People who can afford iPhones and MacBook Pros can also afford $10 pedometers. Especially if they “need” them.

Sweet blog, Sean.

PS. Please don’t send me an email with your reply, cause I rarely check my mail.

The point I was try to make was that I think raising interest rates is a good idea right now and how that change is thought to ripple through the system - at least at a high level. Of course I’m generally in favor of anything that gets people to use less credit and actually save more money, too. Plus I’d love it if I could earn more in my supposedly high interest money market accounts, dammit! Stupid low interest rates….

So, some more fun stuff to research. My wife likes to call this the magic money system.

/me adusts tinfoil hat, and finds a laser pointer.

K, some basics. To you, a savings account is an asset, to a bank a savings account is a liability (a loan), you depositing money is you *lending* money to the bank. To you a car loan, house loan, credit card (with something charged on it) is a liability (a loan) to a bank it’s an asset (they loaned you money).

Our banking system is based on a system called ‘fractional reserve banking.’ What this means simply is: cannot loan out more then X% of their deposits. Usually X is ~90%, meaning they have a 10% reserve. The Federal Reserve (the central bank) is the authority in the US that determines the reserve levels.

The Federal reserve is also the entity that decides what kind of bank assets can qualify for that 10%. The Fed Reserve says qualifying assets are: cash in your vault, or funds your bank has placed into it’s savings account (non-interest bearing) here at the Federal reserve.

What happens if one day your accountants are going through your books, and you find out that you’re below the reserve requirement? What is frequently done is they go to another bank, who is over their reserve limit (has extra cash) and borrow it. Yes, that works… Think of it as the bank coming to you and asking you to deposit more money into your savings account. Does it matter if that other you is another bank? Not in the magic money system.

Now, this ’suddenly wake up’ thing can happen more often then your realize. See…all their assets (your loans) have ‘valuations’ that are necessarily the actual amount of the loan that is their ‘booked’ asset value. Examples would be: ever been upside down on your car loan? Yea…so, in the banks asset column should they be using the balance of the car loan, or what they would get for the car should you default? Valuations, for simplicity, tend to be somewhere in-between. But, you can see how determining your asset value is sometimes tricky for a bank.

Especially ones that loaded up lots of home loan assets…that are dropping like a rock.

So, when you’re in a lurch, and under your reserve requirement, you call up your competition and get them to loan you some money. But, being that they are banker’s, they aren’t going to be ok with some simple passbook savings account, they are going to want something special. This is the federal funds rate. And actually, the fed doesn’t *set* it, they recommend it. Kinda funky, they make it sound so solid on the news, don’t they? Nope…it’s just a recommendation for bank to bank lending. Usually the rate for interbank lending is pretty close to the ‘federal funds rate.’

Now, if you want to borrow *directly* from the fed reserve to restore your reserve buffer, you can. This is called the ‘discount window,’ it’s usually a few points higher then the federal funds rate, as the fed reserve is supposed to encourage the banks to borrow from each other first.

Now, if you harken back to the days of yester…well…december-januaray you’ll remember that the ‘discount window’ was in the news quite a lot. What was going on was: the banks didn’t trust each other. Home loans were being devalued *so* quickly, any bank that came knocking on the door needing a short loan to hit their reserve requirements *must* be in trouble. Why would I loan money to them. So, the actual rate that the banks were negotiating was way *way* above the federal funds rate. Actually…a lot of banks weren’t lending to each other period.

So, the fed reserve stepped in, and dropped their ‘discount window’ rate … really low, for a while to help out the banks that couldn’t get anybody to lend them money.

So…what does any of this have to do with inflation.

Magic money.

Let’s imagine a little tiny island country, totally isolated with only one bank. And, let’s say that bank runs on a fractional reserve banking system, with their reserve rate set at 10%. Let’s say I live on this island, and I go buy a car…or really I got get a car loan to buy the car. So, I borrow $10,000 to buy this car. The car dealer is totally stinkin rich, and just takes my $10,000 to buy the car (remember, we’re thinking simple examples here) and deposits at the bank. Guess what, the bank has another 10,000 * (1 - 0.10) = $9,000 to lend out. That’s just one loop of the money around the system.

Now, scale this to the size of the US and global economy.

And you thought it took a printing press to print money. Nope, all it takes is a credit card. Pretty amazing eh?

These figures are actually tracked:
M0: Physical printed money and coins
M1: M0 + ‘demand despots’ (your checking account)
M2: M1 + savings accounts, some money market funds
M3: M2 + larger more complex security arrangements and loans

This is a pretty picture:
http://upload.wikimedia.org/wikipedia/en/9/95/Components_of_the_United_States_money_supply2.svg

Oh…M3 didn’t disappear. The fed reserve decided that it was ‘too expensive’ to track. Oddly about the same time that they had the rate really low a few years back, and the whole housing bubble thing was building up. The money generated by home loans: M3.

So yea, lower interest rates == more borrowing. More borrowing == more M3. More M3 == all the dollars are worth less. The dollar gets worth less…people start demanding more of them for the same stuff. And…pow! Inflation.

You wanna turn it around. Raise the interest rates. Make people pay off their loans, some of the magic money disappears. Fewer dollars mean the ones that remain are worth more.

K, yea…go do something else now.