Thursday, December 10, 2009

Fractional Naked Shorting

Every dollar-denominated loan can be viewed functionally as a partial naked short position in FRNs (Federal Reserve Notes, 1.e. cash). The extent of the naked short is the inverse of the reserve ratio, so at 10% reserve, the position is written as 90% naked short. The entry is created where the bank shorts notional dollars into existence where none existed before. The Fed is a mechanism for supporting those naked shorts against margin calls that would otherwise happen in the real world - that's what a bank run really is, a margin call by lenders (depositors).

The continued existence of this naked shorting depends utterly on the willingness of the lenders to accept repayment in virtual instead of real dollars. Wire transfers, checks and book entries are all dollar substitutes, not actual dollars. An entire massive infrastructure has been erected to push people towards the conclusion that these are actually identical to FRNs. Banks will freely exchange your book entry with them for cash - until they can't anymore. The FDIC exists to guarantee that you will get cash for that book entry or other cash substitute. The Fed holds stocks of FRNs which it can exchange on a limited basis to commercial banks in danger of running out.

The scale of the pyramid scheme can be measured by the ratio of actual cash to virtual cash. Total cash in circulation (real cash) is $923 billion per the H.4.1 release dated December 10. The amount of virtual cash is the total credit outstanding, which is $52.6 TRILLION as of September 30 per the Z.1 release also dated December 10. In other words, each one dollar of cash is supporting nearly 57 dollars of credit. Through the mechanism of this gigantic naked short position, the value of the underlying security - the US dollar has been driven down to a huge extent. In fact, the short ratio can also be expressed as 98%. Not coincidentally, that is also the extent to which the US dollar's purchasing power has been reduced since the advent of the Federal Reserve.

This gives you some idea of the extent to which the value of the supply of dollars has been diluted by all of the substitutes that have been introduced into the system. If the dollar were a drug, it would be so heavily cut as to have no discernible effect. It also explains the desperation with which the financial world is attempting to save "the system" - by which they mean the machine that issues dollar substitutes and convinces you to accept them. There are sufficient dollars to cover less than 2% of domestic debt outstanding. That takes no account of the naked short positions of foreign banks. The bankers are short 57 dollars for each dollar that actually exists. You can well imagine what would happen if such a short position were to be squeezed to any significant extent.

One can justify banking to the extent than it increases productive capacity and therefore ultimately wealth. The increase in the pool of dollar substitutes will have minimal inflationary impact as that growth will be counter-balanced by an increase in the pool of goods those dollars can buy. This is a social good and one of the few philosophical reasons to support banking. Of course we are long past the point at which such banking was the norm, or even a large minority of credit activity.