Browsing the archives for the Trillion tag.

Virtual Fixed Assets

Economic Reality, Virtual Reality
According to the US Bureau of Economic Activity, the real US economy (i.e. non-public sector) spends just over $1 Trillion / year on non-structural fixed assets.
This number excludes the cost of buildings, warehouses and factories but includes all household, farm, business, and non-profit organization spending on fixed assets.  A precise definition is found here.
Roughly half of that amount ($537 Billion in 2011) is on information processing equipment and slightly over half of that amount ($279 B) is software.
Spending on transportation equipment (trucks, cars, ships) was $232 B and industrial equipment (engines, lathes, robots, …) $178 B. Furniture and other types of equipment (e.g. agricultural, mining, oil rigs, …) was $194 B.
Within the $537 B on information processing equipment, is spending on computers ($79 B ) and network equipment ($77 B).  The 3rd largest sub-category after software is medical equipment at $72 B.
So the largest single spending area for fixed assets is for software which is a virtual asset! Henry Ford must be spinning in his grave!
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Demystifying The Price of Gold

Economic Reality, Financial Crisis

Putting long-term savings into GICs is turning out to be riskier than investing in hard asset such as precious metals, land, or other commodities such as oil, copper, etc.

The World Gold Council just published a historical view of central bank “balance sheets” since the 2007 crisis: (click on the chart if you need to make it larger)

A central bank’s “balance sheet’ is a relative measure of money supply.  Although there are more exact measures of money supply, when you see a central bank’s “balance sheet” tripling in the case of the USA, or quadrupling in the case of the UK, it really doesn’t matter which one you use and this one is good enough to understand the price of gold.

The buying power of money over time reflects the forces of supply & demand in an economy.  Basically you have money supply on the one side and economic demand for money on the other (i.e. the size of the economy).  If these are not in balance, then inflation or deflation will occur.

  • Suppose a country has $1 T dollars and an economy measured using a hard asset (like gold) worth $1 T dollars.
  • If the economy grows, as it has since 2007, by roughly 2% compounded per year, it will have grown 10.4% after 5 years – i.e. to $1.1 Trillion.
  • If money supply had stayed constant, each 2007 dollar would be able to buy 10% more in 2012 than it did in 2007 since there is more economic value for the same amount of dollars.
  • But if the money supply tripled over the same time period, as it did in the USA, there would be $3 T dollars to balance that $1.1T in economic activity.
  • So each 2012 dollar is actually worth 1/3 x 1.1 = $0.37 compared to its buying power in 2007.

Can that be true?

  • Consider that the price of gold on Jan 2, 2007 was $639.75 in USD.
  • On Oct 18, 2012 it is $1752 in USD.
  • Deflating back to 2007 dollars, we get $1752 x 0.37 = $642.33!
  • Not quite spot on since we used an average of 2% for economic growth over 5 years instead of individual values.  But you can plainly see what has happened.

By inflating the money supply beyond the natural growth in the economy, the buying power of our long-term savings has dropped by 60%.  The reason why we haven’t seen prices radically increase depends on the type of good:

  • Any commodity which is consumed by economic activity (oil, copper, iron, etc.) will have its price primarily determined by the forces of supply and demand for that commodity (to establish a value) and secondarily by the buying power of money (to establish a price for that value).
  • As an example, we’ve seen a significant increase in the cost of oil & gas but this increase is also affected by global consumption of the fixed supply of oil.  Recently global consumption has been dampened by the global recession being experienced everywhere except Asia, causing a drag on what would otherwise be a soaring price.
  • A manufactured good contains both commodity and labour as inputs.  While the input commodity prices in a manufactured product like a refrigerator or car has increased, the labour cost has decreased since most manufacturing has moved to low cost labour centres such as China, Thailand, and Vietnam.
  • Cheap labour has acted as a brake on inflation in developed economies – effectively exporting the inflation problem to Asian economies.  As an example, the official inflation rate in China has been 2 – 4x the North American rate since 2007 and the actual rate is widely believed to be higher than the official numbers.
  • A precious metal such as gold, or a non-consumable good such as land, will act as a perfect reflector for the buying power of money.  For example, although the value of land in the USA was artificially depressed by the explosion of the housing market bubble in 2007, the price of housing in economies unaffected by that crash, such as Canada, has soared.
  • Much of this increase is not due to another bubble forming, but due to the decline in the buying power of the dollar.  In other words, the house is still worth what it was in 2007, it just takes more 2012 dollars to buy it since a 2012 dollar buys less than a 2007 dollar.

So if you think that the banking crisis is over in Europe and that the USA can afford its ridiculous debt levels without either raising taxes or cutting military spending, then go ahead and invest your hard-earned savings in GICs.

Or you can invest some of your savings in gold as a safe hedge against further erosion of your buying power in future.

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US Inflation Warning

Financial Crisis

Although economists were expecting a $23 billion inflow of capital due to foreign purchases of all US securities, recent Treasury International Capital data showed there was a net outflow of $31.2 billion.

This means that foreign investors are less willing to subsidize the US economy in general.  An important subset of this total is the market for US Treasuries and T-Bills since the market for this debt sets the interest rate benchmark for all other debt.

China is the single largest foreign holder of US Treasury debt – to the tune of $776 Billion out of a total of $3.4 Trillion and China reduced this holding by approx $25 B from May to June 2009. Interestingly  Russia, the 7th largest holder of US Treasuries, has also reduced its holdings by $20 B since March.  Maybe the commies aren’t so dumb when it comes to economics after all.

As China’s appetite for U.S. Treasuries wanes the yield for U.S. Treasuries will have to go up. This will suck more money out of the economy just as the Fed is trying to pump it up to prevent further economic collapse.   The other alternative is for the US to devalue its currency either overtly (not likely) or with the help of inflation (far more politically expedient).

This is bad news for the Canadian high tech and manfacturing sectors that depend heavily on a low Canadian dollar.  A devaluation of the USD means a higher Cdn dollar and also the illusion of higher prices for oil, resources, and gold which are normally denomiated in USD.

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Bailout Madness

Financial Crisis

According to the New York Times, the US government has committed $3.1 trillion as an insurer, $3.0 trillion as an investor, and $1.7 trillion as a lender.

However, the Times omits roughly $5 trillion in guarantees made by Fannie Mae and Freddie Mac that are now officially on the government balance sheet.  The total of commiitted bailout funds (without any auto industry funding) is now at $12.8 Trillion.

US GDP is about $14 trillion per year; the budget deficit in recent years has been running in the half-trillion range.  So that means that the total government spending is roughly 13.3 / 14 T = 95% of the entire US GDP!

The US government is betting that actual spending will be less – provided that that banks can repay some of these loan guarantees and preferred securities.  But with dominos now falling across the US auto and other manufacturing sectors, and with the housing and construction sector in the toilet, it is not hard to imagine a second phase to the banking crisis that serioiusly impairs these repayments.

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Anatomy of The Financial Crisis

Financial Crisis

Originally published October 9, 2008 in Facebook.

Subprime Loans

The US subprime mortgage market was approximately $400 B. Nearly half of these loans were enhanced by so-called piggyback loans to help borrowers pay for the equity portion of the first mortgage. It was common for a first mortgage to cover 80% of home value (underwritten by Freddie Mac) and instead of the 20% buyer equity, the piggyback loan (usually from the same bank) would cover the difference – i.e. a second mortgage but with virtually no lien on the property.

Since the first morgage was secured by Feddie Mac, it was easy for the originating bank to sell it to other institutions, so the bank only needed to fund the piggyback portion of the loan. And since, those banks operated with 10x leverage ratios, they only had deposits & equity to cover 1/10 of those bad loans. 1/10 x 20% x $400 B = $8 B. Trouble indeed as the estimate for defaults on those mortgages has esclated from approx 20% to 40%.

Bank of England

 MBS

The first mortgages in turn were purchased by large lenders who pooled loans of varioius quality which were sold to investment banks who in turn issued preference tranches on each pool. Top tranches would be paid out first, lower tranches would be paid out later, thereby artificially creating different instruments with different levels of credit grade. Since major banks operate with a leverage ratio of appoximately 6:1, the securitized MBS must have had a book value of approx 6 x $400 B x 80% = $2 Trillion.

Bank of England

At the start of the crisis in 2007 as defaults mounted on the mortgages, the market for the MBS securities started to dry up. As shown in the chart above the estimated total impact of impaired MBS securities is $160 B.  The immediate problem facing banks was the rapid increase in their funding requirements when they could not securitise or otherwise distribute their loan warehouses. Banks began to hoard liquidity to meet actual and potential increases in these funding requirements, causing interbank rates to spike during August and September 2007.

Structured Credit

Towards the end of 2007, banks began announcing substantial losses on their own holdings of structured credit products. That $2 Trillion of market value was starting to unwind. Current estimates (see below) show that the structured credit market losses are in the vacinity of $400 B (so far).

Bank of England

Counterparty Risk

An element of counterparty credit risk began to influence interbank lending decisions. Some banks could not gain unsecured funding, amplifying their financing difficulties. As the end of the year approached, banks sought to increase their liquid asset positions, in part to strengthen the appearance of their reported balance sheets. This was a major contributing factor to the rise in London interbank offered rates (Libor) internationally in early December. This was alleviated to some extent by co-ordinated central bank action on 12 December 2007 causing money market conditions to improve during January 2008.

In February and March 2008, however, money markets tightened again as banks reported significant additional write-downs on ABS and the prospect of losses on exposures insured by monolines increased. Central banks provided a second round of co-ordinated liquidity provision on 11 March 2008.

However, by Aug/Sept 2008 not just the originating bad lenders have gone under, but also the major investment banks and large US lenders that created the MBS mess have failed (or been forced to merge). This has extended the counterparty risk substantially to international banks and the dominos continue to fall.

Bank Failures

We are now seeing bank failures in UK, Germany, Holland, and Iceland. These will in turn extend the imprint of counterparty risk and cause even more bank hoarding. Banks hoard by declining to deal with other banks and by raising credit costs to businesses and consumers. The impact on business is growing with each passing week. Already 20% of all US car dealers are facing bankruptcy as they cannot finance their inventory due to tighter credit imposed by their banks and a drop-off in spending by consumers who can’t afford to pay the rising interest on their mortages.

Substantial interest rate cuts will be necessary to improve bank margins (making it easier for them to hoard cash) but don’t expect to see any of it in your personal credit card, car loans, or mortgages and certainly not in your business lines of credit, lease rates, etc.

Coupled with over $1 Trillion so far in bailouts in the USA and UK to guarantee the bad loans and ensure bank creditworthiness, we can expect serious degredation in the buying power of cash. Only by devaluing the purchasing power of the dollar can the central banks suck excess liquidity out and devalue the bad loans at the heart of it all.

So don’t be surprised when everything costs a lot more this time next year.

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