Money Flows Part 1
Research for Online Investors

by John Dalt

8/09/10

Today and tomorrow we are going to reprint emails your editor exchanged with paid up subscriber D.E. this weekend. These questions and answers should help many understand the current money supply efforts by the Fed and how it is affecting the economy and stock market. This is good information with the Fed meeting and releasing a statement Tuesday.

D.E.--- Like me, you no doubt have read reports that money has moved out of the stock market and money invested in the bond market has increased. If money on net is moving out of stocks, how can the major averages increase?  If there are more sellers than buyers…then it seems that the law of supply and demand dictates that the prices must drop. What is your understanding?

John:  If I sell a stock for $100 per share, and overtime it drops to $75 when I buy it back.  I have $25 to invest in bonds.  Money has flowed out of the stock market into the bond market, the same quantity of stock units have sold.  If I am a long term investor and hold it the stock may rise to $100 but there was a net outflow of money to the fixed income market.  I would suggest the outflow to fixed income affects the velocity of the market but not the price of any stock or index.  I would use the lower volume in the markets as confirmation of this phenomenon.  A rising market creates wealth, as a falling market destroys it, but these paper gains or losses are only realized upon a sale.  We can construct a simple series of trades with two or three buyers each starting with $100 trading back and forth with the traded item back at the starting price, but more or less cash in each participant’s bank at the end.  I believe this is illustrates the ability of the market to move higher or lower and cash being removed from the market.

D.E.---Thanks,  John. Another way to look at it is the market is in balance as long as there are an equal number of buyers and sellers. In this case, prices can remain unchanged. But this can happen for any total amount of money in the market, whether it is one trillion or two trillion dollars - in both cases, as long as there are equal buyers and sellers, prices will be supported at the current levels. So this is a way that money can be removed from the market and yet prices stay the same. I see the endpoints, but how one gets from one state to the other I don't quite understand.

John--- You have it, this is tough to get around.  We know what the answer is but explaining it is tough.  Look at the stock market as a micro economy.  Inflation is the velocity of money, not the amount of money.  This is why we have the present situation in the U.S. economy.  The Fed has printed $1.7 trillion, but banks and people are holding onto it, so there is neither velocity nor inflation (right now).  Inflation = higher stock prices  deflation= lower stock prices still the same number of stocks  Inflation (increasing prices) comes about not by the increase in money on the sidelines but by the velocity (trading activity) of the money.  Deflation (lower stock prices) occurs because of lower velocity not the amount of money invested.  Remember the market creates and destroys wealth as it moves up and down.  It bestows both effects on different participants depending on their activity.

D.E.---You said, “Remember the market creates and destroys wealth as it moves up and down.”  I have always found this kind of difficult to understand.   “The Fed has printed $1.7 trillion, but banks and people are holding onto it, so there is neither velocity nor inflation (right now).”  What do you think is going to happen to this money? I suppose it's theoretically possible that it could never be used, like just forgotten about, as though it was never "created" in the first place, which would be highly desirable. Or taken back by the Fed surreptitiously. I find it amazing that the money has not yet been used. I mean, it's a rare person who, given a large sum of money, will not go out and start spending it.

John--- Due to the wide spread between short term rates and long-term rates the banks are "investing" the money the Fed created and lent to them at 0% to 0.25% in U.S. Treasuries at 3%.  It is better than lending to customers!  Liquid capital that is insured by the government.  Nice interest rate spread.  No loss risk, nor scrutiny by regulators.  The Fed has withdrawn from creating new money Quantitative Easing) but is still rolling over the short term loans to banks at low interest rates.  They can gradually withdraw renewal of these loans which removes this money from the money supply.  They will not do this until we see the velocity of money increasing.  This will happen when businesses and consumers begin to borrow money for expansion or consumption (because of fear of higher future prices).  The deflation occurring now is indicative of the excess money on bank ledgers being put to use buying treasuries rather than being used for economic expansion by business.  The opinion of the K.C. Fed Governor and now the St. Louis Fed Governor is to increase the interest rates the Fed charges for their loans to banks, then meeting demand for these loans to banks with more Quantitative Easing money.  This forces the banks to loan money to customers to make an interest rate spread (this is how banks make money).  This forcing of money into the market is opposed to waiting for loan demand from business.  The dilemma of low loan demand is caused by the government creating an atmosphere of fear among business leaders.  Fear of more regulation, fear of higher taxes, and fear of more punitive legislation.

D.E.--- You said “The opinion of the K.C. Fed Governor and now the St. Louis Fed Governor is to increase the interest rates the Fed charges for their loans to banks, then meeting demand for these loans to banks with more Quantitative Easing money.  This forces the banks to loan money to customers to make an interest rate spread (this is how banks make money).”  But if this is done, then this injection of new money into the economy is what produces inflation. Isn't there a way of the Fed taking back this money from the banks, which seems to me would be undoing the creation of it? Seems to me that doing so should not hurt the ability of banks to make loans, since they still have money from the other sources. And it would prevent the inflation that would otherwise occur.  We went through a period when there was irresponsible borrowing, when banks were too loose in making loans. I wonder if the pendulum has swung too far in the other direction, and banks are too strict in making loans - as a partial explanation for the slow economy - as opposed to because the demand for loans is just not there now. However it works itself out, hopefully both of us will still be around to see the outcome; but it feels like some kind of intellectual mystery that I am anxious to know how it will end to satisfy my curiosity, even though I don't think I will like the end result (much less freedom and even bigger govt).

John--- Only the velocity of the money produces inflation.

Editor's note:  We will publish the remainder of this email exchange tomorrow.

Today in History:  The U.S. dropped Fat-Man, the second atomic bomb, on Nagasaki, Japan on this day in 1945.  Japan announced it would surrender six days later.  Obama sent a delegation to the 65th anniversary ceremony last Friday marking the bombing of Hiroshima.  This was the first time the U.S. has attended this ceremony.  Today, revisionists argue the bombing was not necessary.  Tell that to the men that fought in the Pacific, and were tasked with invading Japan.

The Japanese were kind to American POW's.  They supplied them blindfolds as shown in this picture.  No other comment necessary.

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future. 

Money Flows Part Two

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