Shortage of Dollars?

Less than a year ago, crude oil was $145 and everyone was wondering how fast the dollar would inflate into worthlessness. Could it be that today there’s a shortage of dollars? The usual discussion centers around the supply of money, defined as the quantity (M1 or M2) times the velocity (how quickly a dollar gets passed around the economy). Over the last year the fed has roughly doubled the supply of money while the velocity has roughly fallen in half, keeping the real supply stable. But what about the demand for dollars?

First let’s look at the domestic demand for dollars. For 5 years, homeowners have used their homes as piggy banks. When they wanted cash to buy something, they just took out a home equity loan. Stocks looked like an attractive investment, so people generally had little desire for money, everyone preferred to own stuff like houses and stocks. Companies held as little cash as possible because cash doesn’t generate the aggressive growth that’s so attractive to investors. As asset prices collapse, every seller demands money. After a foreclosure, banks try to sell the foreclosed home as quickly as possible; during bankruptcy, the court or debtors liquidate the company’s holdings. Any potential buyers of homes or corporate assets need to sell other assets to free up money.

What about the international demand for dollars? Over the last decade, investors and banks rushed to send money to emerging markets for higher rates of return. For example, Eastern Europe had net foreign borrowings of $1.6 trillion at the end of 2008. Any foreign loan or investment requires a purchase of the foreign country’s currency and a sale of your own (there are exceptions, but debt denominated in foreign currencies is relatively insignificant). As the world economy comes under pressure, we’ve had a flight to quality. Investors sought to sell their subprime loans to emerging markets and buy top rated US debt. So investors are selling their zlots and forints and even euros to buy dollar denominated assets.

As asset prices continue falling, inflation concerns wane, general economic conditions deteriorate, people hoard cash. Individuals fear unemployment and increase their savings. Companies find fewer attractive investments and financing costs rise, so they hold more cash. Investors worldwide flee all currencies but the safest. As people hoard cash, the velocity of money drops further and asset prices drop further, deepening the cycle. The fed can mitigate this by printing more money, but just about everyone consistently underestimates the deflationary effects of deleveraging, so the fed is too slow and the dollar shortage deepens. Eventually the cycle ends when there are fewer new foreclosures and new bankruptcies and enough debt is liquidated that companies and individuals start spending more.

Where does the deleveraging end? It’s hard to predict in advance, but we can at least identify when asset prices have further to fall. Real Estate is stagnant in most of the country as sellers remain anchored to old prices and refuse to hit the “too low” bids of the buyers. California is the exception. After a 40% drop in median prices, the real estate market is starting to look healthy with plenty of transactions. Californian real estate may have reached equilibrium while most of the country obviously hasn’t. Prices keep falling until sellers and buyers agree on prices. Another example is mortgage derivatives. With some derivatives, buyers are bidding $0.20 on the dollar while the banks that hold the derivatives are refusing to sell at less than $.80. Without massive subsidies, the result would be that eventually the banks would become realistic and lower their offers or go bankrupt and be forced to sell. The government and the banks are hoping that special programs can subsidize buyers to pay closer to $.80 or that the economy will improve enough for the buyers to pay $.80. History suggests that eventually it is the sellers who must compromise and lower their offers.

Originally published at Risk Over Reward blog and reproduced here with the author’s permission.

6 Responses to "Shortage of Dollars?"

  1. NFrazier   April 27, 2009 at 6:03 pm

    No doubt that the US government should be responding to the down-turn with “shock-and-awe” scaled government spending.But there is another imperative of possibly even greater importance: that the US government spends on items that will contribute to the long term growth of the economy. Even for small amounts of expenditure, this is a daunting task in a fully developed, technologically advanced economy that already has problems of excess supply in several sectors.If simultaneously meeting these two imperatives is difficult for the private sector to attain right now, imagine how difficult it is for the public sector to attain them. The best the government can do for now is to “back the invisible hand” with its “visible hand;” in other words, to spend aggressively on items that facilitate the restructuring and rebalancing of the economy.For example: If the 19 largest banks in the US “are too big and complex” to nationalize, then spend massively on hiring the accountants, attorneys, and regulators required to clean them up. Deficit spending on bailouts to prop them up only adds to debt levels, maintains excess capacity, and leads to worse debt-deflation down the road.

    • akouvi   May 1, 2009 at 9:21 am

      I’m not a financials person at all, but enjoy reading what real people who do understand the system have to say. Thank you for this sensible idea–they seem to be rare as unicorns these days!

  2. NFrazier   April 27, 2009 at 6:19 pm

    Regarding the Southern California property market rebound, it is indeed anomalous to see such an illiquid market behaving like the stock market. I suspect that speculators and financial institutions are “buying the dips.” Since very little restructuring or rebalancing of the global economy has occurred since the credit crisis began, these prices are likely to fall again in real terms at some point.Shiller has noticed the effect of social networks and “animal spirits” on market prices. Arguably, sunny beach cultures seem to be pervaded by the related psychologies of both social fads and “excitement” & “disappointment.” It will be interesting to see if a similar rebound occurs in Florida as well.

  3. Guest   April 27, 2009 at 11:52 pm

    Don’t believe any mass media about the California real estate market. The home purchasers are almost all speculators. Lots of these homes just sit empty.Also, the unofficial foreclosure moratorium is still on. Privately, the Federal Government has told the big banks no more home foreclosures.Also, this is being applied to commercial real estate.The real emerging problem is lack of money. Debt can be extended like taffy, but if there is no money, nothing moves.The piddling activity in housing is usually paid for in cash (in some cases, literally in dollar bills).The California economy is simply a disaster area. There is one area which will show you that there is no money here any more: state and local tax receipts. Watch them collapse.This is the economy on the ground, to which idiotic commentators pay NO attention.John Ryskamp

  4. Nordaune   April 29, 2009 at 12:36 pm

    Great post! I found if very interesting. When you get a chance please check out my blog Rochester MN Real Estate