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The Super Inflation

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If I ask you “What is the value of the apple?” you might answer me 50 cents. But how did you come up with this value? “That is the price I pay for an apple yesterday at Vons.” But how did Vons set the price? We can get the answer back in the ancient time.

Before money was invented, people use gold and silver to trade for commodities. And before people learn to use gold and silver as a median to trade for goods, they exchange. For example, we are willing to use one apple to trade for one orange, one orange to trade for 5 eggs. This is the way of how we value our goods, and nowadays we transform it into the price we pay in the supermarket. From this we know that each good has a price that is correlated to another good. Once we know that the value of goods are comparative, it is obvious to tell that the bills we are using nowadays is just a median, well, more accurately just a piece of paper.

In my last blog post, I have mentioned that whether the government should print as much currency as they can to satisfy our needs, the answer is no. Printing currency doesn’t increase our wealth, it will decrease the value of currency we have on hand. Infinity currency means there are cash bills everywhere and people are willing to pay a higher price for a single good since they have tons of cash, this will lead to a super inflation.

What is a Super Inflation? Let me give you an example. Right after WWII, Hungary has a rate of inflation of 4.19 × 10¹⁶ percent per month (price double every hour). That means that you life-saving will be eaten up by the super inflation and you can only buy an apple with that amount of money. This is not very likely to happen in the states but if we cannot clear our huge debt, the only way for the government to pay the bill is to print huge amount of money and it will lead to a huge inflation. The only thing that can overcome the inflation is gold and silver, because their intrinsic value is always there. So that is why it is important to have a gold standard system, but should we go back to gold standard system at this point? My answer is no. The currency we have is way much bigger than the amount of gold we had and it is impossible to re-link them together unless we depressed the dollar in a very large rate which is a huge impact to our recovering economy. We need some policies to solve our huge debt as soon as possible, nor we might not survive from the crisis this time.  

(Source: satyadev.net)

Who created our currency?

Everyone knows that the dollar bills we are using nowadays are issued by The Federal Reserve. Although it is called “Federal”, it is actually a private bank, which is out of the U.S. government bank system. The currency is not issued by the U.S. government but the Federal Reserve. They issued the currency and lend to the U.S. government and the banks and earn interest from them. You might ask then, “Even if we payback all the currency to the Reserve, we still got interest unpaid, where do we have extra money to pay for that?” The answer is you have to borrow more from the Reserve in order to pay the interest. That is the reason why our national debt keeps increasing and can never payback. If you do the math, you can find out this is ridiculous. And what makes people more confuse is the way how Federal Reserve creates currency - they are creating currency from nothing and allow you to buy things using the currency. This is the reason why I am using the term “currency” but not “money”.

Here I have to introduce a term “Monetary base” - which is related to the money supply in the economy. When currency is issued, they will be deposit in a bank. If the monetary base is set to 10%, that means that the bank need to keep the 10% of the total amount of deposit and lend the rest to other banks. Here is the trick! Other banks who borrowed the money only need to keep 10% of it and can lend the rest of the 90% to another bank. This is how our currency is created. That is why we always heard a bank will go bankruptcy when everyone tried to get their money back from the bank because they only have 10% of the money deposit In this case you will ask. “Doesn’t that mean the Federal Reserve can create infinity amount of money to satisfy our needs?” The answer is yes and no. The Federal Reserve can indeed do so but it will bring a disaster which I will discuss it in my next blog post. .Around the time of WWI, most developed countries were using the gold standard system. The gold standard system is a monetary system in which the standard economic unit of account is a fixed weight. When the system still existed, there is not a term called “inflation” because the currency is linked to a fixed amount of gold. But since this system no more exists, the Federal Reserve suddenly becomes a powerful giant system which no one can control it. In my next post, I will talk about the potential disaster that our currency is no more controlled by the gold standard system.

(Source: money.howstuffworks.com)

The impact that the housing bubble brought

The housing bubble burst brings a huge impact to people who bought the house at a very high price which they are not able to repay their loan. This is a disaster to the mortgage market, but only a few economists foreseen this bubble burst will lead to the Great Depression and furthermore the global financial crisis. But how did it happen?

Thanks to the magic of the Wall Street’s financial engineers, while banks are issuing subprime mortgage loans, the banks will usually undergo asset securitization - which means the loan become stocks or bonds which have value. Make it a simple example, when a bank issue a 1 million dollars subprime mortgage loan with an 8% annual interest rate, the bank can change this loan into a 1 million dollars valued bond with a 6.5% interest rate, thus hedge funds, banks and pension funds who want to earn this interest rate which is much higher than the market’s interest rate are willing to buy this bond. For the bank that issued the bond can get back the loan from the stock and at the same time earning 1.5% interest from it, which is a very good deal for them. And that is the reason why the banks are willing to issue loan to people - which I mean everyone - because they won’t care who borrow the money because they can earn it back from the bond they issued.

Of course, investors are not silly to think that the risk is low in the example above and thus they will not put much investment in it. And that’s why the Wall Street financial engineers play some tricks in it. They mixed different kinds of loans - including both prime and subprime - which brings up the rating and it formed collateralized debt obligations (CDO) that can be traded in the stock market. And most of these CDOs have a high credit rating which means that it seems to be safe to invest in.

Due to the reasons mentioned in my last blog post, the cases of default housing increased, many of those borrowers cannot pay interest anymore that thus the stock prices of the CDOs drown. And those CDOs are held by many large companies and banks because they believe those CDOS are safe to own. The decrease in price of CDOs brought a huge impact to those companies, and they start to lay off employees and some of those companies went either bankruptcy (eg. Lehman Brothers) or request financial aid from the government (eg. AIG). This is a great burden to the government which has a huge amount of national debt already, and thus the housing bubble become an important factor of the great depression. And companies from different countries also bought huge amount of CDOs and thus it brought down the stock market and thus furthermore become a global financial crisis.

How did the housing bubble happen?

The subprime mortgage crisis, which is well-known as the housing bubble crisis brought a huge impact not only to our country, but also the global economy. I believe that there are many people who still don’t understand what is it crisis about and how it damaged our economy and still not yet recovered from it. I did some research on this and I found most of them are explaining it in a complicated way. I summarized what I found and show it in a simple way that everyone could understand.

For a long time, the U.S. mortgage loan is giving out at a prime rate, which is following the market’s interest rate. And the banks will follow this interest rate and give out loans to people who are buying house. The borrowers need to meet certain qualifications, which mean they need to have good credits and a stable job. They also need to put a down payment for the house (usually 20%), which means they need to pay a certain amount of money when they buy the house and finance the rest of the amount through the bank. Everything goes on great with this system, but one day something called subprime mortgage changed everything!

A few years ago, the value of real estate increase rapidly, which is way higher than the inflation rate, and some banks issued subprime mortgage loans, it is a loan specially designed for people who are not eligible for financing before - no matter you have a bad credit, or unemployed and of course you need to pay a higher interest rate (around 2-3% higher than usual). So why still people will take it even with such a high interest rate?

 As the interest rate is very low at the time, 2-3% increase in interest rate makes a subtle change. Since you don’t need to put a down payment of the house, you only need to pay the interest for the first 2-3 years, and the most important thing is that the value of real estate keeps rising! Try to imagine, if I take this loan, live in the house for 1-2 years and sell it. I could have even earned a lot of money from this. It is a great deal and everyone thinks the same thing and it seems like there isn’t a problem bothering.

However, the Federal Reverses raises the interest rates which is out of people’s expectation. When the interest rate increase, people with subprime mortgage loan (Remember, they are bad creditors and can be jobless) can no more afford to pay the interest which lead to a lot of housing foreclosure. Suddenly the market are full of people who are trying to sell their property, this furthermore brought down the property prices. But how did this bubble burst lead to the Great Depression and then the global financial crisis, I will discuss that in my next blog post.

(Source: stock-market-investors.com)

The high unemployment rate we are facing

“The unemployment rate fell by 0.4 percentage point to 9.4 percent in

December, and nonfarm payroll employment increased by 103,000, the

U.S. Bureau of Labor Statistics reported today. Employment rose in

leisure and hospitality and in health care but was little changed in

other major industries.”

     “When is it gonna end?” Designed Phrase

This is something we can always found on financial news, but what is actually unemployment rate? Does that mean among every 100 people in the U.S., there are almost 10 people being unemployed?  

First of all, you need to learn the term “labour force”, which includes people of working age and below retirement who are actively employed or seeking employment. And the unemployment rate is calculated by counting the number of people unemployed in the labour force. It seems like everything is logical, but actually there is a trick in here! The unemployment rate does not count in discouraged workers - people of legal employment age who is not actively seeking employment or who does not find employment after long-term unemployment. 

From this we knew that there are more people who need a job than the statistics reported. “The unemployment rate fell by 0.4 percentage point” - What they are trying to tell is that people are getting more jobs and eventually the economy is getting better. But how can you tell the percentage points is due to the increase of employment or people who were seeking employment and now discouraged thus removed from the labour force? The statistics never include people being laid off and number of discouraged workers. 

So what is the reason that the unemployment rate doesn’t decline while the U.S. economy is recovering after the Great Depression. It can be concluded in two reason - skills mismatching and low job openings.

The Dow Jones Index have been increasing since 3/2009 (Graph from Bloomberg)

During a recovering period, companies will first hire skilled-people, thus many unemployed workers with only a high school degree are not qualified for most of the job openings. Be aware that those people were usually people being laid off during the recession, those people are hired only when the economy is fully recovered. And this can bring us to another reason - low job openings. People don’t have money to buy and thus the companies’ sales will not increase. As a result, the companies are not willing to hire new employers especially they are uncertain with the future economy.

While companies are not willing to offer jobs, people unemployed don’t have income and thus they cannot buy products or services from companies, which causes the low sales of the companies and thus they are not willing to offer jobs - a cycle occurs. Unless there is something to boost up the economy, it is hard to see a fully-recovered economy in the short run.

Source from BLS and Dollarsandsense.org.