut back on the money supply (M), however recall there is a two year delay before changes in the money supply cause a reaction in GDP. As was experienced when the FED last attempted this it caused our present economic crisis. Decreasing the money supply will cause interest rates to increase and our economy will again be entering into what we would hope will only be a recessionary period.

Our credentialed government officials responsible for our economy appear unable to apply that knowledge to which we know they must have been exposed. It appears that they would rather use ideological and political solutions even when they are obviously damaging to our country. It would be hoped that someone will just look once again at the simple formula M x V = P x T and intelligently apply it.

The true cause of the economic tsunami

Unfortunately that which has actually caused our present economic crisis is not even being given lip service by anyone. It is hoped that which is contained herein will help fill that void for the reader..

As every family knows, when it spends more than it earns it can only make up the difference by borrowing or increasing income. It is the same for the government except they also have the power to essentially print money. Let's look at how government appears to get away with running continuing deficits while any of us who did the same thing would eventually be forced into bankruptcy. When the government spends more money than it receives, the Treasury Department has the power to borrow the difference by offering bonds for sale at market interest rates. Ready buyers of these bonds are those foreign countries who sell more of their products and services to U.S. entities then is purchased from them. The dollar difference (trade deficit) must eventually return to the U.S. and is predominantly used to buy this debt.

When the amount of funds required to satisfy the deficit exceed the amount of trade deficit dollars available to buy our bonds, the Federal Reserve Bank (FED) buys the bonds. The FED presently owns around 40% of the national debt and this means the government essentially owns this portion of its own debt. They buy these bonds by crediting the attendant purchase amount to the bank accounts of the dealers that sell them. Since banks are required to only maintain 10% of their deposits in reserve they can lend 10 times that amount. This 10 to 1 leverage is then further increased when money is moved by transactions to other banks.

Why should this be of concern? Because this created money is just like any other commodity and its purchasing power decreases when the amount of it available increases . When there is more supply than demand of a commodity the value of that commodity decreases.. Hence, the devaluation of the dollar and resultant eventual inflation.

Our present economic condition has been brewing for many years. Its beginning can be traced back to what ensued after it was agreed by 29 nations at the Bretton Woods Conference in 1944 that the U.S. would guarantee to sell gold at $35 an ounce effectively pegging the value of world currencies to the U.S. dollar. Subsequent continued deficit spending that exacerbated in the 1960's coupled with an increasing trade deficit resulted in marked devaluation of the dollar relative to gold. This led to the issuance of what were called “special drawing rights (sdr's)”, that were in essence iou's, to offset the difference between the market price of gold and $35 an oz.

In 1971 the continuing increased national debt and ensuing pressure from speculators and central banks forced President Nixon to abandon the gold standard. Thus the dollar became a fiat currency whose value was to float in relation to other world currencies. Without the restraint of the gold standard, deficit spending accelerated and rose from under $500 Billion in 1971 to $9 Trillion in 2008. During this period the FED continued to manipulate the money supply resulting in an inordinate increase in the price of homes followed by a marked decrease in these prices circa 1985 to 1998.. What then followed brought us to our present economic predicament described as follows..

In order to allow banks to obtain additional funding Fannie Mae and Freddie Mac (GSE'S) were created many years ago by our government. By being able to sell loans through Fannie Mae, Freddie Mac and others, retaining fees for servicing and a small profit margin, banks could again use these derived funds to make more loans. Once loans are sold the lender no longer bears the risk of foreclosure when borrowers default. The result has been to progressively relax loan standards to allow marginal buyers to qualify.

We see this specifically when the Fed placed an excessive amount of money into the economy to address the recession that started just prior to the GWB presidency and extended to ease the economic blow of 9/11. This inordinate amount of money deposited into our banking system had to be loaned out since that is how banks make money. The ability to easily sell the loans removed the liability of foreclosure and the result was the accelerated development of creative loans to meet the demand.

The increased demand caused home prices to increase markedly attracting speculators. The increased need for buyers of these loans was met by Wall Street's investment bankers. They created bonds that were backed by a bundled package of a variety of mortgage types and initially priced by a complicated mathematical formula. Called Mortgage Backed Securities (MBS) they became considered as highly desirable investment vehicles and were sold worldwide.

Meanwhile, attempting to counteract what was occurring the Fed started to reduce the money supply. This increased the Federal Funds Rate multiple times but was unable to curb the excesses that had been created and the housing price bubble finally burst. The collapse of housing prices also resulted in the collapse of the market for MBS. Their value could no longer be adequately determined by the market or by the original pricing mechanism due to this complexity of this security.

In correspondence I had with economist Milton Friedman over a ten year period in the 1990's he stated that the Fed board should be eliminated and the responsibility of controlling the money supply should be left to a computer. The PC would be programmed to keep the money supply increasing only in proportion to the increase in population (about 3-5% per year). He also sent me graphs from his computer to show that it took two years for GDP to react to a change in the money supply. Thus the Fed's power to control the money supply should not be used to counteract fiscal policy. He believed that deficits should be addressed by either cuts in spending or increases in taxes. However, he preferred cuts in spending.

He believed that taxpayers would more likely spend money in an economically beneficial way than government and, by that virtue, was more likely to increase our national income {GDP). The benefit of a growing GDP is higher tax revenue that can be used not only to pay for government services but also our national debt. The interest alone on our massive national debt caused by deficit spending is huge.

If the money supply was limited in growth as Dr. Friedman suggests then the legislative and executive branches of government would be forced to either curb spending or raise taxes to balance the budget. This would mean that these elected officials would have to answer to the voters and would be more likely to be more fiscally responsible.

There is no question that deficit spending has led to our present economic predicament. Increasing the money supply to offset deficit spending must eventually cause hyper inflation. In the past we have seen prices on goods rise due to this. Six dollars in 2009 is equal to one 1950 dollar. Thus devalued dollars are used to pay off debt. The extraordinary increase in deficit spending will at some point in time accordingly devaluate the dollar resulting in dire effects on the economy and will especially negatively affect the growing senior community who live on fixed incomes.

Unfortunately until this is recognized and steps are taken to no longer use the Fed to bail out actions taken by the legislative and executive branches of government, our country will continue to face continuing and worsening cycles of economic boom and bust leading to periodic financial tsunamis'.

WHAT CAUSED THE HOUSING PRICE BUBBLE TO BURST

The terms supply and demand usually are what cause prices to vary whether it be real estate or any other freely traded commodity. This is true but to go beyond this simplistic answer one must look to what factors enter into establishing the supply and the demand.

Let's start first with supply. Before Developers decide to initiate the construction of housing they obtain as much information as possible relating to the potential demand for specific types of housing so that they feel assured that there will be buyers for them when they come to market. Thus demand is the initiating factor.

Then what affects the demand for housing? The obvious primary answer is the ability for buyer's to have sufficient assets and monthly income to qualify for mortgage loans. What follows is the availability of these loans at an affordable cost, along with the funds to which buyer's have access necessary to complement the loan amount so that the purchase can be effected.

Factors that effect the cost of a loan include credit score, loan fees, term of loan, fixed or adjustable interest rate amount, interest rate change triggers and possible prepayment fee. The availability of funds from lenders that affect these factors is related to the nation's money supply that is controlled by the actions of the Federal Reserve Board (FRB). The expansion or contraction of the money supply acts to change the Federal Funds Rate that is the interest rate paid by one bank to another to borrow funds in other to meet their reserve requirement. The financial markets use this interest rate as an indicator that other interest rates should move accordingly including mortgage rates. In addition, there is a relatively long period of time between the time the FRB makes a change in the money supply and the market reacts to it. This can be viewed in Figure 3 on the M1 Money Stock graph for the period 1975-2007 comparing it to Figures 1 and 2).

With this basic knowledge now again view Figure 1, the graph California Median Home Prices and Population 1968-2003. The graph shows that population has grown steadily at a linear rate over this period of time. However, the median prices show periods of moderate growth, rapid growth and decline. A period of decline occurred between 1989 and 1998 preceded by and followed by a period of relatively rapid growth. The period from 1998 to the fourth quarter of 2005, where one might say "the price bubble burst", is especially marked by an inordinate rapid increase.

A rational explanation for what occurred can be made. A recession in our economy developed in 1990-91 that had started the reduction in the number of potential buyers of homes that lasted until circa 1998. To counteract the recession, the FRB had already begun to incrementally increase the money supply (see figure 3) and correspondingly lower interest rates. When home prices started to erode due to the decreased demand, investors speculating in real estate moved their money into stocks and the stock market began its run up. The FRB began to react circa 1994-95 and the money stock leveled off for a bit before starting to decline. Lenders in reaction to the increase in the money supply creatively found new ways to lend their money out and buyers reacted accordingly.

Hence, although the FRB reacted to the decrease in demand, increasing the money supply incrementally over time, it wasn't until 1998 that the increased money supply, that already had exacerbated the increase in stock prices, took hold. Figure 3 graph shows that the money supply started its downward trend in 1995 but the stock market didn't fully react until 1998 when the decrease in the money supply effected the beginning of a subsequent recession in 2001. The financial indicators of a pending recession caused the stock mark bubble to burst. This in turn caused investors to turn to other investment vehicles and some returned to Real Estate.

Much can be learned by again viewing the Figure 3 graph that shows a leveling of the Money Stock growth starting in 1998 and then starting its rise up again in 2001 to counteract the recession. This increase was exacerbated due to an inordinate increase in the money stock as a reaction by the FRB to the terrorist attack on 9/11. The money that was generated in the economy had to be loaned out by the various lending institutions since that is where their profits are derived. A most important contributing factor was the acceptance of Credit Scoring during the 1990's. This aided and abetted the movement to substitute the rating of buyers on their ability to pay off their loans for the previous widely used requirement for adequate collateral to back their loan.

The loan industry was quick to adapt to this and, in fact, created loan vehicles that were able to circumvent the need for mortgage insurance that had for many years been required for loans exceeding 80% of property value. The flood of available money to be loaned exacerbated by this factor led to truly creative mortgage terms that allowed many to qualify for loans that would not have under previous rules. Loans were packaged into securities where by that virtue appeared to normalize relative risk and could be sold to investors. This allowed lenders, although still servicing them, to pass on to securities investors loans they might not normally make if they had to continue to own them.

Thus new home construction boomed to satisfy the demand created by the many people taking advantage of the opportunity to own a home of their own or to buy up to a more spacious and higher priced one with the every increasing equity being built up in their previous home. The increasing price spiral attracted more speculative investors away from the stock market. Buying with high leverage, having put very little down with prices increasing at an annual rate of 20 to 30% resulted in an extremely high return on invested capital. As seen in Figure 1 and then Figure 2 the price rise starting in 1998 rose virtually asymptotically until the bubble burst in the third quarter of 2005 as shown in Figure 2.

The foregoing clearly shows the causal factors for the recent collapse of housing prices and is available to everyone. The obvious question that arises is "will those having the means to implement correct measures utilize them? Future events in the housing and securities markets will answer that question.