Note: If you don’t want to read a long interpretation of our Macroeconomic forces, please skip this posting.

If trillions of dollars have disappeared from the stock markets, commodities, housing markets, banks, and other worldly assets, where has it all gone?

My summary:

1. Much of it is on the sidelines parked in short term cash like instruments. This has created a huge demand for USD and hence the run up in the currency. This simple change is responsible for much of the downward change in the POG.

2. To pay for credit liabilities

3. We have already created the inflation from credit interest.

4. How will this effect KXL? It will take longer for prices to rise to levels once reached. Luckily time is something the company has – or more accurately the company has the cash to spend the time drilling and moving results forward. The economics will improve but patience is going to be necessary. For now, macro will dominate micro.

Dmastercard

“I think it could be really different this time because most of the new money that came in the last 25 years was in the way of credit through the mass.” – Yes I totally agree.

Hrattle,

“Much of the increase in money supply has been to boost bank capital adequacy” - Yes I totally agree.

“Deflation often follows excess credit” – or is it a balancing of liabilities to assets? Do the liabilities shrink or assets grow to find the balance?

My answer lies in the balance sheets; the balance sheets of the banks, the balance sheets of the home owner, and the balance sheets of the governments. Balance sheets are interesting because no matter what, they always balance – and not always how you want them to (even if you have the best and most creative accountant).

Here is a little thought exercise.

There is an island with 2 people. There is a bank, and a federal reserve that can print money. The two people on the island each have 100 physical loonies. This is all of the money on the island. Person ‘A’ deposits all of his 100 loonies into the bank at 2% annual interest. Person ‘B’ takes a loan for 100 loonies from the bank to build a house at 10% annual interest. (ok I know this couldn’t happen in a fractional banking system but this is to keep this model as simple as possible)

Question 1: How much money does the island have at the start? A: 200 loonies

Question 2: How much Money does the island have after 1 year?

Since the Federal Reserve did not mint anymore loonies, there must be only 200 loonies still on the island. But the bank owes Person ‘A’ 102 loonies while Person ‘B’ owes the bank 110. On the combined balance sheets, there are now 108 loonies. If the Fed doesn’t mint more loonies and loan to the bank there will be a problem. If person ‘A’ asks for his 100 loonies back the bank will be forced to go to person ‘B’ to collect. We know person ‘B’ doesn’t have 110 loonies and defaults on the loan. More importantly, the bank defaults and person ‘A’ doesn’t get his money.

Is this simple story starting to sound eerily familiar? This bank must have been WaMu or Bear Sterns. Now think about how many mortgages were loaned out during the housing bubble. Trillions! So we know just from this simple example that this would lead to an increase in the money supply.

Question 3: What if Person’s ‘B’ house isn’t worth 100 loonies anymore but drops to only 80?

Here lies our problem. Not only is person’s ‘B’ balance sheet looking very bad, but so is the bank’s. Person ‘B’ has assets worth 80 loonies, but has liabilities of 110. The bank, if forced to foreclose on Person’s ‘B’ house would only have assets worth 80 loonies and liabilities of 102.

Question 4: If the Feds give the bank 22 loonies to keep them from defaulting, how much of it is increasing the money supply? The answer is of course only by 2 loonies.

So in the real world, when the government approved and loaned the banks 700 billion, most of this is not actually increasing the money supply… yet. In fact, it is simply playing catch up.

Question 5: After the Feds bail out the bank, person A gets his money, but is person ‘B’ in any shape to borrow money anytime soon? No, and here lies the other problem in the real world. There are lots of foreclosures happening so we know these people are in ruff shape. But think about everyone else. In the real North American world, credit has been passed out and used up like no tomorrow. Everything is actually linked to credit of some kind. You buy a car by leasing or financing. You pay for gas on a credit card. You use your credit card to earn air miles. You use your line of credit to buy stocks, build a basement, buy Christmas gifts. And we know most of this credit is not paid off and therefore billions and trillions of interest is being paid. Guess what another name for this interest is? INFLATION! It means that everything costs principal plus interest. How much did the gas actually cost that was paid on the credit card that has a balance and %18 interest? This is a huge inflation that isn’t in any of the calculations spit out by any government. In fact it’s even worse than normal inflation because it is on products already bought! With normal inflation if a product is too expensive you just don’t buy it. Credit interest inflation is your liability and will not go away unless you default. When this happens the difference between your liabilities and your assets is shrinkage in the money supply (deflation)

What I firmly believe is that we have already created the inflation. The government money is playing catch up. Money used to pay liabilities is not increasing the money supply. This interest inflation is personal liability. People are paying off their liabilities more than paying for goods and services. So when your biggest asset, your house decreases in value, your personal balance sheet gets worse. You might not even qualify for more credit let alone afford to use it. Maybe you can survive… but you aren’t going to be spending like you once did. Business sell less, and are forced to cut back. People lose their jobs. The spread between assets and liabilities increase.

So where has much of the money gone from the stock markets? To pay for credit liabilities. This is money that won’t show up again until personal balance sheets get healthier. What will the governments do? Once they know the banks are safe from failing, they will spend and spend on creating assets. Things like infrastructure, schools, even car manufacturers. Anything that will create jobs and put this catch up money into the real economy. Of course they will go to far and when the economy changes, this is when we will see another wave of inflation. The tell tale sign for this is when interest rates raise again. But for now, my prediction is no signs of new inflation hitting the markets for awhile.