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David Cret !er

"#$%# &y Weat!er'Eye Advi()r(


The economy is complicated and often misunderstood. Not only does it drive the behavior of its participants it also drives the behavior of investments. A fundamental understanding is necessary to the selection of investments. To understand how it affects the world of investments, you must divorce yourself from economics, as it is taught in schools and universities, and focus on economics as it really happens in the day-to-day economy. You need to understand the big picture of how the economy works in practice. Forget what you ve learned in elementary economics class about supply and demand, e!uilibrium, perfect competition, marginal cost and production. Those micro-economic concepts are hard to apply to investing. To make intelligent investments step back and look at the economy as a whole. "hen you look at the big picture, you ll find that the economy works on a simple model. #n practice, the economy functions like a steam engine, but instead of steam pressure it runs on money pressure. $oney pressure is the force behind the money supply in an economy, %ust as steam pressure is the force behind the steam in an engine. The economy is a closed system that creates and destroys money and builds pressure from a variety of sources. The money pressure is pushed through three main economic paths or circuits %ust like steam is pushed through the turbines of a power plant. The &omestic 'ircuit, the Foreign 'ircuit, or the Financial 'ircuit "hen there is too much pressure withing the circuit to be absorbed by the domestic circuit. This e(cess pressure can cause three types of inflation. #t can inflate foreign or domestic economies and create economic growth, inflate financial asset prices like houses and stocks, or inflate the price of goods and services.

MONEY PRESSURE DRIVES THE ECONOMY )veryone knows money makes the world go around. #t flows through the economy from one hand to another without being destroyed. "hen you have money in your pocket you can only do three things with it - spend it, invest it, or save it. *pecifically you can spend it on something within the domestic economy, something made by a foreign economy or it can be spent to pay ta(es. You can also invest it in a financial asset, or you can save it in a government-guaranteed bank account, savings bond or treasury security. That s it, and that s what happens daily in the economy as people get money and spend, save, or invest it. "ithin the economy farmers grow food, miners e(tract resources, businesses convert raw materials and people consume them, but not money, the money isn t consumed it %ust stays in the system going from one person to the ne(t. $oney can t even be wasted because one persons waste is another persons income. #f you blow it in the casino, the casino still has the money - they don t destroy it. #n fact, it is against the law to destroy currency, only the government has the power to destroy currency in the economy. #n a well functioning economy the money pressure builds in the system like steam in a steam engine. The pressure is then forced through the three main circuits+ the domestic economy, foreign economies, and the financial circuit where is continually recycled.

To understand the process, imagine a simple economy with ,-- dollars of currency in circulation producing ,-- mouse traps annually. )very year the population buys ,-- mouse traps for a dollar each. This creates ,-- dollars of nominal gross domestic product./&01 and ,-- dollars in national income. The ,-- dollars flows through the system. #t is spent for mouse traps generating profit for the trap company and wages for the workers. Afterward, these new profits and wages are again re-spent for a new batch of ,-- mouse traps. The economy consumes the raw materials - the wood and springs re!uired to make the ,-- mouse traps every year, but the money isn t destroyed - it is continuously recycled through the circuit from spender to producer back to spender.

CHANGES IN THE PRESSURE CAUSE CHANGES IN THE OUTPUT Now, if for some reason the citi2ens decide not to spend all the circulating money and instead save 3- dollars and put it into a bank account. "hen this occurs, the money is parked unused outside the circuit like a car pulled from a race track and put into the garage, it is still at the track but no longer on the race circuit. This act of savings causes the money pressure to drop, because there are now only 4- dollars left circulating in an economy that can build ,-- mousetraps. The ne(t time around only 4- dollars is spend and only 4- mouse traps are sold causing the /&0 drop from ,-- to 4- and creating 3- dollars less in national income. "e have a recession when this happens. 5ntil the 3- dollars in savings is respent back into the economy, or the 4- dollars is recycled at a 3- percent faster rate, the economy stays at a new 4- dollar level. #f do the opposite and instead magically increase the amount of money in the system by 3- dollars so there is now ,3- dollars circulating in the economy, this increase in the supply of money is often assumed to cause inflation because too many dollars are now chase too few goods. Therefore a 3percent increase in money leads to a 3- percent increase in prices. This is a common refrain forcefully promoted by in the press and by gold salesman. 6ut, this answer is incomplete. A number of other money flow scenarios can happen. First, when there are enough raw materials and available labor at the current price, the production capacity can e(pand by 3- percent allowing the economy to make ,3- traps and generate a /&0 and national income of ,3-, resetting the economy at the ,3- mouse trap level. *econd, the savings level can increase. #f no one wants more mouse traps the e(tra 3- dollars can be parked outside the system in government-insured bank account or treasury bond temporarily going unused in the economy. Third, the money can be used to buy 3- imported mouse traps, in which case the 3- dollars leaves the domestic economy and may or may come back. .the foreigners may simply decide to save and park the money in a bank or 5* Treasuries 7 like the 'hinese currently do1. Alternately, the money can be ta(ed back by the federal government destroying the e(cess money and leaving the economy with its original ,-- dollars. 8ast, the e(tra money can be spent on financial assets like stocks. "hen this happens a third circuit is engaged.

ASSET PRICE INFLATION AND PHANTOM MONEY "hen the money goes to buy financial assets a new phenomena starts. The movement of the money toward financial assets and stock purchases doesn t remove the money from the economy like saving it to a bank account does, it %ust transfers the money from a buyer to a seller. This movement can however cause the creation of new phantom money. To understand this, imagine the e(tra twenty dollars goes to buy stock in 9- percent of the mouse trap company with 9- shares at one dollar each. The money is spent and goes back into the economy

from the buyer to the seller, in this case, the mouse trap company. Then lets imagine the person who bought the stock creates a credible story about the future of mouse traps and finds an enthusiastic person willing to buy a 3- percent stake in the mouse trap company at double the price or 3- dollars - two dollars per share. Again the money is not destroyed it is recycled from buyer to seller. Now if we stop and ask these investors how much money they have, they will tell you they have ,-shares of the company worth two dollars per share or :3-- dollars total. That s 3-- dollars in stock value, but remember there is still only ,3- dollars circulating in the entire economy. *hould they try to sell these shares at the same time, the most they can possibly sell for is ,3- dollars because that s the total money in the economy. *o, ask yourself, where did the e(tra 4- dollars come from; #t is phantom money. #t is %ust an estimate, a book value, it isn t really there, but investors believe it is because that s what it says on their statement. <ur imagined economy has ,3- dollars and ,-- shares of stock in total, not =3- dollars comprised of the ,3- dollars in the economy plus another 3-dollars worth of stock. #f the inhabitants of this imaginary economy believe they have =3- dollars to retire on, they will be disappointed in the end, because there is only ,3- dollars of actual money in the economy. The point is a small amount of real money can create a large amount of phantom money in the economy. Take another e(ample, if there are ,- ounces of gold in the the world and the last ounce of gold sells for >- dollars, then there is a total of >-- dollars .,- ( >-1 worth of gold in the economy. Now if a speculative fren2y occurs and the ne(t ounce of gold sells for ,--- dollars instead of >-, there are now ,-,--- dollars worth of gold .,- ( ,---1. #n this case, a small amount of money, the ,--- dollars used to make the last purchase, causes an increase of ?,>-- dollars in the worth of the gold stock without changing either the amount of gold or the amount of money in the economy. #f the amount of gold didn t change and the amount of money didn t change where did the additional worth come from; #t came from thin air. That s why it is phantom money.

5ltimately, investments are worth what they can be sold for and the investor won t know the amount until the asset is sold. "hen retirement savers watched the value of their 9-,.k1s tank during the financial crisis, they didn t lose real money they lost phantom money. 5nfortunately, it feels the same.

A great way to get rich is to convert phantom money to real money at high prices, but not everyone in the economy can do that because there isn t enough money in the economy to make it happen. 5nless there is a continually increasing money supply, it will only work for a minority, the ma%ority will, as the saying goes, be stuck holding the bag. The important point to keep in mind, is the dollar figure on your statement is not how much money you have. #t is %ust an estimate of what you can sell your assets for on that day. 5ltimately their worth won t be known until the end when they are sold. The result is back-ended. The further the total amount of phantom money increases above the supporting money supply in the economy, the less likely the assets can be sold for their statement value. This is simply because there won t be enough money within the system to make all the sales at the price everyone believe the assets are worth. The misconception that stock value is the same as cash money is one reason the ordinary investor finds making money in the stock market more difficult than it looks. *imilarly, the housing market is also susceptible to phantom money, a small increase in the price of houses can create a huge amount of 0hantom $oney. This 0hantom $oney causes an important economic effect - it increases the amount of collateral available for loans and results in increased credit. 0rior to the financial crisis a lot of phantom money was converted to credit money through home e!uity loans. This increased credit creates new money in%ected in the economy. "ithin the financial circuit, circulating money is multiplied to create 0hantom $oney as described in our gold e(ample above,. 0hantom money is than used to collaterali2e loans, this creates additional credit money. 8et s review, the economy has three main circuits - domestic, foreign and financial. And there are three types of money inside the system. G)ver*+e*t'(,--.ied rea. +)*ey' the money created when the government spends to buy goods and services, pays for transfer payments, or pays interest on bonds. This money is permanent unless it is ta(ed back by the government. #t represents a new financial asset created in the economy. Private.y' reated redit +)*ey - the money created when you borrow from a bank on your credit card, margin account, or mortgage. This money is temporary and re!uires the payment of interest. 'redit money is not a new financial asset, it an asset with a corresponding liability. #t is new circulating money that can be used to purchase things. P!a*t)+ +)*ey - the pseudo-money in your brokerage account created when asset prices inflate. This is not actual money - it does not circulate and it cannot be spent, to be used it must first be used as loan collateral and converted to credit money or sold to a buyer for currency before it can be spent into the economy. $oney that is not re!uired for immediate spending or investment purchases can be saved outside the economy in a bank account or a government bond or it can be destroyed by federal ta(ation. )(tra money in the domestic economy can also be sent outside to buy foreign goods, and may or may not be returned.

HOW MONEY PRESSURE IS CREATED AND ABSORBED #n the 5* economy, the money pressure is created from five main sources+ ,1 New money spent into the economy by the federal government. 31 $oney returned to our economy from foreign economies. =1 New bank loans created by commercial banks. 91 $oney spent from savings or dissaving. >1 And last by labor or resource constraints. #ncreases in these si( sources build money pressure within the economy.

'onversely, money pressure is absorbed by five opposite actions+ ,1 The federal government can destroy the money by ta(ing it out of the economy. 31 $oney can be spent outside the 5* economy on foreign goods or oil.

=1 6ank loans can be repaid or defaulted on. 91 $oney can be parked away from the economy by being saved into a bank account or government bond. >1 And last the domestic economy can e(pand to accommodate the pressure sub%ect to resource constraints. #ncreases in these five actions cause the money pressure in the economy to drop.

"hen the money pressure is increased drives the 5* economy by circulating through it like steam through a turbine, spinning the wheels of commerce, producing goods and services which create wages and profits that are re-spent, saved or invested. "hen there a lot of pressure the economy grows .inflates1 and the wheels spin faster and the money is re-spent. "hen the money pressure drops the economy contracts.deflates1 and the wheels spin slower creating less wages and profit available to be re-spent. This deflation creates less production. @#n economic terms, the change in money pressure is the net change in bank loans plus the net change in government spending minus the net change in government-guaranteed savings, net change in new federal ta(es and net new dollar-denominated imports. 6ut unless you want to be an economist you don t need to worry about that.A

HOW MONEY IS CREATED AND DESTROYED 5nderstanding how the economy works in practice, involves two concepts investors should understand that are that are counter to what is commonly taught and believed. First, in the actual economy, there is no direct connection between the federal government ta(ing and spending. #n practice, the 5* government doesn t collect ta( money from citi2ens and then buy things with the ta( money. The process is the opposite the government spends money the money first and then collects it back as ta(es. #n the real world, the government collects ta( money and destroys it. They virtually remove it from the system. #nside the banking system when the government spends money the Fed credits the accounts of the supplier or receiver, and when they ta( the money back they debit your checking account and credit their federal reserve account. "hen this happens the money essentially disappears. Another way to view this is by looking at the life of a dollar bill. <ur dollar is a Federal Beserve Note which is technically a non-interest paying bearer bond 7 a bill of credit 7 hence the name dollar bill. "hen this dollar bill.of credit1 is returned to the Federal Beserve the loan is e(tinguished and the credit .bond1 is destroyed, %ust as a bank loan disappears from the bank balance sheet when a consumer pays it off. The returning ta( money is destroyed by the Fed and the notes are e(tinguished. *imilarly, if you pay your ta(es in paper currency the government will shred it. 'ra2y as it sounds, it s true, you can check their accounting.

GOVERNMENT SPENDING CREATES NEW MONEY To make a payment, or spend, the government %ust credits the account of the person or entity it is paying. "hen it does this it manufactures new money. There is an accounting relationship between ta(ing and spending but it is not a direct mechanical connection like in a household budget. A household takes in money and spends it, #f you think the government runs like your household, it will cause you to make bad investment choices. Think of it like a faucet, sink, and drain. The water coming from the faucet into the sink is new water, the water going out of the drain is not recycled back to the faucet. #t goes to sewage. Federal government spending is the faucet, the drain is federal ta(es and bond sales and the water level is the currency supply in the economy. The two flows from the faucet and the drain may be e!ual but the drain is not connected to the faucet. The money must flow first out of the faucet then be removed by the drain through ta(es and bond sales. That is the government must spend first and then ta( back the money it spends. There are selfimposed political constraints and legal regulations on how the 5* government can manufacture money but they are a mechanical re!uirement. 6e aware state and local governments don t create or destroy money, this ability only applies to the federal government. 8ikewise, currency loaned to the federal government when a government bond is sold isn t used for government spending like commonly believed - it is also removed from the economy and destroyed, at least temporarily. The government manufactures new money to pay off the loan when it matures. This is not theory this is the actual mechanics of the operation. The bond money is removed. #t doesn t recycle directly into the economy.

6y definition, the government deficit is the sum total of the amount of money the government has manufactured during it s e(istence minus the amount it has destroyed by ta(ation. #f we get rid of the deficit, we also get rid of the money. #t s similar to a stock buyback by a private corporation. /overnment spending creates money pressure by releasing new money into the system and ta(es destroy money pressure by removing the money from the system. *hort of self-regulation, governments with their own floating national currency are not re!uired to borrow money to fund their operations, only governments without their own money, like cities and states and )uropean countries, must borrow to fund operations. /overnments borrow their own money voluntarily as a matter of public policy not necessity. 5nlike a household, the 5* government borrows its own money. Couseholds borrow other peoples money. #n practice, 5* bonds function as a government-guaranteed savings mechanism and public service as much as a funding mechanism. 5nder what circumstance would you borrow your own money to pay for your household e(penses if you, like the government, had the enumerated power D@TAo coin $oneyD and Dregulate the Ealue thereofD;

BAN/ LOANS CREATE EVEN MORE MONEY The second counter intuitive mechanism is there is in practice no direct connection between money deposited in a bank and money loaned to customers. #t is commonly believed that money deposited in a bank account is loaned out to customers. This may have been true many years ago. 6ut in the modern world banks %ust create the money they loan you. For the most part they arenFt even re!uired to keep reserves. #n practice they %ust recycle the money lent to you for reserves. Beserve re!uirements have effectively been eliminated and if the loans donFt work their way back into the banking system as reserves the bank can always borrow the needed reserves from the Federal Beserve. This means when a bank makes a loan it creates the money electronically out of thin air, the loan is new privately minted credit money spent into the economy. 6anks can make as many loans as they can find credible borrowers willing to take them. These loans form the ma%ority of the money in the economy. "hen you buy a tank of gas of gas on your bank credit card the money comes from thin air not from someone s bank account. <n the other side, money saved in a bank account is not directly loaned out it is money parked outside the economy unused. The importance of this is that bank loans are another faucet pouring money into the economy, when loans are issued money circulates into the system and conversely when the loans default or are paid off the credit money is drained out of the economy. 5nlike government manufactured money, bank created money is temporary - it only last as long as the loan lasts. The draining of credit money from loan defaults and the resultant decrease in money pressure was a ma%or cause of the recent financial crisis. The bank bailout, like it or not, was an effort to stop the draining by intervening in the default process.

6efore the crisis, easy loans pumped new bank-created credit money and pressure into the economy spinning the wheels of commerce and creating additional phantom money by inflating the price of houses, stocks and other assets. The inflated assets were then used to collaterali2e more loans and create more circulating money in the system. "hen the economy became recessionary, marginal loans began to default draining credit money and pressure from the system, destroying phantom money and loan collateral as the markets collapsed. This slowed the wheels of commerce. This money destruction created a downward spiral of increasing defaults, more credit money destruction, and lower pressure, turning a recession into a crisis. &uring the crisis, gas prices also increased sending more money outside the system to foreign oil suppliers. #nstead of investing in financial assets people and business sought financial safety increasing their savings putting money into the bank and purchasing government bonds and removing pressure from the system. #t also drove down interest rates decreasing the amount of government money created to pay interest. These actions further reduced money pressure and lowered national income. 6efore the collapse, money pressure was increasing and creating a feedback loop where money was driven through the asset markets inflating the market price of assets. These inflated assets collaterali2e additional credit and the new credit money recycled through financial assets further biding up the asset prices increasing more phantom money. "hen pressure flow reverses, the collateral prices deflate, loans default and credit money is destroyed. This leaves a shortage of money in the economy. These concepts may seem unorthodo(, but the important point is to see ta( payments as removal of money and pressure from the system, government bond purchases as a temporary removal from the system, and bank loans as newly manufactured credit money and pressure. *een this way the mechanics of the economy and the behavior of your investments will become much easier to understand and visuali2e when. #f you disagree with these ideas you don t need to argue, you can %ust make the opposite investment.

THE ECONOMIC EFFECTS OF MONEY PRESSURE #ncreasing money pressure can create many types of inflationG it can inflate the si2e of the economy, inflate the price of financial assets, and inflate the amount of savings in the economy. #f increasing money pressure can t be vented by an e(panding economy, increasing imports, increasing savings, or be ta(ed back by the government, then and only then, will the economy get higher domestic goods and service inflation. 5n-vented pressure can drive up the price of goods, services, wages, houses, investments or inflation. 6ut, typically there isn t enough pressure to do all of those actions at the same time. To make money in the markets, investors want the money pressure to inflate the price of the financial assets they own. *tock prices benefit when the wheels of commerce are spinning and generating profits, but they benefit most from money pressure inflating their relative cost, or the price-earnings ratio of the stock. The biggest stock market gains are made when investors are willing to pay =times a companies yearly earnings instead of the eight times the same earnings the investor may have paid for the shares. Heep in mind that goods inflation changes the dynamics and money distributions in the economy but doesn t always slow economic growth. #nflation is maligned in the press but there have been many economies e.g. 6ra2il and #srael and the 5* in the ,?I- s that have had strong growth with high inflation. <ne reason for the growth is inflation makes paying off debt easier and reduces the amount of debt relative to the money supply. #nflation is good for borrowers and bad for creditors. Cope for high inflation if you owe people money, better to have your wages double with a fi(ed mortgage then have them halve. Also, don t confuse inflation with hyper-inflation - hyper-inflation is a form of economic collapse. Just because a steam engine holds a lot of pressure doesn t mean the boiler will e(plode.

SUMMARY The economy is driven by money moving from one agent to another within the economy like steam driven through a turbine. The economy has three main pressure circuits, the &omestic 'ircuit, the Foreign 'ircuit, and the Financial 'ircuit. "ithin the &omestic 'ircuit money is spent creating profits and wages. 0rofits and wages are then respent, invested or saved. $oney in the Foreign 'ircuit is either respent back into the &omestic 'ircuit as e(ports, invested through the Financial 'ircuit, saved into government-backed savings or is circulated outside the 5* economy for oil or other goods. $oney in the Financial 'ircuit is transferred from the buyer to the seller of financial assets thus returning to the &omestic 'ircuit.

There are three broad types of money within the system - /overnment $oney from government spending, bank-created 'redit $oney and last, 0hantom $oney created through financial asset inflation. The money is driven through the economy from pressure that results from the amount of circulating money in the system, the willingness of the system agents to spend the money and the ability of the system to hold the pressure within the &omestic 'ircuit. $oney is introduced into the system from two primary sources 7 government spending and private bank loans. $oney is removed from the system from three actions - government-backed savings consisting of insured bank accounts and treasury securities, payments for dollar-denominated imports and federal ta(es. Five forces build money pressure within the system 7 increased government spending, new bank loans, lower import spending including oil, lower federal ta(es and decreased availability of labor and resources. Five counter-forces actions vent the pressure from the system 7 decreased government spending, loan payments and defaults, increased dollar-denominated import spending including oil, increased federal ta(es and increased availability of labor and resources. $oney driven through the Financial 'ircuit to purchase secondary financial assets like stocks and houses bids up the book value of those assets to create 0hantom $oney. This 0hantom $oney is money the asset owner e(pects to receive for the asset at sale if it is sold currently. #t is perceived as money but is not money. $oney circulating through the Financial 'ircuit flows directly from buyer to seller.

0hantom $oney generated from asset sales can be used as collateral for bank loans creating additional 'redit $oney in the system. /oods and service inflation occurs when the money pressure cannot be vented through economic e(pansion, increased dollar-denominated imports, government-backed savings or increased ta(ation. "hen this happens the money pressure cannot be vented and there are then too many dollars chasing too many goods. &eflation occurs when there is decreased government spending or money pressure is !uickly vented to government-backed savings, increased dollar-denominated imports, or increased ta(es. #n this case there is too many goods looking for too few dollars. Financial asset inflation occurs when the pressure is diverted through the Financial 'ircuit to create 0hantom $oney. )very time an asset is sold for more money than previously then the book value of all similar assets increases. Asset bubbles occur when this newly created 0hantom $oney is used as collateral to convert 0hantom $oney to 'redit $oney introducing new money into the system. As the value of financial assets increases so does the potential value of available collateral. )conomic growth occurs when the pressure is contained and is utili2ed to inflate the productive capacity or /ross &omestic 0roduction of the &omestic 'ircuit.

USING MONEY PRESSURE AND MONEY FLOWS TO MANAGE INVESTMENT RIS/ #ntelligent investment decisions re!uire an understanding of the mechanics of money flow and how the flows effects the economy and financial asset values. There are four main conse!uences of rising money pressure 7 increased production, increased savings, increased financial asset purchases and if none of those happen - increased goods and service inflation. The best designed portfolios react and counter-react to these money movements within the economy by containing four types of investment assets. ,. Assets that perform well when the wheels of commerce spin normally generating steady economic growth. 3. Assets that e(cel when money pressure is diverted toward financial assets =. Assets that protect against inflation from unreleased money pressure in the system. 9. And last, assets that hold their value during times of deflation and decreasing money pressure. KKK A&),t t!e A,t!)r
&avid 'retcher is the director of "eather )ye Advisors,#nc. a non-for-profit Begistered #nvestment Advisor. Ce has an A.6. in )conomics from $iami 5niversity and an $6A from <hio *tate 5niversity. Ce can be reached