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Modern currency (money) is little more than a unit of measure, which is used to facilitate the exchange of goods and services. Currency is now largely digital. This carries significant differences from past times when money was tied to a physical commodity such as gold, silver, copper or even paper.

The major central banks in the developed world have been doing unprecedented monetary easing (somewhat inaccurately called "printing money") since the 2008-2009 financial crisis.

The Federal Reserve (U.S. Central Bank) is in charge of the monetary supply and is charged by Congress with a dual mandate:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates. --Chicago Fed

The U.S. Federal Reserves' dual mandate is unique to the U.S. The European Central Bank has a single mandate: Price stability (this would indicate that the ECB is more concerned with controlling inflation than deflation).

Price stability relates to maintaining the currency as a stable unit of measure. The Fed's target is around 2% inflation per annum, in an attempt to keep the economy growing.

The U.S. was the first to organize the modern version of a central bank in 1913. This was in response to the 1907 financial crisis, where the stock market lost about half its value in a few days. Amid the panic, JP Morgan personally came forward and started buying stocks hand over fist. This injected sufficient liquidity into the market to restore confidence and turn the crisis around.

The Fed built a new site on a patch of and encompassing Maiden Lane, Nassau and Liberty Streets.

NY Fed Building Under Construction, 1922.

Prior to the presence of a central bank, there was a major boom/bust cycle about every 10 years, the bust phase was often accompanied by bank runs. The primary purpose of the central bank is to protect the vulnerable banking system or perhaps more accurately described as the fractional banking system:

A bank takes on deposits from several depositors. The bank knowing that it is rare for all depositors to withdraw all of their money at once proceeds to lend out (using paper instruments) much more than the total that they have on deposit. This works great and hugely multiplies the bank's revenue until there is a bank run, where depositors wish to withdraw as a total more than the bank has currently on deposit. Without support, the bank collapses due to insolvency.

This is why bank runs were so feared before the central bank was around to back up the fractional banking system. Now, when there is any hint of a bank run or any lack of liquidity in the system, the central bank simply injects liquidity.

In the 19th century most of the boom/bust cycles were brought on by agricultural supply and demand imbalances. The farmers would have a good year and would plant more the next year and yet more the next, until there was an oversupply. Then, the prices of the commodity would drop and the farmers, not understanding economics, would plant still more to try to make up for the lower prices (deflation) by producing more volume. This eventually would lead to a collapse in the commodity price, which in turn would cause a significant portion of the farmers to lose their farms. This reduced the supply of the commodity and then the price of the commodity would start to recover.

There was very little the government could do about these boom/bust cycles because the currency was tied to a commodity gold (NYSEARCA:GLD) of which there is only a limited quantity.

Now that the currency has been unpegged from a commodity it can be expanded and contacted at will by the central bank. The danger with too much expansion of the monetary supply is inflation. The danger with too much contraction of the monetary supply is deflation. These both describe a lack of price stability. The monetary supply can be expanded (example: buying bonds, mortgage backed securities, etc) or contracted (raising interest rates, selling bonds, mortgage backed securities, etc) at will by the central bank, literally at a keystroke.

As money has become digitalized (starting in about the 1960s) the dangers of runaway inflation have become significantly reduced due to the control that the central banks have over the money supply.

The hyperinflation situation that the German Weimar Republic faced after WWI was complicated by its lack of control over the money supply. It attempted to inflate the currency to diminish the debt burdens from WWI. Since it was using paper money (which is tangible, though not of any significant value in and of itself) it was easy to print the money (expand the monetary supply) but it was not possible to recall all that paper currency once hyperinflation took off. The German Mark eventually collapsed as the authorities were unable to maintain its stability as a unit of measure.

The Start of The Super Bubble: The power of a stable, digitalized currency has allowed the developed world to experience a boom cycle that started after WWII (partly as a response to the great depression) and ended with the housing crisis bubble bursting in 2007, which led to the credit freeze of 2008-2009. This half-century boom cycle coordinated with the demographic tailwind of the baby boomer generation.

Chart forS&P 500 (^GSPC)

The Greatest Generation's belief in the purchasing power of its currency combined with the hardships witnessed during the depression gave rise to high savings rates and a culture of financial responsibility. The generation equated having a growing savings account with security and prosperity.

After WWII, U.S. Debt to GDP was about 160%. The economic outlook was still grim after the war and depression, but the people as a whole were ready to do whatever it took to succeed and have a good life. Through the 1940s and '50s the Federal Reserve practiced an easy monetary policy in an attempt to revive the economy. Sweeping government programs came into favor in an attempt to engineer a "great society." The economy came back to life and by the time the Baby Boomers were in their early adulthood, inflation was the name of the game.

The difference between being raised in a deflationary environment vs. an inflationary one caused a significant difference in the perceptions of and attitudes toward the relationship between money and buying power. The argument could also be made that materialism was perceived very differently by the two generations. The parents saw materialism as the profligate spending of money on stuff, while the Boomers saw materialism as the hoarding of money.

The parents of the Boomers, having experienced deflation (seeing that their dollars increased in purchasing power), were comfortable saving their money and being conservative in their consumer spending.

This differs dramatically from the Boomers who experienced the inflation (seeing their dollars decrease in purchasing power) of the '70s and developed an attitude of "spend it now, before it's worthless."

(click to enlarge)

Add the leverage of increasingly easy access to credit through the 80s and 90s and you have a recipe for out-of-control spending--which is what happened.

The relative absence of any serious bust cycle in that 50-year boom time frame led to the creation of a super-bubble. The super-bubble is now in the danger of deflation (at the same time that the baby boomer generation is retiring at 10,000 per day). This potential bursting (a crash over a relatively short period of time) of the super-bubble, which started with the bursting of the housing bubble in 2005-2009, has the potential to lead to the biggest deflationary threat ever faced.

This deflationary threat is what the central banks are currently attempting to fight by adding huge amounts liquidity to the financial system. This causes imbalances and bubbles of its own.

Falling incomes and declining real wages are putting increasing pressure on the consumer. Meanwhile, the Fed continues to attempt to stimulate the economy and lower the unemployment rate by means of monetary easing. However, it seems that the real effects of the Fed's actions are starting to show up in commodity prices being propped up while incomes and wages stagnate and fall. Rising taxes are a part of this equation.

As we dig into this a bit further, it appears that an economic cycle may be starting to develop:

The Fed eases to stimulate the economy, this props up asset and commodity prices. Fewer people, especially those with lower incomes, can then afford these necessities. This causes those people to seek government assistance. Ballooning government assistance programs then add to the deficit and national debt. Higher taxes are then needed to close the deficit gap. Higher taxes and high debt to GDP drag on the growth of the economy and then...more stimulus is needed. See start of paragraph to go through the cycle again.

This does not appear to be the beginnings of a virtuous economic cycle. In fact, this cycle, and more pointedly the growing gap between incomes and consumer prices, could force the Fed to rethink its current monetary easing actions. In its 2012 annual report the Bank For International Settlements (pdf) warned the central banks of the developed world that imbalances of this nature could result from the over-use of monetary easing tools.

The BIS report also warned that the independence of the central banks could be at risk if imbalances such as those described above go too far. In other words, the central banks could come to be seen as the consumer's enemy rather than a friendly economic force.

Conclusion:

Since the 2008-2009 financial crisis, we are in a period of a generally defensive and conservative financial mindset among investors. If history is a guide, this more conservative mental construct is unlikely to change much over the next couple of decades as a generation that has been shaped by the current deflationary environment comes on the scene. This relatively conservative financial mindset is evidenced by the persistently low bond yields of perceived safe-havens and on-going strength of the U.S. dollar.

Using this broad-based framework as a foundation of understanding market behavior, it is not unreasonable to say that a core mindset of speculation is generally out of favor. This is not to say that speculation does not currently exist--it does and likely always will. Speculative bubbles however, are much more likely to be limited in size and scope than in a less defensive financial environment.

As this core base-line of a financially conservative investor outlook is expressed in the bond yields of perceived safe havens, by monitoring these yields, we can see changes rather easily and examine them. This goes without saying, that those looking for large gains in a short time by trying to short-sell safe-haven bonds are likely to be disappointed unless there is some catastrophic event.

The better spots to look for significant returns in this type of environment, are those places where bubbles form in fear of financial disaster or in frustration with the slow-growth environment.

As leverage is being reduced world-wide, it is relatively easy to see that in a normal situation deflation (money becoming more valuable in reference to the price of goods) would result. However, the central banks are committed to fighting deflation through monetary easing; this will likely add to the volatility experienced in this general de-leveraging period.

This major shift, from a generally expanding credit situation to a contracting one, calls for a major shift in thinking about the future value of the U.S. dollar. The many warnings, often from seemingly credible sources, regarding the value of the U.S. dollar (DXY) being at risk due to runaway inflation, presuppose that the underlying fundamentals remain the same as they have been since the 1970s.

The Federal Reserve has gone from defending against inflation, to a stance of locking arms with central banks around the world in a desperate fight against deflation, and it does not appear that the fight is anywhere near over. This major shift in the approach of central banks in regard to monetary stability should not be ignored.

As the world-wide deleveraging process works itself out there will likely be many opportunities to purchase assets at fire-sale prices. Having a store of value will be key. The most stable store of value over the next few years is likely the primary reserve currency of the world--the U.S. dollar.

Historical Data Chart

ETFs for going long the U.S. dollar include: (NYSEARCA:UUP), (NYSEARCA:UUPT)

Should it be seen that the Fed's actions are starting to have a negative effect on the all-important consumer, it would stand to reason that current aggressive Fed policy would have to be adjusted.

It is likely that as we go forward, a shift from a focus and dependence on Federal Reserve monetary policy actions, to fiscal and legislative economic actions will take place. This shift has been made difficult by a sharp political divide, which still exists. The necessity of a shift of this nature will be made clear should it be shown that the Fed's easing actions are reaching the point of diminishing returns.

If the Fed is forced to scale back its monetary easing actions without reaching its stated goal of low unemployment (6.5%), it would likely be attributable to an economic imbalance such as the one described above that may be taking shape right now. A policy shift by the Fed in such a situation would likely signal a deflationary environment.

In a situation of this nature I would look at shorting U.S. equities as their incredible multi-year run has been largely predicated on real inflation starting to take hold. A necessary ingredient for inflation is that the consumer has extra money to spend. Falling incomes and rising prices are not likely to lead to a true inflationary environment. In other words, people have to have money to spend in order for real inflation to happen.

U.S. Equity Index ETFs and ETNs include: (NYSEARCA:SPY), (NYSEARCA:SDS), (NYSEARCA:DIA), (NYSEARCA:DXD), (NYSEARCA:IWN), (NYSEARCA:TWM).

In a deflationary situation, the already crowded bond market could see even further increases and falling yields. Going long bonds during a time of deflation could be a profitable trade.

Bond ETFs and ETNs include: (NYSEARCA:BND), (NYSEARCA:TLT), (NYSEARCA:LQD), (NYSEARCA:HYG), (NYSEARCA:JNK).

The past performance of Treasury Inflation Protected Securities or TIPS ETFs indicate that going short these ETFs in times of deflation is likely to be a profitable trade.

TIPS ETFs and ETNs include: (NYSEARCA:TIP), (NYSEARCA:SCHP), (NYSEARCA:IPE)

For guidance on when to exit positions given the scenario above, I would look for legislative and fiscal action that would start to aggressively take the place of monetary stimulus. For a historical guide, the actions taken by the FDR administration to lower the unemployment rate in the late 1930s and '40s should be considered as somewhat of a historical norm that governments have tended to follow to correct rising unemployment and a generally deflationary situation by fiscal means.

Please remember that levered ETFs are designed for short-term trading.

Source: Understanding The Fed, The Super Bubble And Your Money