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Frustrating conceptual roadblock. Any Help Appreciated

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brettman9 posted on Sat, Feb 14 2009 2:44 PM

In Jim Grant's latest Interest Rate Observor, he makes a point that I have long assumed I understood...until I thought about it at a basic level. The result: It turns out I don't understand. I assume his logic is correct, but I'm not sure how.

The point: Grant says that a current account deficit creates leverage through reciprocal investment by the surplus nation in securities issued by the deficit nation. For example: we buy a million striped socks from China for a million dollars. They take that million dollars and invest it in treasuries. (so far, quite familiar territory for me there)

...then he claims that the $mm is now serving "double duty": The money is back in the US, so we still have it. But it's also "gained" by China. Hence, it is both of the following: 1. not lost by the US, and 2. Gained by China.

I don't see how that's double duty. If I work for XYZ Inc., and they pay me a million dollars, and I take that million dollars and invest it in XYZ stock shares...I have chosen to invest that $mm, rather than spend it. Technically, it is not serving "double duty".

Similarly, China has chosen to invest that $mm, rather than spend it. Where is the leverage? If the answer is exemplified by the US turning around and using that same $mm to buy another million pairs of socks, then that leveraging effect isn't really the result of the trade deficit. It's just debt creation. We could achieve the same thing by borrowing $2mm from China and using it to make the socks ourselves.

But then they wouldn't also have the money. So I think I just answered my question. I'll post this anyways in case I'm still missing something.

Thanks,

Brett

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what is leverage?

Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid

Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring

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Just in case you're not being sarcastic...The point is about credit expansion. For example, the fractional reserve banking system expands the money supply by leveraging a unit of savings. (ie, the same dollar of savings is used many times over, and accounted for in credit relationships - it is leveraged). Deleveraging is the collapse of those offsetting relationships as the debts are repaid. If the leverage is used for risk investment, some portion vanishes in default (see Lehman, BSC, etc). At least, that's the gist of it in practice.

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brettman9:
I don't see how that's double duty. If I work for XYZ Inc., and they pay me a million dollars, and I take that million dollars and invest it in XYZ stock shares...I have chosen to invest that $mm, rather than spend it. Technically, it is not serving "double duty"

whoever you bought XYZ shares from has your cash, which gets money multiplied through fractional reserve banking?

Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid

Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring

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nirgrahamUK:

brettman9:
I don't see how that's double duty. If I work for XYZ Inc., and they pay me a million dollars, and I take that million dollars and invest it in XYZ stock shares...I have chosen to invest that $mm, rather than spend it. Technically, it is not serving "double duty"

whoever you bought XYZ shares from has your cash, which gets money multiplied through fractional reserve banking?

More to the point: let's say I bought XYZ debt (instead of shares) from XYZ inc in a debt issuance to finance their payroll, and then let's say XYZ used that capital to pay me another million dollars in salary...They would have paid me twice with the same million dollars.

Now I have 1 million in cash and 1 million in XYZ debt assets.

I deposit the cash in a bank.

The bank then loans out 900k of my savings to XYZ, who uses that to give me my bonus. 

Now I have 1 million in XYZ debt, and 1.9 million in cash at the bank...

The bank then lends XYZ 1.71 million of my savings. XYZ uses this as a cash holding for extra liquidity.

Now I have 1.9 million in the bank, and XYZ has 1.71 million in cash. And the bank has 290k in cash reserves.

All leveraged off of the original million dollars.... That million dollars is now acting like 3.61 million in liquid spendable money, and 290k in reserves with the fed.

Now if XYZ goes belly up and defaults on their debt, to me (1 million) and to the bank (2.61 million), causing the bank to collapse...now I have 250k (from the FDIC) and no job.

Probably some errors in there...but that's basic idea. My original point was about whether or not this same dynamic is actually rooted in sovereign relationships when all is said and done. That's Grant's point, I think.

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brettman9:

More to the point: let's say I bought XYZ debt (instead of shares) from XYZ inc in a debt issuance to finance their payroll, and then let's say XYZ used that capital to pay me another million dollars in salary...They would have paid me twice with the same million dollars.

Now I have 1 million in cash and 1 million in XYZ debt assets.

I deposit the cash in a bank.

No increase in the money supply has happened at this point, because the 1 million in debt assets is not money. The form of money has changed - by depositing your 1 million in Fed Notes at the bank, there is a 1 million dollar shift from actual cash to a demand deposit certificate. The bank cannot spend your Fed notes, unless they practice fractional reserve banking.
brettman9:

The bank then loans out 900k of my savings to XYZ

If it loans out your physical notes, the bank now has a 10% reserve ratio plus a 900k debt asset of XYZ. It has added 900k to the money supply (notes in circulation + demand deposits = 1.9 million).
brettman9:

[XYZ] uses that to give me my bonus. 

Now I have 1 million in XYZ debt, and 1.9 million in cash at the bank...

You have your original 1 million dollar demand deposit, and 900k in notes. If you deposit the notes in the same bank, that bank now has 1 million bank notes covering your 1.9 million dollar demand deposit (52% reserve ratio). You also have your 1 million XYZ debt asset still.
brettman9:

The bank then lends XYZ 1.71 million of my savings. XYZ uses this as a cash holding for extra liquidity.

The bank cannot possibly hand 1.71 million over in cash, because it only has 1 million in notes. It could however create a demand deposit slip for 1.71 million and exchange this for a 1.71 million dollar XYZ debt asset. Then the bank will have a 28% reserve ratio.
brettman9:

Now I have 1.9 million in the bank, and XYZ has 1.71 million in cash. And the bank has 290k in cash reserves.

All leveraged off of the original million dollars.... That million dollars is now acting like 3.61 million in liquid spendable money, and 290k in reserves with the fed.

No - you have a 1.9 million dollar demand deposit slip (and 1 million debt asset), XYZ has a 1.71 million dollar demand deposit, and the bank has 1 million in cash reserves (and 2.61 million debt asset).
brettman9:

Now if XYZ goes belly up and defaults on their debt, to me (1 million) and to the bank (2.61 million), causing the bank to collapse...now I have 250k (from the FDIC) and no job.

Before it goes belly up, XYZ will draw down it's demand deposit, converting it back to cash. As soon as XYZ withdraws 1 million in cash, the bank is bankrupt, as it now has no reserves at all. If it can, the bank will try to redeem the XYZ debt asset, to try and get some reserves. If XYZ can't pay, they will default and the bank will collapse. Your 1.9 million dollar demand deposit slip will be worthless. (At least 900k of it was worthless anyway in a sense, as it never could have been redeemed).
brettman9:

Probably some errors in there...but that's basic idea. My original point was about whether or not this same dynamic is actually rooted in sovereign relationships when all is said and done. That's Grant's point, I think.

All this is due to fractional reserve banking. There is nothing inflationary about reciprocal investment per se. Unless I am missing the point?
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Yeah...Point was not about inflation. As I said (and you, I'm sure, correctly pointed out), there were errors in my example. But they don't dispense with the point, which was to describe how leverage builds in the system as a function of many normal taken-for-granted processes at the heart of our current financial paradigm. And also to imply indirectly what all the talk about the carnage of deleveraging is really about. In addition, my point with the original post hopefully comes through a bit more clearly: that there is a meta-nightmare possibly now just beginning, if the same deleveraging process takes hold at the wider sovereign debt level.

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