Inflation, Money & Credit 101

Deflation: Increasing purchasing power rather than declining.Inflation = increase in money supply, all things being equal.


This means that when the supply of money (dollars or notes) in circulation increases, the relative value of that money declines versus a fixed supply of goods. The resulting increase in the price of said goods corresponds to the decline in purchasing power of the money. Note: if money supply remains unchanged, an inflation is possible if the demand for that money decreases. I shall elaborate below.

The post-war era has been monetarily remarkable in that State and household credit finance has exploded parabolically. These days, the monetary logic implies that money = credit, insomuch that a dollar of money supply equals a dollar of credit or a loan  underwritten by a financial institution. If credit = money, borrowers must emerge to demand loans in order to avoid reducing the standard of money (i.e. inflation OR deflation). Upwards of 70% of all new US debt is being monetized or "created" by a single,  private institution: the US Federal Reserve Bank.

When one considers the yet unwound collapse of values in real estate throughout the West, especially the United States, coupled with the "unpublished" depression-level of unemployment (viz. 20-23% according to estimates), one immediately sees the intermediate-term problem with an inflationary condition. The demand-side of the ledger is very soft, if at all extant, while the supply side continues to inflate unabated. 

My colleagues practicing economics know well that an increase to money supply, according to one of the fundamental tenets of that dismal science, Marginal Utility Theory, implies an inflation (i.e. a decline in money's purchasing power versus a said quantity of goods or services). But the theory contains a flawed assumption: that the dynamical forces underlying money standards have pound-for-pound consequences irrespective of what dynamic one considers; supply or demand. The forces are obviously unequal. Test the theory the next time you ask for a raise.

In the real world, a unit of said demand X does not necessarily correspond to a unit of supply Y. The parabolic and occasionally non-linear relationship between the two are more the norm than the exception. Two examples come to mind: the price dynamics in the stock market and the real estate market.

According to marginal utility theory, a change in the demand or supply ledger of a said market for a good or service will be met by a contravening, or offsetting, adjustment on the opposite ledger, i.e. a rise in the supply of widgets implies a corresponding increase in its demand, all things equal; otherwise prices fall, and vice-versa should there be a fall in supply or a rise in demand. But there are plenty of examples of just the opposite phenomenon, e.g. stock market bubbles. 


The past generation or so has witnessed price conditions indicating greater investor appetite (i.e. demand) with higher share prices. With a fixed supply of common shares outstanding in the marketplace,  economic theory implies that demand should decline. But the expectations (and increasing confidence) for higher prices in the future attracts a swelling mass of investors who bid up share prices further still, providing a self-fulfilling prophecy of sorts. The ultimate terminal condition is a bubble whose extreme "off-the-chart" valuations lead to a crash whose decline often takes prices even below the point where the trend began.


The real estate markets in the West are a good example too. There ought to be little doubt  that the past couple of decades witnessed a bubble in housing values with some regions particularly hotter than others (e.g., United States, UK, Spain, Ireland, Australia, etc.). Coupled with deflationary money policies at the outset of the 2000s in order to stem the global stock market collapse, housing values shifted into overdrive and another, far larger, bubble emerged. Since the market peaked in 2006, some regions have seen housing values drop like dead weight. For example, Las Vegas, San Francisco and some Miami counties have seen median home values decline by more than 80%, and dropping. Where are the  buyers? Where is the offsetting demand to stabilize prices? 

Therein lies the problem: a potential for a deflationary crash. As with price bubbles where rampant speculation and greed drive prices higher, and higher prices beget more buyers and speculators, deflationary crashes are driven by a similar dynamic. Unfortunately, given the broader condition defining most, if not all, Western economies today, the destructive forces of price bubbles may remain preferable to a deflation. At least with inflation, debts lose relative value as the purchasing power of the underlying money declines. In a deflation, debt values actually increase. Given the unprecedented explosion of debt and the global credit crisis--especially within the US which also represents the world reserve currency--it's easy to see why one might lose  sleep at night. 

Today, virtually all levels of Western government (the US particularly) are tapped out and can no longer sustain their gargantuan debts; most are in chronically deficitary positions that are often prohibited by legislation. The only two remedies--both unpopular--would be to either raise taxes or cut spending. Raising taxes is seldom a desirable policy to pursue, especially in the US where a deepening recession one year ahead of presidential elections is looming. Spending cuts seem more politically palatable, at least in the very short-term, but cutting government spending and entitlements would only serve to dampen aggregate  demand further. To be sure, American governments are caught between a rock and a hard place. Any solution to the country's fiscal woes is liable to alienate and anger a number of crucial constituencies. The near-term political future of the current POTUS and his hopes for re-election in 2012 are far from secure.

Moreover, when one considers the precarious balance sheets of millions of households and the corporate sector, the case for an optimistic turnaround anytime soon--let alone this decade--becomes untenable. Inflation, it would seem is a desirable prognosis when all factors are pointing to a deflation. This is the reason why central governments throughout the Western world have their feet firmly pressed heavily on the throttle with zero-interest rate policies; they are pressing to create an artificial inflation. But this is where a majority of text-book trained economists are categorically wrong. A physician does not pump syringe after syringe of adrenalin into a human body whose vital signs all point to high blood metabolism, heart rate and other critical bodily function; a doctor pumps adrenalin into a decaying, near-comatose body whose vital signs are weaning. When I hear economists proffer all this nonsense about inflation and that deflation is the foolish prognosis, I can't help but laugh. I laugh at the contradictions so painfully obvious in such a loopy prognosis. Economists, like bad physicians, are confusing the artificially high vital function with natural function and are ignoring the adrenalin of a hyper-counter deflationary policy. The heart is racing BECAUSE of the adrenalin; stop feeding adrenalin lest you destroy the body!!

In keeping with the biological metaphor, consider the economic "vital signs" that are being confused for inflation: Trillions of dollars of assets are currently near or at their all-time peak "bubble" values (i.e. bonds, dollar-based commodities, common shares, derivative notional principal) that the next major event is more likely than not a decline in prices across the board rather than a persistent increase. These vital signs didn't emerge of their own volition or dynamical price mechanism; they are totally artificial, and as such, temporary. The world is being gagged with a force-fed dollar devaluation by means of an inflation via historically low interest rates and money creation at the U.S. Treasury level.

This will end soon because contrary to Dr. Alan Greenspan's recent outlandish remarks on Meet the Press, the United States CANNOT print all the dollars it wants and avoid defaulting on its debts. A default by any other name is still a default--whether the US merely refuses to pay its debts nominally or adopts an orgiastic printing press policy, it's a default no matter how one looks at it.

Prognosis: Deflationary crash.


Joblessness is high and/or on the rise in most Western regions; asset bubbles in real estate and financial assets have tapped out most owners and have squeezed future, potential buyers from the marketplace; further price declines must be on the docket in order to re-establish a semblance of equilibrium between buyers and sellers. Western governments are cutting spending to the tune of trillions of dollars annually, another engine for decline in aggregate demand. So-called growth tiger states like the BRIC (Brazil, Russia, India and China) are already showing signs of tempering growth and now reversing course. Dollar-based commodities are now at historical bubble peaks and will only likely reverse course in an equally violent manner; like a pendulum, it will overshoot on the decline as it has overshot on the rise.

But first, we suffer the inflationary squeeze in those dollar-denominated commodities as the US dollar implodes to a fraction of current value. Patience is a virtue.

PM




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