How does the economy really work? (Banks, loans, value, economics)

[WJK]

Why do people borrow in such a risky environment?
At least here, it's become even harder to get a loan from a bank with even higher interest rate, so unless there are some special deals to institutional investors, borrowing money to buy even riskier assets does not make sense.
Even though almost nobody can get a loan here, inflation is at least 50%, even though government is saying it's just 5-6%.


If I had an extra million dollars, I would still buy same amount of bread and use same amount of oil on my car.
Also, can't think of any product that is in scarcity, I could buy a spaceship today if I had money. So, is it a lack of products or increase of desire that increases prices?


This could definitely be a reason, but why would it increase price of oil? or real-estate?

"Why do people borrow in such a risky environment?"

Because of FOMO... They see prices going up and they feel like they are going to miss out. They feel like everyone around them is buying and the prices are going up. It's "herd" mentality.

"If I had an extra million dollars, I would still buy same amount of bread and use same amount of oil on my car. Also, can't think of any product that is in scarcity, I could buy a spaceship today if I had money. So, is it a lack of products or increase of desire that increases prices?"

We must be living in two different world. We're experiencing a whole bunch of scarcities. I'm having a bad time getting parts and goods.

Last time I bought a bunk of building studs (294 pieces of 2"X4"X8'), I paid $3.13 each. Last week I had to pay $8.43 each. And I had two other sources that wanted $11 each. I can't get a lot of building materials that I need such as treated lumber. My current project is going to require piles of sheets of plywood. The idea of buy those stacks is scary.

I bought the last fridge and kitchen range that my appliance store has on hand. They don't when they will have more appliances. Everything is back ordered.

And that just a couple examples. What world are you living in?

This could definitely be a reason, but why would it increase price of oil? or real-estate?

We were oil independent and exporting it one year ago. Biden's policies are making us import again and causing a scarcities. As far as RE goes, people are moving out of the cities and into areas creating a pressure on those markets. The RE markets that they left have declining prices due to less demand.

It's all based upon that balance between supply, demand, and available money/resources.

 

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[Deleted70138]

What world are you living in?

I'm also involved in residential house development and even though there is a price increase for wood and stone, salary for workers are slightly deflated in USD and slightly inflated in local currency.

As for home appliances, I have not even heard about shortages about any item, and prices are slightly deflated in USD and slightly inflated in local currency.

Price of oil is same here in USD.

We must be living in two different world.

I appreciate your detailed answer, but we one thing is for sure - we live in two radically different world. 1) We get most of our oil from Azerbaijan, therefore there are no supply chains broken.
2) Wood from Russia
3) Stones from within the country. The only reason they got inflated, is because many started stacking them up to hedge against possible inflation.
4)

As far as RE goes, people are moving out of the cities and into areas creating a pressure on those markets. The RE markets that they left have declining prices due to less demand

Great majority of people have countryside home, therefore there is no major shift in RE market. It's quite confusing for me to read about US when it does not resonate with local markets, but I don't really have other source of quality information.

 

[Guest-5ty5s4]

I'm also involved in residential house development and even though there is a price increase for wood and stone, salary for workers are slightly deflated in USD and slightly inflated in local currency.

As for home appliances, I have not even heard about shortages about any item, and prices are slightly deflated in USD and slightly inflated in local currency.

Price of oil is same here in USD.


I appreciate your detailed answer, but we one thing is for sure - we live in two radically different world. 1) We get most of our oil from Azerbaijan, therefore there are no supply chains broken.
2) Wood from Russia
3) Stones from within the country. The only reason they got inflated, is because many started stacking them up to hedge against possible inflation.
4)

Great majority of people have countryside home, therefore there is no major shift in RE market. It's quite confusing for me to read about US when it does not resonate with local markets, but I don't really have other source of quality information.

Makes sense. A lot of problems are geopolitical.

If you live in a different country, your problems will be completely different, and you might have no problems at all (or a bunch of problems others can’t relate to).

 

[Guest-5ty5s4]

Also to anyone reading this who doesn’t get it... You need to know that banks lend out more money than what they have.

Fractional reserve banking lets them loan “new” money - money that didn’t exist before.

This starts at the Federal reserve, and is passed to member banks.

This is my understanding of it - I am not an expert.

Fractional Reserve Banking: What It Is and How It Works

Fractional reserve banking is a system in which only a fraction of bank deposits are backed by actual cash on hand or available for withdrawal.

www.investopedia.com

Basically, your business owes money to a bank, which it got from the Federal Reserve, that’s really just an IOU from the US government.

 

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[Antifragile]

@Zaratustra
Interest rate monetary policy increases the value of investments, causes purchasing on credit to become more lucrative, and lowers the carrying cost of existing debt burden. Interest rate policy also inflates asset values and puts money in the hands of the wealthy, focused on incentivizing spending.

Unfortunately, there are limits. One, as we approach near zero-rates it becomes less effective.

And two, the wealthy might not spend the money and instead save or invest, which drives up the value of investments such as real estate.

Quantitative easing (“QE”) monetary policy

QE policy is for central banks to buy bonds and other financial instruments, giving investors cash in return. The Bank of Canada was soinflarge-scale purchases of at least $5 billion per week of Government of Canada bonds.

When the interest rates approach zero, the interest rate monetary policy becomes less effective. QE policy has the same effect at later stages. At some point the price for assets is too high and returns are too low to motivate spending.

Other than interest rate and QE, Central Banks can do little to effectively motivate institutional buyers to spend.

That just leaves “Helicopter money” is the idea to put money in the hands of those who need it most and will spend it.

Hope this helps you understand “why would anyone borrow”. It’s not as simple as you made it seem.

 

[Deleted70138]

QE policy is for central banks to buy bonds and other financial instruments, giving investors cash in return. The Bank of Canada was soinflarge-scale purchases of at least $5 billion per week of Government of Canada bonds.

When the interest rates approach zero, the interest rate monetary policy becomes less effective. QE policy has the same effect at later stages. At some point the price for assets is too high and returns are too low to motivate spending.

So, during QE price of bonds will increase partly due to increased demand from central bank and partly due to low interest rate, right?

That just leaves “Helicopter money” is the idea to put money in the hands of those who need it most and will spend it.

When they give out free money an asset, does anything go as a liability on central banks balance sheet? Or is it just... Poof... "magic" money from magicland?
Even though that money is digital, do they create numbers out of thin air?

 

[Guest-5ty5s4]

Interest rate monetary policy increases the value of investments, causes purchasing on credit to become more lucrative, and lowers the carrying cost of existing debt burden. Interest rate policy also inflates asset values and puts money in the hands of the wealthy, focused on incentivizing spending.

It's morbidly funny to me that politicians simultaneously print more money, "stimulate" the economy, while also griping about the "rich getting richer."

They are making the "rich richer" through the exact process that you described.

But they act like the solution is for them to do more of the same thing that is causing the thing they are complaining about...

 

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[Antifragile]

So, during QE price of bonds will increase partly due to increased demand from central bank and partly due to low interest rate, right?

Under QE, a central bank buys government bonds. Buying government bonds raises their price and lowers their return—the rate of interest they pay to bondholders. This rate of return is also known as the bond’s yield.

Government bond yields have a big influence on other borrowing rates. Lower yields make it cheaper to borrow money. So, QE encourages households and businesses to borrow, spend and invest. For example:

• CB can buy five-year government bonds, which will lower their yield. This would be reflected in lower interest rates on five-year fixed-rate mortgages, making it cheaper to borrow to buy a house.
• Or, CB can buy long-term government bonds, which mature in 10 years or more. In this way, we can make it cheaper for businesses to borrow and grow through long-term investments.

When they give out free money an asset, does anything go as a liability on central banks balance sheet? Or is it just... Poof... "magic" money from magicland?
Even though that money is digital, do they create numbers out of thin air?

Yes, there is a liability for sure! That's why so many countries are running trillion dollars worth of debt (think USA).

Yes, the money is printed by just adding zeros on a computer these days. From thin air, yes.

When Nixon (?) abolished gold standard, there is nothing pegging USD to any value. It's just fiat. Every country in the world is fiat money today. It means you can print and then get out of "problems" through letting inflation take care of the "debt". But the message to the public must be "GDP will grow with stimulus and we will work our way out of transitory inflation". This message must be there to be re-elected.

 

[Antifragile]

It's morbidly funny to me that politicians simultaneously print more money, "stimulate" the economy, while also griping about the "rich getting richer."

They are making the "rich richer" through the exact process that you described.

But they act like the solution is for them to do more of the same thing that is causing the thing they are complaining about...

Let's set the media aside here (where they belong) and just talk about the economy. Let's pretend for a moment that you were "the chosen 1" ha-ha, to lead policy. What would you do? The hard part is that when I get a lower rate on my loans and my properties just went up 50%, it's hard to imagine that I'll take that extra money and put it into a production facility or buy enough new lambos to promote a lambo company in Italy. At some point of my wealth, I start spending less as a % of my wealth. This means that it is factually true that these policies make the rich richer. But to say that it was intentional, probably isn't right either.

The other option is what Nassim Taleb promotes - let them fail. The more you let them fail, the stronger the remaining survivors will become. But let's be real here, do you or anyone here really want to see a major and prolonged depression, with 30%+ unemployment rates etc? It might as well lead to such desperation that the USA would become like what we just saw in South Africa.

So what do you suggest we do?

 

[Deleted70138]

Under QE, a central bank buys government bonds. Buying government bonds raises their price and lowers their return—the rate of interest they pay to bondholders. This rate of return is also known as the bond’s yield.

When CB buys government bonds, what does it do with them? Is it the way to get rid of government debt?
When CB buys government bonds, does it buy from government or institution/private investors?

Does it lower bonds yield, because it overbids all the high yield ones?

CB can buy five-year government bonds, which will lower their yield. This would be reflected in lower interest rates on five-year fixed-rate mortgages, making it cheaper to borrow to buy a house.

Local CB has been selling USD in order to maintain exchange rate with local currency (that's what I've read in articles), how could this have led to inflation in local currency but deflation in USD?
Also, local CB has lowered interest rates, but banks have increased interest rates and made it harder to get a loan, so why would there be such a great difference between countries?

Yes, there is a liability for sure! That's why so many countries are running trillion dollars worth of debt (think USA).

But who has the liability, central bank or a government?
How is this different for other countries, who's currency is not "reserve currency"? I imagine it to be much easier for US pay it's debt by printing money, compared to my country which has to actually pay it off.

 

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[Guest-5ty5s4]

Let's set the media aside here (where they belong) and just talk about the economy. Let's pretend for a moment that you were "the chosen 1" ha-ha, to lead policy. What would you do? The hard part is that when I get a lower rate on my loans and my properties just went up 50%, it's hard to imagine that I'll take that extra money and put it into a production facility or buy enough new lambos to promote a lambo company in Italy. At some point of my wealth, I start spending less as a % of my wealth. This means that it is factually true that these policies make the rich richer. But to say that it was intentional, probably isn't right either.

The other option is what Nassim Taleb promotes - let them fail. The more you let them fail, the stronger the remaining survivors will become. But let's be real here, do you or anyone here really want to see a major and prolonged depression, with 30%+ unemployment rates etc? It might as well lead to such desperation that the USA would become like what we just saw in South Africa.

So what do you suggest we do?

I don't want to see a massive correction take place.

Nobody does.

But the can has been kicked for decades, and everybody is scared of being "the guy" with all the red numbers on their hands.

After the massive deleveraging (a la Andrew Jackson, for instance), there would be a price floor, and things would become affordable...for everyone.

It would hurt a lot, it would hurt me too, but it would make the future better for everyone.

I just find it ironic that the narrative paints this picture that THAT is the type of sacrifice being made in our economy, when in reality, the OPPOSITE is the case.

So, honestly, the best course of action may just be to "let it fail." And then regroup. With sounder economic policies.

TLDR; just do the right thing, even if it sucks in the short term.

 

[Antifragile]

@Zaratustra I wish I had more time to dig into this with you as it's something of a hobby of mine AND predicting the direction is how I make or lose money in my business.

I highly recommend you read Ray Dalio's work, he explains it eloquently and it's available for free.

One thing to note: the USA does benefit from being a currency of choice, USD is what your country considers dominant. The biggest fear for the USA is to lose that status. Without it, inflation would be like wildfire. Wealth would be obliterated. And China is trying to do just that. They never followed "the rest of the world" in terms of letting their currency float and be market driven on exchange rates. They decide what it is. Lots of hate because of this behaviour. No one else could get away with that (especially your country, being smaller).

We could write a book on this topic alone.

 

[Guest-5ty5s4]

@Zaratustra I wish I had more time to dig into this with you as it's something of a hobby of mine AND predicting the direction is how I make or lose money in my business.

I highly recommend you read Ray Dalio's work, he explains it eloquently and it's available for free.

One thing to note: the USA does benefit from being a currency of choice, USD is what your country considers dominant. The biggest fear for the USA is to lose that status. Without it, inflation would be like wildfire. Wealth would be obliterated. And China is trying to do just that. They never followed "the rest of the world" in terms of letting their currency float and be market driven on exchange rates. They decide what it is. Lots of hate because of this behaviour. No one else could get away with that (especially your country, being smaller).

We could write a book on this topic alone.

If wealth is obliterated, if the inflation stops, if the overleveraged fail...

..Suddenly the most attractive thing for investors and businesses would be to become MORE RESPONSIBLE with money.

I see that as a win.

Affordable house prices would just be a nice side effect for the folks who currently don't own assets.

(That being said, I prefer wealth not to be obliterated. I'm just saying that the overleveraged parts of the economy are at big risk, and right now the policy is to keep propping it up and leveraging more and more)

 

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[Deleted70138]

@Zaratustra I wish I had more time to dig into this with you as it's something of a hobby of mine AND predicting the direction is how I make or lose money in my business.

I highly recommend you read Ray Dalio's work, he explains it eloquently and it's available for free.

One thing to note: the USA does benefit from being a currency of choice, USD is what your country considers dominant. The biggest fear for the USA is to lose that status. Without it, inflation would be like wildfire. Wealth would be obliterated. And China is trying to do just that. They never followed "the rest of the world" in terms of letting their currency float and be market driven on exchange rates. They decide what it is. Lots of hate because of this behaviour. No one else could get away with that (especially your country, being smaller).

We could write a book on this topic alone.

Thanks for your responses and recommendations. Asking every question that comes into my mind is the only way for me to get an education, as I have not had any.

 

[WJK]

I don't want to see a massive correction take place.

Nobody does.

But the can has been kicked for decades, and everybody is scared of being "the guy" with all the red numbers on their hands.

After the massive deleveraging (a la Andrew Jackson, for instance), there would be a price floor, and things would become affordable...for everyone.

It would hurt a lot, it would hurt me too, but it would make the future better for everyone.

I just find it ironic that the narrative paints this picture that THAT is the type of sacrifice being made in our economy, when in reality, the OPPOSITE is the case.

So, honestly, the best course of action may just be to "let it fail." And then regroup. With sounder economic policies.

TLDR; just do the right thing, even if it sucks in the short term.

IF that's what will happen... it's gonna be bad. It's the long-term debt cycle rearing its nasty head. We've had several "corrections" but this could be the big "reset". 2008 was rank-piker compared to what may happen next. Think about the Great Depression in the 1930's. They, the people, were lot more self-sufficient then. They had gardens. They hunted and fished. They lived off the land and traded for what they didn't produce. That lifestyle is gone for most people.

 

[Guest-5ty5s4]

IF that's what will happen... it's gonna be bad. It's the long-term debt cycle rearing its nasty head. We've had several "corrections" but this could be the big "reset". 2008 was rank-piker compared to what may happen next. Think about the Great Depression in the 1930's. They, the people, were lot more self-sufficient then. They had gardens. They hunted and fished. They lived off the land and traded for what they didn't produce. That lifestyle is gone for most people.

I have thought about that too.

It could be intentional.

The real evil of it wouldn't be the ensuing correction, recession, etc.

The evil of it would be letting it build up more and more, first. Even encouraging it to grow before pulling the rug out.

 

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[WJK]

I have thought about that too.

It could be intentional.

The real evil of it wouldn't be the ensuing correction, recession, etc.

The evil of it would be letting it build up more and more, first. Even encouraging it to grow before pulling the rug out.

I agree. It's been building up for a long time and the powers-that-be are either incompetent or possibly evil -- like you said...

I've been preparing for this moment for a long time. While everyone else in RE was doing big time leverage around me, I was getting ready to meet this fork in the road. They told me that I was stupid -- I didn't know how to make money in RE -- and I just laughed. I tried to explain the 1990's crash to them. It fell on deaf ears. They retorted that they had been in RE for several years. I countered that I started 45 years ago. That didn't cut any bait with them either. So, I shut up and went back to working my program. Then Covid hit with the problems with evictions...

 

[Antifragile]

@WJK
People’s memory in financial markets (economy) is so short that most think of 2008 as some distant past! It’s not that distant. And the next one isn’t that far out.
But I disagree with @thechosen1 - I don’t think USA is being evil, humans are just being humans. When a lion hunts, is it evil to the prey? We humans are just another type of animal and our behaviour is predictable. Sometimes very evil, but not with monetary policy, at least I don’t think so.

 

[WJK]

@WJK
People’s memory in financial markets (economy) is so short that most think of 2008 as some distant past! It’s not that distant. And the next one isn’t that far out.
But I disagree with @thechosen1 - I don’t think USA is being evil, humans are just being humans. When a lion hunts, is it evil to the prey? We humans are just another type of animal and our behaviour is predictable. Sometimes very evil, but not with monetary policy, at least I don’t think so.

The cycles are predictable for the most part. The economy has a heart beat and it repeats itself over and over again. I spend a lot of my time listening to that rhythm. I try to always play against the market. When everyone is buying, I'm selling and so on... I don't try to wait for peaks and hit them perfectly. It's like with hand grenade or playing horseshoes -- close is good enough for me. The market moves too fast and I don't wanna miss the whole thing.

 

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[Antifragile]

The cycles are predictable for the most part. The economy has a heart beat and it repeats itself over and over again. I spend a lot of my time listening to that rhythm. I try to always play against the market. When everyone is buying, I'm selling and so on... I don't try to wait for peaks and hit them perfectly. It's like with hand grenade or playing horseshoes -- close is good enough for me. The market moves too fast and I don't wanna miss the whole thing.

You are wise!
We do the same thing. Always in the market but fluid between aggressive and defensive action. When everyone is buying, we tend to sell more than buy but still look for hidden gems.

 

[Antifragile]

Thanks for your responses and recommendations. Asking every question that comes into my mind is the only way for me to get an education, as I have not had any.

I still plan to come back and answer questions. For serious responses I tend to need a computer as opposed to my phone. Easier to type… but don’t have the time ATM.
Good on you for asking questions! Best way to learn.

 

[ocricci]

Gold thread for sure !

 

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[Antifragile]

When CB buys government bonds, what does it do with them? Is it the way to get rid of government debt?
When CB buys government bonds, does it buy from government or institution/private investors?

Does it lower bonds yield, because it overbids all the high yield ones?


Local CB has been selling USD in order to maintain exchange rate with local currency (that's what I've read in articles), how could this have led to inflation in local currency but deflation in USD?
Also, local CB has lowered interest rates, but banks have increased interest rates and made it harder to get a loan, so why would there be such a great difference between countries?

But who has the liability, central bank or a government?
How is this different for other countries, who's currency is not "reserve currency"? I imagine it to be much easier for US pay it's debt by printing money, compared to my country which has to actually pay it off.

Paying with settlement balances, not cash​

QE is not the same as printing cash. Under QE, central banks pay for bond purchases with settlement balances, not bank notes.

Settlement balances (or reserves) are a unique type of money that the central bank creates. They are a normal part of central banking operations. Financial institutions use them to settle payments among themselves. CB pay interest on these balances, like deposits at a regular bank.

Being able to issue settlement balances is a privilege that only central banks have.

It’s important for central banks to be independent from the government. Simply put, the power to create money should be kept separate from the power to spend money. But the lines are blurry, as politicians are elected and they in turn have power over who’s hired where.

As part of our normal operations, CBs buy bonds directly from the government to help balance the stock of bank notes that exists on their balance sheet. But under QE, they buy bonds only on the secondary market. This means they buy bonds that have already been sold by the government to banks and other financial institutions.

Here’s how it works:

1. CBs offer to buy bonds from financial institutions that are willing to sell them to us at the best price. (This is called a reverse auction because we are auctioning to buy—not sell—the bonds.)
2. To pay for the bonds, CBs create settlement balances and deposit them into the accounts that financial institutions have at the say, Bank of Canada.

Eventually, when the economy has healed enough, CB will no longer need to hold the bonds. At that point, they will have options about how to wind up QE program. For example, they could sell the bonds back to financial institutions. This would shrink their deposits of settlement balances. Or, they could hold onto the bonds until they mature. They could then use the money we receive to redeem settlement balances. CB choice between the different options would depend on our outlook for the evolution of inflation.

I’ll talk about the power of USD later… please remind me
Also to cover deflation and devaluation of a currency.

 

[Deleted70138]

Settlement balances (or reserves) are a unique type of money that the central bank creates. They are a normal part of central banking operations. Financial institutions use them to settle payments among themselves. CB pay interest on these balances, like deposits at a regular bank.

So, "settlement balances" are something like casino chips?
If yes, then it seems it's used for increasing their balance sheet without actually printing money.

CBs buy bonds directly from the government to help balance the stock of bank notes that exists on their balance sheet.

On whose balance sheet? CB or government?

1. CBs offer to buy bonds from financial institutions that are willing to sell them to us at the best price. (This is called a reverse auction because we are auctioning to buy—not sell—the bonds.)
2. To pay for the bonds, CBs create settlement balances and deposit them into the accounts that financial institutions have at the say, Bank of Canada.

Oh, now it makes sense:
CB makes such an offer for bond holders that they can't refuse. Bond holders get money from their bank. Bank get's casino chips from CB, which could later be redeemed or used to pay of their liabilities for CB.

Eventually, when the economy has healed enough, CB will no longer need to hold the bonds. At that point, they will have options about how to wind up QE program. For example, they could sell the bonds back to financial institutions. This would shrink their deposits of settlement balances. Or, they could hold onto the bonds until they mature. They could then use the money we receive to redeem settlement balances. CB choice between the different options would depend on our outlook for the evolution of inflation.

Are this things taught in universities? I've never heard any MBA graduate talking about topics like this.