A p2p market for low-income housing tax credits?

I just stumbled upon this interesting paper from the FRB on how to re-ignite the market for low-income housing tax credits. These are credits that investors buy so they earn tax credits they can apply to lower their tax liability. Currently this market has been limited to large players but the FRB paper suggests it may be good to open it to individuals directly.

The universe of Low Income Housing Tax Credit (LIHTC) investors is limited to a small group of large institutions. Since the tax credit was created in 1986, banks, corporations and government-sponsored enterprises (GSEs) have purchased nearly all the credits made available through the program. Unfortunately, the concentration of investor demand in a small group of institutions has introduced volatility to the LIHTC market. Specifically, demand for these tax credits has proven extremely cyclical. As financial institutions and other large institutional LIHTC investors suffer losses (as they have in the current recession), their appetite for tax credits decreases rapidly. The result is a collapse in the price of LIHTCs, which endangers the very feasi­ bility of tax-credit-financed affordable housing projects.

Affordable housing investment was not always domi­ nated by large corporate entities. In fact, individual taxpayers played a prominent role in financing afford­ able housing development during the early 1980s. That role changed with the passage of the Tax Reform Act of 1986.

Prior to this legislation, individuals could deduct construction period interest and taxes, accelerated depreciation, and amortization of building costs. Taken together, these tax benefits were significant enough to attract many wealthy individuals to the mar­ ket. By 1986, however, Congress had become wary of overly generous tax benefits, loopholes and deductions. The result was the passage of new passive loss, passive credit and at-risk rules. Among other changes, the new rules established a financial disincentive for individual taxpayers to claim credits in excess of their marginal tax rate multiplied by $25,000. These rules have not been updated since 1986 and continue to suppress individ­ ual demand for tax credit investments.

Benefits of Individual Investors

Bringing individual investors into the LIHTC market would have several important benefits.

First, bringing individuals into the LIHTC investor pool would stabilize pricing and create a more robust market for the credits. Of course, individuals are not immune from economic hardship. Nevertheless, most people carry tax liability from year to year and, presumably, would benefit from a program that offsets this liability.

Second, individual investors would also help round out the LIHTC market’s financing of smaller projects and underserved geographies. Increasingly, large institu­ tional LIHTC investors have dealt directly with afford­ able housing project developers. To maximize efficiency, investors have sought large projects with correspond­ ingly substantial tax credit allocations. As a result, “it has been difficult to attract corporate investor interest to small and rural deals, since corporate investors look for larger deals with higher amounts of tax credits to offset their federal tax liability,” according to the National Association of Home Builders.2 Individual investors, by contrast, have lower tax liability than corporations and might be more attracted to smaller deals.

Finally, opening up the LIHTC market to the grow­ ing number of individuals seeking social impact invest­ ments would diversify the investor pool. According to the Social Investment Forum, “socially responsible investment (SRI) encompasses an estimated $2.71 trillion out of $25.1 trillion in the U.S. investment marketplace.”3 This growing market indicates that investors are increasingly looking for mission return in addition to financial return. Financial products such as socially responsible mutual funds, positive and nega­ tive stock screens, and deposit accounts in community development credit unions are frequently used by individual investors to satisfy both social and financial preferences. Socially motivated individuals might also invest in LIHTCs if given a cost-effective, efficient way of doing so. This would benefit the market by further diversifying the pool of LIHTC investors.

Barriers to Individual Participation in the LIHTC Market

In addition to passive loss tax restrictions, individuals have largely remained outside of the LIHTC market because of four key challenges: high transaction costs, program complexity, compliance risk and the illiquidity of the investment.

High Transaction Costs

The limited tax benefits offered by LIHTC are often insufficient to offset the cost of individual participa­ tion. Tax-credit-financed deals can be multimillion dollar projects. New construction financed by LIHTCs can require raising tax credit equity of 70 percent of eligible construction costs. The cost of soliciting such investment from small-dollar individual investors is cost-prohibitive for most affordable housing developers (and most syndicators, for that matter). Historically, it has been more cost-effective to engage a select group of large investors not restricted by passive loss rules that can finance whole projects on their own.

Program Complexity

LIHTC deals are extremely complex. The technical expertise required to complete a LIHTC project is a dizzying array of real estate, legal, tax, development and policy know-how. Most individual taxpayers lack even a basic understanding of the LIHTC program—let alone how to responsibly evaluate the investment risks.

Compliance Risk

LIHTC investors are subject to credit recapture and penalties should a project fall out of compliance during the first 15 years of its operation. Compliance is a function of the rents charged to the development’s low-income tenants. Should rents exceed specific federal guidelines, the project is deemed out of compli­ ance, the credits are recaptured and a penalty is levied. Individual investors have likely shied away from tax credit deals because they lack the expertise to quantify and price the risk posed by this central program requirement.

Investment Illiquidity

The 15-year compliance period, coupled with restric­ tions placed on the reselling of credits, makes purchas­ ing LIHTCs a relatively illiquid investment. This tends to favor investors with long investment time horizons. Further, the tax benefits that flow from a LIHTC investment only begin when the project is completed. This can be up to three years after the credits are originally allocated. To date, corporate entities with long-term tax obligations have been most comfortable with the illiquidity of the investment.

An Individual Investor Solution

First and foremost, the easiest way to attract indi­ viduals into the LIHTC market is to change the passive loss restrictions that discourage individual investment. Whether the passive loss limit is increased or the rule is

eliminated altogether, increasing the tax benefit would make the credit more appealing to individuals. Even with tax reform, however, the barriers outlined above would still discourage many individuals from partici­ pating in the program.

While only a partial solution, the creation of a fully transparent online platform to broker the sale of tax credits to individual investors would address some of these challenges, specifically high transaction costs and program complexity. An online marketplace for LIHTC investments would keep the cost of soliciting capital low while simultaneously organizing and com­ municating important information to potential small- dollar investors. In fact, such technology already exists in the form of so called “peer-to-peer” (P2P) lending. P2P lending sites attempt to lower transaction costs by cutting out the middleman in debt transactions—usu­ ally a bank or a credit card provider. While the long- term viability of their core business model is unknown, P2P lenders such as Prosper, Kiva, LendingClub and others have demonstrated that individuals can lend responsibly in the consumer debt market. The same technology could be adapted to match LIHTC inves­ tors with affordable housing projects.

Direct Investment Model

The simplest method for organizing a LIHTC platform for individual investors is to directly connect these investors with affordable housing developers that have received tax credit allocations. Developers could post project listings on the platform and the tax credits they have available. As part of the listing, develop­ ers would also have the opportunity to promote the project’s financial and social merits as well as set the initial price for the credits. The investment period could be designated by a preset date or simply end when sufficient equity has been raised to proceed with the development.

Tax Credit Syndicator Model

A second way to organize an online LIHTC plat­ form would be to use tax credit syndicators. The platform could connect individuals to syndicators who identify and invest in LIHTC projects on their behalf.

There are two reasons to favor this approach. First, it addresses the complexity barrier noted above. Even with detailed project listings, most individuals would be ill-equipped to evaluate the range of risks that come with an affordable housing investment. In contrast, tax credit syndicators have a great deal of expertise and in-house capacity to accurately assess these risks and invest responsibly.


The recent collapse in the price of LIHTCs has exposed the folly in the market’s over-dependency on large corporate investors. Encouraging individual par­ ticipation in the LIHTC market would diversify and expand the overall investor pool, smooth LIHTC price cycles, bring untapped capital to the market, and help finance small, often rural, affordable housing develop­ ments that today struggle to raise tax credit equity.

An online LIHTC platform, while potentially dif­ ficult to scale and develop, would lower transaction and information costs and allow individual investors to enter a market that, heretofore, has been nearly the exclusive purview of institutional investors. Also, such a marketplace could allow for dynamic, real-time price setting. If sufficient scale could be achieved, a price auction mechanism would be effective in either of

the models outlined above and, importantly, it would create complete price transparency. Online platform or not, however, the benefits are clear: It is time to get individuals into the LIHTC market.

Markets are like highways

Construction Traffic on I-376

Originally uploaded by daveynin

Whenever I drive I realize how much people behave differently when driving their little mobile avatars than when walking or bicycling. I’m for instance amazed to see people trying to get ahead of a single car in a 5mph traffic. I think there is a lot to learn from these behaviors.

Driving a car on a highway is quite efficient from the perspective of going from point A to point B, at least when and where efficient public transportation options are not available. In addition, driving a car has the advantage of anonymity: other drivers don’t know your who you are, only the car you drive and how you drive it. This implies that any legal but aggressive behavior, or illegal but uncaught by the police, has little consequence unless you get into an accident. Knowing that your name won’t be publicly tainted by your bad behavior is an incentive to behave aggressively.

When you walk or bicycle, it’s harder to get away anonymously. People can easily catch up with you and ask you about your behavior. This I think leads to more courteous behaviors.

To me this is similar to a market. In a market that’s completely anonymous and driven only by numbers and mediated by computers, aggressiveness can be expected to be high. In comparison markets that assume conversations between buyer and seller, haggling, behavior is likely to be more subtle. The main reason is that information about a dishonest participant will circulate very quickly in a human-driven market where anonymity is difficult than in a computer and broker-mediated market.

One option of course is to increase the regulation of the markets, which in highway terms is to have more police cars around: drivers stay anonymous to each other but completed naked to a few policemen. This implies that the monopoly of moral superiority is given to one small group, something I think is prone to corruption.

Another option is to limit anonymity and to facilitate sharing information on market participants. On the highway, this would mean dash applications that gives the ability to rate other drivers, directly from your steering wheel, but also that display right away warnings when a badly rated driver is approaching.

Limiting anonymity is much harder in financial markets, since it is easy to conceal a trade behind a chain of intermediaries. In a way, it’s the intermediaries job to help participants conceal their real intentions, especially those participants with the biggest impact on markets. Our financial markets are like high-speed highways with little police and very fast cars remotely driven by participants, in which many small investors drive their little car.

How can “social” improve the morality of markets, without succumbing to either a monopoly of moral superiority or a wild jungle with no morality?

Does gold have any value?

“I didn’t have time to write a short letter, so I wrote a long one instead.” – Mark Twain

Yes, I didn’t have time to figure out good, 140-char answer to questions I received from Steve on Twitter, so I figured I’d write a long blog post.

[warning: controversial topic ahead. If you disagree with me, best is probably to agree to disagree or simply to ignore this post. Have a nice day! I do enjoy a good discussion though.]

To understand my views on gold, you have to understand my views on wealth. To me, wealth is what sustains and expands life. This is a biophysical perspective. I relates to my views that life is a process that is able to limit the effect of the 2nd law of thermodynamics within certain boundaries and that God is who is able to reverse it.

To me gold is not wealth. I don’t know any living matter that is able to directly draw energy from it. Can’t eat it, can’t warm yourself from it. Rather, the only value of gold is social: ownership of gold implies that you are able to satisfy your life needs such as food, shelter, health, and instead can focus on other needs such as recognition from others. If you can own something that isn’t wealth (but simply beautiful and scarce), it can only mean you are wealthy. Although I don’t have historical facts to back this up, I suspect gold was the currency of kings and salt the currency of folks, so historically and possibly to this day, if you want to be perceived as socially closer to the king, you want to own gold.

So gold has social value: it’s value is derived from the fact that others value it. Maybe that’s why Soros called it the ultimate bubble. Even though it is not wealth, it can be exchanged for wealth. It is not wealth, but it represents wealth, and representing wealth is what money does. Of course, Gold has several interesting characteristics as a metal that were historically helpful in this role: it’s scarce and hard to fake, and it’s easy to authenticate.

The problem with gold is that it is scarce, so if a group of people don’t have gold and want to trade to their mutual benefit, they either can’t trade, or have to borrow gold from someone who does own it. This implies that in a society in which taxes must be paid in gold, the result is certainly the enslaving of a class of people by others (note that government-issued money that must be used to pay taxes is just a variation on that, with the added caveat that governments are not constrained by the supply of gold, but by their ability to enforce increasing taxes).

People do not want their productive and creative capacity to be limited by the amount of gold in the ground, nor do they want it to be limited by what the elite or the majority think is a good amount. People want to be only limited by their own imagination and their ability to turn ideas into reality. The major role of government should be to provide the platform to make this a possibility for everyone.

True freedom would be the ability to issue your own IOUs and through the magic of computer networks and security, to turn it into “gold”, so you can buy things and pay with your own creative capacity. Technology is readily available: cryptography can provide the same anti-counterfeiting, anonymity and ease of authentication that gold provides. What is missing is social acceptance, the networks that provide the good enough liquidity for these IOUs to function as money. Research shows that a little trust goes a long way.

I think network money will prove much more valuable than gold to represent wealth. It only requires a few admired “kings” to decide to own network money rather than gold, and the rest of the people will follow. Gold will certainly continue to play a role in this world, likely an increasing role as a currency, but I don’t buy the fact that soon we’ll be back to a fully backed gold reserve standard with gold at $5000/oz+. This is why I don’t invest in gold no matter how high prices are going. I invest my money in wealth and I invest my time in building network money, focusing on social aspects first, not technology first.

Making digital gifts cool

I am on a quest to find the ultimate digital-only gift. Not your 70% coupon, virtual gift card, farmville gifts. Something with the potential to make people say: “Wow! I wanted this more than a 13-inch solid state MacBook Air. How did you know?”.

Here are the criteria, that I thought are relevant:

  • Unique: either something personalized to the recipient, and/or something that would be based on external data like time, temperature, so it would effectively be different all the time.
  • Rival. One owner only at any given time. I would want my digital gift to be rival: if the recipient owns it, the giver does not have it anymore. This could work like this: you get a secret code or URL to access it, which becomes invalid, and a new URL is generated for you to access next time, or gift it so someone else.
  • Re-giftable. This is useful since you may get something you don’t like. It’s also very fun.
  • Economically hard to reproduce. This means it may be the result of a CPU-intensive process that could take several years to complete on a regular PC. Storage-intensive: this would make it unpractical to try to copy. The same goal can be achieved by making the gift very specific to the recipient.
  • some public and social elements: ability to share some aspects of it with the public or specific friends. Starting with the ability to prove ownership of it, for instance by displaying the name of the current owner, or a digital signature. It may be possible to take snapshots of the gift and share them with friends, or perhaps share the experience of the gift with friends if one wants, but only as long as the gift is owned by the person inviting others.

So far, I haven’t found anything matching these criteria. So, let me know your thoughts.

Some ideas that get close: Bitcoin money, DNA analysis service (23andme), digital fashion for virtual worlds.

Good banks and meaningful money today in France

While I’m very interested in the future of money, I’m even more interested in the future of money now: the very practical things that we can do with the banking and monetary system as it is today.

I have come to realize that the ideas I believe about the future of money, in particular making money more meaningful, are very well understood by small community banks and credit unions. They have incredible assets, one of which is the human-sized organization, which allows you to quickly talk directly to the decision-maker. What they lack are simply the resources of the large banks and the sense of urgency of startups, but I know they are open to partnerships to workaround these issues.

Below is my corrected Google translation of a recent post by JCPhilippe, who is Managing Director of the Credit Agricole in the region of Pyrénées Gascogne in France on how the bank he manages is becoming a good bank.

As part of  a week on “socially responsible savings”, we organized a symposium on 3 November. Distinguished guests, Father Bernard Devert,President and founder of Habitat Humanism , François De Witt,founder of Finansol , and Pierre Scherek, Director General of Ideam convinced us of the usefulness of their actions and this form of savings, still limited in use in France. Socially responsible savings consists in selecting financial investments by adding meaning and socially responsible as a requirement in addition to performance.

We fully support this approach. When I say this, I understand it is difficult to believe a banker is telling the truth. If he speaks of social responsibility, ethics, faithfulness to pledges, and sustainable development, how can we not think that he is only doing so to better profit? The mega-banks have left such a strong mark in people’s mind for their subprime profits, losses, their traders and their bonuses, that it is easy to forget the local bank dedicated to a particular geographical area, which serves, people of modest means, small businesses , artisans, shopkeepers, farmers. The headlines make us forget that finance and banking are first and foremost here to help with daily life. So when a banker says: “I want to be useful!”, Who can believe him? Who can believe that a bank, a banker can have be well-intentioned?

A Pyrenees Gascogne, we believe in the good and useful bank, local solidarity, local cooperations. This idea of a good bank can be seen in everything we do. When we say that advisers are not paid on the products they sell, it’s true, or that we advise our customers products that suit them, it’s true. And because we want a good bank that we have developed a consulting business in how to save energy. And when we provide help to non-profit in our area, it’s because we believe their action is vital to the social fabric.

So if we offer our customers financial products around solidarity and socially responsible investing ( here on the site talking about heritage ), it’s because Pyrenees Gascogne invests itself in these products, it’s because these products are purchased by our employees employee for their own savings, it’s because we believe in the value of these investments for ourselves. We do not follow fashion, we are not trying to conquer a market, we try instead to share a belief with our customers.

I am increasingly convinced that of of the key levers to make companies more virtuous, more accountable to the future is to channel savings into those companies that subscribe to the principles of sustainable development, and integrate this philosophy in their decision and accounting. It is more useful to invest in such investments than to give a little to non-profits, (although each donation is helpful) because that way, they have means to improve their ambitions. We can put more solidarity in the economy and the formula of Phocion “private virtues become public morals” is truer than ever. Of course, we must still dare to believe and decide to build!

Can the Fed create money?

I’ve been arguing recently like others that QE2 isn’t really creating new banking money. Yesterday Ben Bernanke was interviewed and said the following (video skip to 19:00 mark) (h/t Pragmatic Capitalist):

What the purchases do… is… if you think of the Fed’s balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves in the banking system. Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed. Now the question is what happens the economy starts to grow quickly and it’s time to pull back the monetary policy accommodation. There are several tools that we have…: [he goes on to describe the use of short-term interest rate on reserves].

I generally agree with Ben Bernanke but with a small distinction: while QE isn’t creating money, it’s artificially maintaining an illusion that there is money, than there would otherwise be. Specifically, it’s forcing savers to invest in places that we would not otherwise invest because they are not really increasing real wealth productivity.

I view banks not as creator of money, but as intermediaries that lend credit to money so it becomes more easily acceptable: they liquify money rather than create it. The only reason we need banks is that we do not have an alternative decentralized infrastructure to efficiently liquify money created by the private or public sector. Efficiency here is measured in how low discounting cost of liquifying money is.

As Hyman Minsky said, “creating money is easy, the hard part is getting it accepted”. In other words, a private party – say a private business like a farm – can create money simply by issuing vouchers for their products/services, as is the case when a farm issues vouchers as part of a Community Supported Agriculture program. They don’t need anyone to create these vouchers, they only need confidence they can do good on their promise. The problem is that these vouchers are not easily acceptable because the cost of evaluating the ability of the farm to do good on their promise, and actually deliver the goods/services is high. Banks merely reduce that cost buy swapping these vouchers with assets that are more creditworthy, specifically claims on their own balance sheet. These claims are more easily accepted because 1) there are claims on a diversified portfolio of assets 2) because regulated banks promise to convert these claims in Federal reserve notes on demand.

The past 10 years have provided great empirical evidence that banks and the Fed are not necessary to create money: the shadow banking system created a ton of money by taking promises from the private sector, liquifying them by turning them into tradable assets via mortgage-backed securities, assigning good rating to them, so they would become acceptable in transactions, effectively turning them into money. These should have evaporated.

What the Fed is merely doing is artificially propping up the value of these debt-based assets to levels that they would otherwise not have. But they are not creating new money, they are just trying to keep the level of money in the economy at least constant or increasing.

Of course, this isn’t without issues. The main problem I see is that these actions are distorting capital allocation decisions. They give incentives for capital holders to allocate capital to assets that they would otherwise not invest in.

Real money should only be created when wealth productivity increases: for instance a farmer becomes more efficient and sustainable at growing healthy food that naturally heals people. Conversely, it should be destroyed when we realize that the wealth productivity increase were fake, for instance a farmer using petrochemicals to artificially prop up production of food that’s causing cancers and destroying land.

What can you and I do?

If you are a short-term speculator, it is important to understand that you can’t fight the Fed. You have to go with their illusion-making but be extremely aware that “debts that can’t be paid, won’t”, which means that at some point, the illusion will drop, likely in a dramatic way.

It’s better to be an investor, which means focusing on investments that represent real wealth for you, your family and your community. These are different for each of us, but to me they start with healthy food, safe housing, access to health and energy, and building relationships with other likeminded “investors” in your neighborhood and in the world. For instance, consider investing in a local farmer, equipping your house with solar or wind energy or investing in a sustainable energy cooperative, learning to share resources, organize and co-create with your neighbors. I would also recommend investments in companies dedicated to true increased wealth productivity: efficient/sustainable farming like aquaponics, robotics, renewable energy, sharing and trust networks, biotechnologies. In the short-term, while shady assets are propped by, your returns may be disappointing, but when the illusion disappears, you will find yourself in a much better position.

Also, if you are a software developer, an angel investor or venture capitalist, you need to invest your talent and capital in the Open Banking infrastructure i.e. the infrastructure that will facilitate the creation of liquid money within and across communities with similar values. This is critical to lessen the power of the Fed to artificially prop up assets that most of us pay for, but which create no tangible value to us.

[This is not an investment advice]

Currencies as new investment category

Gregory Rader asked me to clarify a point.

I essentially think that investing in something because of its actual outcome is a quite attractive value proposition.

I define a currency as a transferable promissory note issued by an entity/individual and backed by its productive/creative capacity.

Currencies can be used to fund projects that equity or debt wouldn’t.

Debt/equity requires a discounting of future market value, that is to say an evaluation of the sacrifice that people other than the investors will be willing to make in the future. This is especially hard in a credit money system where your ability to sell in the future doesn’t just depends on your ability to produce, but also on the phase of the credit cycle. In addition, for the sacrifice to be possible, the wealth generated must be rival, which further limits the creative potential.

Currencies on the other hand simply require the investor to know how much they will value the wealth created. They only require the issuer to produce/create what they promise they would create. Since they allow wealth creation to be funded upfront, rivalry isn’t a requirement. Much easier.

Understanding the consequences of quantitative easing

Lately, there has been a lot of talks about Quantitative Easing, the Fed’s purchase of assets, as a way to fight disinflation or deflation. People talk about it as the Fed printing money, and the media and the population conveys images of Weimar-style wheelbarrows of cash and Zimbabwe. This has fueled an accelerated frenzy in all asset classes, equities, bonds, commodities, including Gold prices, which have reached ($1380/oz).

My take is that this frenzy is essentially based on a misunderstanding by most people of how the U.S. monetary system actually works. QE itself isn’t inflationary at all. What is inflationary is expectation of inflation. But because people believe it is inflationary, it can excite speculation, and in turns, generate inflation, if enough people believe it, particularly those creditworthy enough to get in debt.

Inflation is the result of too much purchasing power increasing at a faster rate than goods and services available to purchase. Deflation is the reverse: purchasing power decreasing faster than products and services available to purchase.

This purchasing power is composed of bank money and paper/coins, bank money being the lion’s share of purchasing power. This purchasing power is bank “created”. The bank takes promises of people on one hand, and gives credit to these promises in exchange for interest and collateral, so that they become acceptable by other people. Because some of this bank money is convertible on demand in paper or transferable on demand to other financial institution, people have the illusion that bank holds their money and actually transfers it. This is not the case. Holding an account at a bank with a positive balance is like holding a different currency than your Fed reserve notes. It’s pegged to the USD i.e. it’s convertible 1:1 for Fed reserve notes, but it’s not the same. The only true USD are the Fed reserve notes and their electronic version, the reserves, held by the Federal Reserve Banks. These Fed reserves are the banks’ currency: this is how they settle debts between one another. No one but banks and the Federal government use the Fed reserves.

So, in a nutshell, because most economic agents are not banks and they use bank money to pay, not reserves, only if bank “created” money increases relative to goods/services production is there a risk of inflation. Another way to say is that reserves have not effect until they are “transformed” into bank money. I’m using quotes again here, because there is no actual transformation, it’s just two sides of a balance sheet.

If we agree on this, let’s see what QE is and what effects it may have. When the Fed buys $1T of assets for Fed reserves, whether private (mortgage-backed securities) or public (Treasury Notes), what the Fed does is does is enter the following accounting entry:

  • they record a new reserves as liability, on the account of the bank they purchased from.
  • they record the purchased assets as assets.

So technically, the bank ends up with an excess of Fed reserves, which they are forced to seek yield from, which some people say they can lend to borrowers, which is inflationary.

Actually, this assumes that creditworthy entities are willing to borrow. Let’s assume 3 types of entities: households, goods/services producing companies, speculators, Government.

  • If creditworthy households do not anticipate asset prices to increase, or have just been spooked by the housing crisis or worse lost they home, they are unlikely to borrow against such assets. If households are unwilling to borrow or if banks feel that they are not creditworthy enough, then no new bank money here.
  • Companies will only borrow if they can invest in productive capacity to satisfy a need they identify.
  • The increased liquidity at banks may end up in the hands of speculators. Problem is: speculators do not consume anything so they don’t really represent real demand. To make money, they need to buy low and then they need to sell to someone who actually values the asset for longer than a few microseconds or even days. It is possible to have commodity prices exploding then crashing just based on speculation, but not actual demand (ex. oil in 2008)
  • The government can borrow money, but in practice the government (in the US) isn’t constrained to borrow to spend. They spend first, then borrow. So the government, represented by Congress, must be willing to spend. This requires political agreement.

Given this, how can we have a sustainable creation of bank money (hence inflationary) scenario:

  • households as an aggregate decide to take on more debt. Not likely in my opinion for the next few years.
  • companies seeing that household are not taking on more debt do not borrow (or borrow but to invest abroad).
  • speculators bid each other rapidly, which creates an asset speculation frenzy. Some households or companies who actually need these assets feel that they are missing and decide to buy and hold. To me, this is possible but unlikely given the current lack of confidence by retail investors in financial markets.
  • last, the government, is unlikely to spend or reduces taxes if there is a gridlock, which seems to be the case at the moment.

In conclusion, it is my belief that QE is more likely to not spur inflation in the coming months. I believe it will indirectly contribute to inflation after a new crisis prompts the Government to go on a new huge spending program. New government spending combined with QE does equal new money, but not QE without expansion of credit.

This is not an investment advice.