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The natural flow of money: don't be fooled

September 19, 2011 by Editor, InvestingForMe.com

Most things in life have a natural structure, cycle, or flow. Our societal structures, our human likes and dislikes, our fears and desires directly influence many of these natural states. The natural flow of money is no different.


Example: Let’s look at a very basic, but real-life example to demonstrate the natural flow of money. Let’s assume that you have worked hard and you have been able to accumulate $20,000.00 in savings. Economic times are good and you decide to deposit your savings with two independent banks that we will call Joe’s Bank and Mary’s Bank. You have deposited $10,000 with Joe’s Bank and $10,000 with Mary’s bank, and you are happy.

Now a year goes by and the economy is not doing so well and you just read a newspaper headline stating that for the past six years Joe’s Bank has been investing heavily in Sub-Prime mortgages, and with the real estate market crumbling, Joe’s Bank was at risk of failing. The same article also noted how Mary’s Bank chose not to invest in Sub-Prime mortgages because their management thought these were too risky.

After reading the news article, your natural fear of losing money causes you to withdraw your $10,000 in savings from Joe’s Bank and give it to Mary’s Bank. This is the natural flow of money. By transferring your savings from Joe’s Bank to Mary’s Bank, you are penalizing Joe’s Bank and rewarding Mary’s Bank. Joe’s Bank will eventually disappear and Mary’s Bank will get bigger and stronger. In other words, bad decisions are penalized and good decisions are rewarded. This is the natural flow of money in its most basic form.

But what would you do if after reading the news article about Joe’s Bank’s risky investments, you read the next headline that stated that the federal government had just announced that all savings deposited at Joe’s and Mary’s Banks would now be government guaranteed? Would you be as worried about your savings deposited with Joe’s Bank? Would you still transfer all of your savings to Mary’s Bank? Most would not.

In the simple example above, by guaranteeing all savers’ deposits at banks, the government has distorted the natural flow of money. As a result of government guarantees, Joe’s Bank is now rewarded for its risky behavior and Mary’s Bank is penalized for making safe and conservative investment decisions. In addition, there is a risk that Joe’s Bank can actually distort the natural flow of money even more by simply offering to pay you a higher interest rate on your deposited savings. This higher rate, accompanied by the government’s guarantee, may motivate you to transfer all of your savings to Joe’s Bank, thereby rewarding Joe’s Bank and penalizing Mary’s Bank. If the government’s guarantee remains and Joe’s Bank continues to offer higher interest rates, the distortion in money flows may actually cause Mary’s Bank to collapse and disappear altogether. Imagine!

The result:  it’s a new day in investing

For the past four years world central banks and governments have been distorting the natural flows of money with their unprecedented policies of intervention. Their decisions are a knee-jerk reaction to individual crises that are constantly appearing and reappearing. The longer central banks keep interest rates artificially low where savers are penalized and borrowers are rewarded, this distorts the natural flow of money. Every time a government guarantees a depositor’s savings, a bond investor’s capital, and money-market mutual funds’ capital, the natural flow of money is distorted. Every time governments guarantee new corporate bond issues, they distort the natural flow of money. Every time governments move into the capital markets and use taxpayers’ money to buy Mortgage Backed Securities, Treasury Bonds, Asset-Backed Paper, Student Loans, Securitized Credit Investments, Car Loans, etc., the natural flow of money is distorted. Every time governments cover a bank’s losses on mortgages, the natural flow of money is distorted. Every time governments modify long established accounting rules and capital market regulations, the natural flow of money is distorted. Every time governments and world agencies, such as the IMF, World Bank, ECU, etc., come to a bankrupt country’s aid with bailout money, they disrupt the natural flow of money. So with so many distortions in the natural flow of money, it has become nearly impossible for investors to comprehend how money will flow in the future.

This is particularly true with the stock markets today. Stock market investors are more interested in knowing when and how much the next government-buying binge [also known as Quantitative Easing (QE)] will be than they are in other fundamental market factors. In fact, some investors actually hope the economy will slow down and unemployment will rise enough to force the government into another round of QE. The distortions in the natural flow of money have become so severe that investment decisions are no longer based upon fundamental or technical analysis, but rather upon government actions.

Now what?

So the big questions for the rest of us becomes, “What do money flows look like in the future?” and “Can governments continue to intervene with guarantees and bailouts perpetuating these distortions indefinitely?

The simple answers to these two questions are “we do not know” and “no.” The reason why government intervention cannot continue indefinitely is very simple: the flow of money has always been guided by an individual’s confidence. Your confidence in the safety of your savings determines where you transfer your savings.  In our earlier example, after the government guaranteed all the deposits at both Joe and Mary’s Banks, your confidence was no longer placed with the financial soundness of Joe’s Bank, but rather your confidence was transferred to your government. If Joe’s Bank went under, that was no problem because the government would pay you, and as long as you have confidence in your government’s financial soundness your savings will stay with Joe’s Bank.

Unfortunately, unless your confidence is restored and transferred back to Joe’s Bank, the distorted flows of money will eventually cause you to lose confidence in the government’s guarantees. And unless a larger organization (such as the IMF, World Bank, European Central Bank (ECB), etc.) is willing to step in and guarantee your government’s promises of guarantees, the distortion of money flows cannot continue. As long as you have confidence in the grantor of the latest guarantee, the distortion of money flows will continue until no more guarantees are available and your natural fear of loss returns resulting in the natural flow of money to be reestablished.

We are presently at this last stage in Europe with the largest agencies (IMF, World Bank and ECB) stepping in to guarantee government guarantees (for example, Greek, Irish, and Portuguese government guarantees). Unfortunately, citizens in each of these countries have begun to worry about the guarantees offered by these large agencies and they have begun to transfer their savings out of their domestic banks into stronger financial institutions in Germany and France. Their natural fear of financial loss has finally returned and they are finally transferring their savings from weak domestic banks to stronger foreign banks. The distortion brought about by government and agency guarantees is breaking down. For example, Moody’s (a U.S. credit rating agency) recently highlighted the risk to Greece as their citizens continue to transfer savings out of the domestic banks.

Conclusion

While we all understand the theory driving the current government and agency intervention,  do we fully comprehend the possible outcome if success is not achieved? In theory, government guarantees enable us to override our fear of loss, thereby removing our motivation to transfer our savings away from weak banks. This should provide the banks sufficient time to restructure their finances and restore our confidence. In time, as the bank becomes more financially secure, the government can withdraw their guarantees.

But what happens if this successful outcome does not happen? What if confidence is lost in the government’s guarantee? Confidence will always dictate that the natural flow of money shifts from the weak to the strong, and unless financial health returns to the original bank (Joe’s Bank, for example), government guarantees cannot permanently alter this natural flow of money.

Investors, therefore, need to be aware of these distortions in the natural money flows and the impact they can have upon their individual investment decisions.

While it is hoped that confidence in the original bank’s financial health is restored and government guarantees can be withdrawn, after the last four years of various guarantees and interventions, it would appear that confidence in the latest guarantor will disappear, and that the natural flow of money, from the weak to the strong, will be restored.

This is a very difficult time for investors and it can be confusing to know which investments to own. No one knows for sure which institutions and countries have benefitted most from the distortions of the past four years. The distortions have been so extensive and pervasive that developing an investment strategy is difficult at best. With this in mind, investors should ensure that their investment portfolios are structured to maximize the safety of their invested capital.

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