IN NEED OF ECONOMIC ANALYSES

IN NEED TO INCREASE OUR ECONOMIC KNOWLEDGE/BACKGROUND 

Specialists need to analyze and explain to the public

 

 

THE ROLE OF CENTRAL BANKS IN THE ECONOMY

 

Below is an analysis by John Rubino (which I found on the internet). Is it correct?

"Between 2009 and 2013 the US Fed more than quadrupled the size of its balance sheet — which is another way of saying it pumped trillions of new dollars into the banking system. Most of this flowed directly into financial assets, spiking stock and bond prices and enriching the already rich. But lately a bit has found its way to Main Street via increased business hiring (hence the good jobs numbers).

 

The Bank of Japan, meanwhile, sat on its hands until 2013 when it belatedly started printing, about doubling its balance sheet in a single year. 

 

The European Central Bank was even tighter, actually shrinking its balance sheet in 2013, to barely more than its 2009 level.

 

Looking at this chart in the absence of any other data, one would expect the US to 1) have a weaker currency between 2009 and 2013 and 2) now be growing more robustly with higher inflation. And that’s exactly what has happened."

 

 
 
 
A SEARCH OF BACKGROUND INFORMATION TO UNDERSTAND THIS ANALYSIS
 

A. FINANCIAL STATEMENTS

http://en.wikipedia.org/wiki/Financial_statements

 A financial statement (or financial report) is a formal record of the financial activities of a business, person, or other entity. Types:

  1. Balance sheetassetsliabilities, and ownership equity
  2. incomeexpenses, and profits over a period of time. A profit and loss statement

3. Statement of cash flows: operating, investing and financing activities

 

B. BALANCE SHEET

http://en.wikipedia.org/wiki/Balance_sheet

A balance sheet is often described as a "snapshot of a company's financial condition"

1. Asset=Resource  http://en.wikipedia.org/wiki/Asset

a. Current assets: cash and cash equivalents e.g. government bonds or treasury bills

b. Non-current assets (Fixed assets): 

    i. Property-Plant-Equipement (PPE): i.e. real estate (land, building), machinery, computers, IT

    ii. Intangible assets: copyright, patents, trademarks

 

2. Liability=Obligation e.g. To pay wages, to pay the income tax of the company, to pay pensions

 

3. Equity or “Owner’s Equity”= Capital Stock or Stock (cf.stocks)

Constitutes the “Equity Stake of Ownership” of the company owners.

It is divided in “shares“. Representation of their “share” of the company.

Equals what is left, if from the assets we subtract the liabilities.

 

The accounting equation is the mathematical structure of the balance sheet. It relates assets, liabilities, and owner's equity:

Capital (where Capital for a corporation equals Owner's Equity) = Assets - Liabilities

 

 

C. FINANCIAL INSTRUMENTS

 http://en.wikipedia.org/wiki/Derivative_(finance)

 

D. MONETARY POLICY - MONEY CREATION

http://en.wikipedia.org/wiki/Money_creation

In economics, money creation is the process by which the money supply of a country or a monetary region (such as the Eurozone) is increased.

 

http://en.wikipedia.org/wiki/Money_creation

Through fractional reserve banking, the modern banking system expands the money supply of a country beyond the amount initially created by the central bank.[4] There are two types of money in a fractional-reserve banking system: currency originally issued by the central bank, and bank deposits at commercial banks:[5][6]

1. Central bank money (all money created by the central bank regardless of its form, e.g., banknotes, coins, electronic money

2. Commercial bank money (money created in the banking system through borrowing and lending) – sometimes referred to as checkbook money[7]

(from the section ‘Physical currency”)

Contrary to popular belief, money creation in a modern economy does not directly involve the manufacturing of new physical money, such as paper currency or metal coins. Instead, when the central bank expands the money supply through open market operations (e.g., by purchasing government bonds), it credits the accounts that commercial banks hold at the central bank (termed high-powered money). Commercial banks may draw on these accounts to withdraw physical money from the central bank. Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new currency.[3]

 

 LET US CONSIDER FOR SIMPLICITY THE CASE OF MANUFACTURING NEW PHYSICAL MONEY (paper or coins)

 The following text was based on:

Chapter 14 Inflation Frustration: Why More Money Isn’t Always a Good Thing

Flynn, Sean Masaki (2011-03-10). Economics For Dummies (Kindle Locations 7011-7012). Wiley. Kindle Edition.

 

Money is at the center of macroeconomy, the study of economy as a whole.

The supply of money is under government control. The government decides how much money it will print and when.

 

If there is a short supply of money, each piece of money will be very valuable. For instance, let us say normally you will need 250$ to buy a computer. If there is a large supply of money you may need many hundreds of dollars to buy the same computer. In that case, the money loses its value, as during times in history where you needed packs of bills to buy a loaf of bread.

 

 People produce different products, e.g. for the sake of simplicity let us consider an agriculture-derived product, for instance bread and a technology product e.g. a computer.  If money did not exist people would have to devise ways to trade goods between them e.g. computers for bread. This is where the government comes and provides an “exchanging medium”, that is money.

 

If an economy is growing, e.g. it produces a lot of goods (such as bread or computers) people will be able to afford their everyday needs (they will not be hungry) and they can change their computers more often (e.g. every 5 years). As their needed exchanges will be greater in number and volume they will need more units of “exchanging medium” or more money.

 

 The government will provide the “exchanging medium”, that is money, in greater quantities e.g. it will increase the money supply. Three scenarios are possible. The government increases the supply of money:

 

1)     at the same rate as demand: the prices don't change

2)     faster than the demand: there is a lot of money and everyone has a lot of money in their pockets. If everyone has the minimum money unit required to “afford” things then prices rise. Inflation occurs.

3)     Lower than the demand: There isn't a lot of money around and as a result money is something “valuable”. Buying goods and services requires a lot of money. Deflation occurs.

__________________________________________________________________________________________________

 

Until 1970 printing money was difficult because most currencies were backed by a valuable metal, such as gold. For instance you could bring $35 to the U.S. Treasury and get exactly 1 ounce of gold (gold standard). In 1971 President Nixon took the US off the gold standard system and on the “fiat” system which in Latin means “Let it be!”. Presumably, this would account for “let paper currency be on its own” and not in comparison to a given standard; therefore people should accept it as if it had a value of its own. As mentioned in the book, “the problem with fiat money is that nothing limits the amount of little papers that a government can print to pay its debts”.

 

 However, other mechanisms come into effect as mentioned in this historic paradigm.

At the end of World War I, Germany's most debts were in its own currency, the German mark. As the German government had the exclusive right to produce German marks, it could use this mechanism to pay its debts. So if it owed a company one billion marks, it could print that amount and give it to it. Or if the public servants had not been paid for the last month, the government could print enough money to pay them. This was the tactic followed by the Weimar government. This triggered hyperinflation in Weimar Germany in 1922 by 100% per month and 6000% per year. Next year prices went up 1.300.000.000.000 times. A loaf of bread would cost 200.000 marks.

 

“Prices rose so rapidly that waiters at restaurants had to pencil in new prices on menus several times a day. And if you ate slowly, you were sometimes charged twice what was printed on the menu because prices had gone up so much while you were eating!“

The dramatic condition of the German economy lead the people to vote for Adolph Hitler because he promised to fix things.

 

Flynn, Sean Masaki (2011-03-10). Economics For Dummies (Kindle Locations 7200-7203). Wiley. Kindle Edition.

 

(Please note that the last section of the text from the sentence “until 1970” is very similar to the relevant book section)

 

 

 

 

MONETARY POLICY, INTEREST RATES AND THE BOND MARKET

as background for understanding "Quantitative Easing"
 

 

    The cited text from the World Economic Forum mentions :

“Diverging growth and monetary policies: As expansionary monetary policy in one part of the world comes to an end, central banks policies in other parts of the world are further incentivizing the growth and employment, with mixed results. What will 2015 bring in terms of growth and monetary policies around the world?”

 

    Quantitative easing, an expansionary monetary policy, was completed at the end of 2014 in the US. It had been initiated 3 months after the Lehman brothers crisis at the end of 2008. This policy has also been used by Japan and the UK. On Thursday 2015-01-22 the ECB will decide whether it should proceed with Quantitative Easing.

 

    In order to understand this expansionary monetary policy, I will continue with some notes on monetary policy. When talking about the latter, the first thing to consider is the determination of interest rates. Interest rate is defined as the cost of borrowing money. For every project, e.g. buying a house, we need money. How can we acquire the needed amount of money ?

 

1. By saving money that we earn; in this way we can acquire the amount needed in the long term.

2. By finding a mechanism that provides us with the money now and allows us to repay later. This mechanism would be a «borrowing mechanism» and it comes with a cost. The cost of the borrowing process is the interest rate.

 

    As mentioned in the chapter on monetary policy of the book by Flynn, Sean Masaki (2011-03-10). Economics For Dummies (Kindle Locations 8965-8970). Wiley. Kindle Edition:

    “The best way to gain an understanding of why the equilibrium interest rate constitutes a stable equilibrium is to understand how interest rates are determined in the bond market. Pay close attention because bond markets are the place where interest rates for the whole economy are determined. Bond markets have a huge effect on everything else that goes on in the economy.”

 

Here is some information on Financial Markets and the Bond Market in particular.

 

 

FINANCIAL MARKETS

http://en.wikipedia.org/wiki/Financial_market

 

 
 

THE BOND MARKET

“Today, bonds are the most widely used of all financial instruments.”

 

For the following notes, I have used the book “The Economist, Guide to Financial Markets, by Marc Levinson, The Economist in association with Profile Books Ltd” (chapter 4) as well as Wikipedia.

 

 

1. How can either businesses or the government and government authorities raise funds?

 

a. Ask for a bank loan.

b. Request financing from a customer or supplier (for businesses) or specialized finance companies.

c. Issue a security e.g. a bond.

 
 

2. What are securities?

http://en.wikipedia.org/wiki/Securities

A security is a tradable financial asset of any kind.[1] Securities are broadly categorized into:

 

3. What is a bond?

A bond is a financial contract issued by a party (issuer) and held by another party (holder).

The holder actually “buys” the contract from the issuer against a certain amount of money.

The holder is the lender (creditor) and the issuer is the borrower (debtor).

The term “debt” is used when we talk about bonds since an “I owe you” (IOU) notion is represented.


 

Using information from http://en.wikipedia.org/wiki/Bond_(finance)


 

This contract “binds” the holder to pay back the amount of money he has paid (termed principal) and according to the terms of the contract to pay additional income equal to the interest rate and/or to repay at a later date, termed the maturity date.

 

bond with sheet of 40 coupons
 

In the past “paper bond certificates were issued with coupons attached to them, one for each interest payment. On the due dates the bondholder would hand in the coupon to a bank in exchange for the interest payment.”


 

4. Why issue a bond?


a. A state (sovereign government) may want to build roads, buy park-land or fund a renewable energy project. As mentioned by the Economist Guide to Financial Markets “Bonds offer a means of requiring future taxpayers to pay for the benefits they enjoy, rather than putting the burden on current taxpayers.”


The bonds issued by governments are called “sovereigns”. They are considered to be the most secure kind of bonds.


According to the Economist Guide to Financial Markets: The earliest known bond was issued by the Bank of Venise in 1157, to fund a war with Constantinople.


Also: “The best-known sovereigns are those issued by the governments of large, wealthy countries. US Treasury bonds, known as Treasuries, are the most widely held securities in the world (…). Other popular sovereigns include Japanese government bonds, called jgbs; the German government’s Bundesanleihen, or Bunds; the gilt-edged shares issued by the British government, known as gilts; and oats, the French government’s Obligations assimilables du trésor. Governments of so-called emerging economies, such as Brazil, Argentina and Russia, also issue large amounts of bonds.”

 

b. A municipality (municipal government) may want to fund a project of social housing.

Bonds issued by a government at the sub-national level are called “semi-sovereigns”.


c. A corporation, such as an electric company, may want to fund a renewable energy project.


 

5. Why buy a bond?

A pension fund knowing with certainty its obligations far in advance, estimates its financial requirements e.g. in 20 years and searches for bonds of acceptable quality that will be repaid on that year, i.e. with a maturity date of 20 years (long-term bonds).


 

6. What is the status of bond trading in the market?

“Today, bonds are the most widely used of all financial instruments."

 

 

7. What are the properties of bonds?

The yield of an investment refers to the income return from the investment. For bonds, we have:

 

a. The interest rate at issuance (coupon). The annual interest payment as a percentage of the price at issuance. 

e.g. 6% coupon. A bond was issued for 100€ and pays 6€ of interest each year. This bond has a 6€/100€ = 6% coupon.

 

b. The current yield. The annual interest payment as a percentage of the current market price or what it is worth in the market currently.

e.g. Let us assume that this bond has become « more popular » and that it will trade not at 100€ but at 105€.The current yield is 6€/105€=5.71%. This is below the coupon.

 

If the price of the bond has risen since issuance, the yield will be lower than the coupon.

If the yield increases, this actually means that the market estimates that the bond is worth less.

 

This is why we hear in the news that as a result of an unfortunate economic development, the bond yields increased. This actually means that the market thinks that these bonds are worth less.

 

If a buyer such as the Central Bank decides to buy massively bonds this will be synonymous to increased demand. Increased demand is equivalent to « increased popularity » (like for a rock star for instance) and drives the prices of these bonds up.

 

3. The yield to maturity (an estimate of what an investor will receive if the bond is held to its maturity date).

 

 

 

 

DETERMINATION OF INTEREST RATES AND THE ROLE OF THE CENTRAL BANKS

 

    From the book by Flynn, Sean Masaki “Economics For Dummies” Wiley Location 9034

“In the United States, changes in the money supply are controlled by the Federal Reserve Bank, which is often just referred to as the Federal Reserve or the Fed. The Fed has the exclusive right to print currency in the United States, which means that it could make the money supply as big as it wanted to by printing more money and handing it out. However, the Fed actually relies on a more subtle method for changing the money supply, a method that economists call open-market operations. Open-market operations refers to the Fed’s buying and selling of U.S. government bonds. That is, open-market operations are transactions that take place in the public, or open, bond market. Depending on whether the Fed buys or sells bonds, the money supply out in circulation in the economy either increases or decreases:

 

If the Fed wants to increase the money supply, it buys bonds. To buy bonds, the Fed must pay cash, which then circulates throughout the economy.

 

If the Fed wants to decrease the money supply, it sells bonds. The people to whom the Fed is selling the bonds have to give the Fed money, which the Fed then locks away in a vault so that it no longer circulates.”

 

(end of text from this book)

 

__________________________________________________________________________________________________

    A bank has a specific reserve which corresponds to money in the vault. However, the banks can carry out transactions that are bigger than the amount of money they have in the vault. (One could say that it is highly improbable that all clients will ask for their money savings on the same day. Also, it would take a lot of physical space, a lot of buildings, to store all that money in bills and coins). By law in some cases the reserve of the bank should be 10% of their needs.

    However, banks surpass that limit from day to day. The situation is different from one bank to another. Some days, one bank could have deficit and will need to borrow and some days it could have surplus and could lend. Therefore, banks can accommodate their needs with each other and this is done officially in the interbank lending marker. The borrowing transaction has a rate that is called the interbank rate (also called the overnight rate if the term of the loan is overnight). There is a wide range of published interbank rates, including the federal funds rate (USA), the LIBOR (UK) and the Euribor (Eurozone).

 

    The central bank influences the interbank rate via open-market operations. When it wants to increase money supply towards the banks, it buys bonds sold by the major associated banks and other financial institutions. Buying bonds from banks means deposits in their accounts (creation of new money electronically). The banks have therefore more money and can lend more easily to people. The central bank by affecting the interbank rate affects all other interest rates in the markets, e.g. the rates that the bank define for the different loans and services they provide.

 

    Attention: What kind of bonds does the central bank buy upon conventional monetary policy?

 

   Short-term bonds e.g. with a maturity of one week as it wants to increase liquidity immediately. Its aim is to target the interbank rate or overnight rate.

 

    Quantitative easing is an expansionary monetary policy that is defined as unconventional. It consists of purchasing of financial assets such as bonds in large scale (by creation of new money electronically). The bonds that are appropriate for this scale are government bonds (not corporate ones for instance)

 

 

What were the ECB open-markets operations recently?

http://www.ecb.europa.eu/mopo/implement/omo/html/index.en.html

 

 

 

MONETARY POLICY

 

From the book: Flynn, Sean Masaki (2011-03-10). Economics For Dummies (Kindle Location 7232). Wiley. Kindle Edition.

“Stimulating the economy with inflation: Monetary policy”

“…if the economy is in a recession, the government may print up some new money and spend it. (…) All those businesses that received money from the government can now go out and spend that new money themselves. And whoever receives the money from them will also go out and spend it to buy things. In fact, this can theoretically go on forever and stimulate a heck of a lot of economic activity — enough to lift an economy out of a recession. If this sounds too good to be true, it is. Why? Inflation. (…) For example, if the government doubles the money supply, businesses will double the prices they charge because each piece of money is worth half as much as before. Consequently, the total amount of goods and services sold will be the same(…).

 

The sad upshot is that an increase in the money supply stimulates the economy only when it’s a surprise. If the government can print the money and start spending it before people can raise prices, you get an increase in the amount of goods and services sold. (…) In fact, if the government keeps trying to surprise people, people begin to anticipate the government’s actions, and they raise prices even before the government prints more money. Consequently, most modern governments have decided against using this sort of monetary stimulus and now strive for zero inflation or very low inflation.”

 

 

BLOOMBERG INTERVIEW   by Ben Steverman 2014-12-31  Link 

Sarah Ketterer, chief executive officer and fund manager at Causeway Capital Management

"There are wonderful gems out there. Nobody wants [them]. There are quite a number of industrial stocks in Europe whose share prices have come down because of concerns about growth in China and Europe. The concerns may be legitimate. But ultimately these companies will end up outlasting their competitors, taking market share and becoming even more efficient.

This is the part investors seem to sometimes misunderstand: If businesses are doing their job, they are constantly evolving. Even in a stagnant environment, they can succeed."

Q: Speaking of investors and what they don’t know, what’s a mistake they often make?

"Short-term-ism is the worst. In the mutual fund world, investors get impatient. If they aren’t pleased with short-term results, they have a habit of shooting themselves in the foot by selling at just the wrong time."

"But just buying the S&P 500 or a world index in an ETF? It’s not a good time for that, because markets are fully priced. And the stocks that make up the largest weights in the benchmark are the ones that are most fully priced. Whereas you could have bought anything in early 2009 – you could have thrown darts and made a fortune."

Q: You're saying that in an index fund, especially one where stocks are weighted by market capitalization, investors end up concentrated in the most overvalued stocks?

"You’ve just bought what went up. You get a fully valued or overvalued basket of stocks.

 

So, sure, in active management we get some fees. But we ought to get paid if we can identify the stocks that have been left behind, [and those] that are not going to blow up the portfolio. That’s our job."