Is Money Cash, Credit, or Both?
Posted by Michael A. Kamperman on June 11, 2009
First of all modern money is not gold. Gold is a commodity. In ancient times gold was money, but not today. If you don’t believe me just go to the local grocery store and try to buy your cart of goods from the cashier with a measure of gold as payment. However, if you pull out some cash, or write a check, you can acquire the groceries. Similarly, in the vast majority of stores you can pull out the plastic fantastic and if the electronic swipe says transaction approved, then you can walk out of the store with the groceries. What constitutes money is whatever gives you the ability to complete a transaction. It doesn’t matter to the grocer where your money comes from as long as he gets paid. Likewise, when you sell your home you only care if the buyer can show up with the cash to complete the deal. It doesn’t matter to you whether or not the buyer is a cash buyer, or whether he needs a loan. It’s all cash to you. Hence, what constitutes money is whatever enables a buyer to complete a transaction with the vast majority of sellers.
Why this is important is it is relevant to the discussion of whether or not we are on the verge of deflation or renewed inflation. It is imperative the Fed gets this right at their next meeting. Those that look at only cash as money are insisting we are on the verge of hyperinflation. But they miss that credit is money too. For the seller of the house it doesn’t matter where or how the buyer gets the cash. If the buyer can get the cash, then the deal goes through. If the buyer cannot get the cash, then the deal falls apart. Has the Fed increased the monetary base, absolutely. Has it led to inflation, no. The reason is the credit side of the money equation has collapsed. The access to credit is severely constricted everywhere in the world, except China. To illustrate this truth despite the Fed’s printing money the M1 multiplier has fallen almost in half, from an average of 1.6 in 2008 to .86 last month. Transactions are not occurring nearly as frequently as they did in the past. If this continues our fate is deflation, not inflation.
When the Fed meets soon it will be confronted with a market that fears fiscal irresponsibility and pending inflation, maybe even hyper. But it will also face a real world economy where transactions are still slowing because credit is becoming even tighter. For example, the cap rate on commercial real estate transactions in 2007 was 4%, despite a Fed Funds rate of 5.25%. This means that a bank would loan a company 25 times the annual collected rents on a building. Today the cap rate for commercial real estate is 8%, despite the Fed Funds rate being close to 0%. This means a bank will only lend 12.5 times the annual rents collected. It is not enough for Ben Bernanke and his colleagues to have an intellectual knowledge of what to do. They also have to have the chutzpah. The real economy needs massive quantitative easing and the bond vigilantes, like China, call for raising rates and defending the dollar. The Fed needs to lead and not follow.
