Gaping Hole in the Deflation Argument

There are many people still bandying around the idea that we will suffer a prolonged period of deflation. Their primary argument in support of this thesis is the fact that despite the ECB, the Federal Reserve, the Bank of England, the Bank of Japan and other Central Banks printing trillions upon trillions of currency out of thin air, the cumulative amount of this printing still does not equal the enormous wealth destruction that has occurred over the past several years. In this article, I’ll explain why this argument as the justification for prolonged deflation holds no water.

The figures regarding the level of wealth destruction over the past several years vary from $30 to $50 trillion. From October 31, 2007 to November 21, 2008, the MSCI World Index has fallen 51% which equates to losses of $21 trillion (source: the Financial Times). However, when you factor in losses in bond markets, currency markets, and collateralized financial instruments, and extend the time frame from one year to four years (2003 to 2007), according to an Asian Development Bank study (Global Financial Turmoil and Emerging Market Economies: Major Contagion and a Shocking Loss of Wealth), cumulative losses may very well exceed $50 trillion. In comparison, Bloomberg released a report at the end of March in which they estimated total U.S. bailout money at $12.8 trillion.

The basic deflationary argument is built around the premise that if you add up all the bailout money from the major economies of the world, this sum is still far less than the $30 to $50 trillion of wealth destroyed over the past several years, not to mention the trillions more that will be destroyed in coming years. Thus, a prolonged bout of deflation must be a certainty. However, the very premise upon which this argument is based is heavily flawed. The destruction of the paper value of these grossly distorted financial instruments has little bearing on global monetary supply growth and subsequent inflation, so comparing the destruction of paper wealth to the growth in monetary base is like comparing apples to oranges.

To illustrate my point with an analogy, consider that I lived on a small hypothetical island nation that had 88 inhabitants. I was the wealthiest citizen of this small island nation and decided to purchase a fleet of 100 Maybach 62 S. Though I didn’t realize it at the time, I overpaid for each car at a price of $800,000 because I dealt with an unscrupulous car dealer that took advantage of my naivete. Four months after I purchased my fleet, I realized my egregious mistake and that the market value of each car was only $450,000. Upon this realization, I marked down the book value of my fleet of Maybachs from $80 million to $45 million and that this markdown of $35 million in value equaled the entire wealth destruction of my island nation.

During the same period of my losses, the Central Bank of my small island nation decided to increase the monetary base by $45 million, $35 million of which ended up in the monetary supply. In this hypothetical scenario, would the value of my fiat money decline due to inflationary processes? Of course, because the monetary supply of my small island nation just increased despite an equivalent destruction of wealth. Though this is a hypothetical example, this analogy is absolutely applicable to real world situations.

If $50 trillion of grossly distorted paper values of stocks and other financial instruments have been destroyed over the past several years, this destruction can still have a muted effect on the growth rates of monetary supply that dictate inflation rates. What if a tranche of $50 billion of MBS (mortgage backed securities) had instead ballooned, at the height of our financial bubbles, to a paper value of $150 billion and would now be valued in the open market at $10 billion. Does that mean $100 billion of wealth was destroyed instead of just $40 billion?

In book valuations, yes, but in reality, no. Though MBS and ABCP (asset backed commercial paper) comprise some money market funds and money market funds are considered part of the monetary supply, certainly the bulk of the $50 trillion of wealth destruction has not been from financial instruments that constitute money supply.

The definition of M3 money supply is the cumulative amount of physical currency, demand accounts, savings deposits, money market accounts, time deposits, CDs, foreign U.S. dollar accounts and short-term repurchase agreements. Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, illustrated that Bank of America (BAC) booked a $2.2 billion gain this past earnings quarter by increasing the value of Merrill Lynch’s (MER) assets it acquired to prices that were even higher than Merrill’s own book values at the time of acquisition. And what if $1 billion of these gains disappear in the future when Bank of America actually sells these assets in the open market because the $2.2 billion valuation of these assets are delusional?

Does this mean $1 billion of “asset wealth” was destroyed? Of course not, because the valuations are meaningless to begin with. And that is why the destruction of $50 trillion will not have a significant deflationary effect, because the bulk of this destruction has not occurred with financial instruments that contribute to monetary supply but rather were paper losses derived from grossly distorted values of financial instruments. In reality, though the paper losses of financial instruments that plummeted as a result of this crisis will feel “real” to their owners, these paper losses merely mean that many financial assets have now dropped back down to their fair valuations or perhaps are even undervalued now.

In response to the trillions upon trillions of dollars being manufactured out of thin air, Dana Johnson, the chief economist for Comerica Bank in Dallas, stated, “The comparison to GDP serves the useful purpose of underscoring how extraordinary the efforts have been to stabilize the credit markets.” The belief that the best solution to solving a problem is repeating the mistakes that created the problem is exactly what is wrong about the central thesis of prolonged deflation.

I can only speculate about where and how deflationary theories garnered so much attention in the media, but I imagine that they in large were disseminated in the media by Central Banks and big banks. Why? Imagine if the world were to discover that in addition to causing this global financial crisis, that Central Banks were now engaging in policies that were going to further destroy the purchasing power of all paper currencies. Mutiny may very well arise upon this realization.

If deflationists still have trouble grasping my argument, then I will appeal to them with logic. From a logical standpoint, what possible reason would the U.S. Federal Reserve have to stop printing M3 statistics more than 3 years ago in March of 2006 if these numbers would support their deflationary arguments? Why is the British Parliament now following in the footsteps of the U.S. Federal Reserve with the introduction of a new banking bill that will abolish a 165-year old law that requires the Bank of England to publish a weekly account of its balance sheet? If a prolonged deflationary period will truly be the consequence of these massive increases in monetary bases, why are the world’s Central Banks not transparent and forthright about releasing money supply statistics?

Of course, the valid argument against massive future inflation is the fact that this bailout money must eventually end up not just in the monetary base but in the monetary supply. Though the U.S. dollar money supply growth rate has shrunk from a peak of about 17% in the beginning of 2008 to about 8% presently (source: Shadowstats.com), the money supply growth rate is still positive and quite significant at 8%, meaning that there has been no deflation this year nor last.

Granted, the slowdown in money supply growth rate has occurred due to the fact that U.S. banks are not lending right now, but if you understand that a bank makes money by creating money out of thin air (i.e. being able to create up to 100 times in loan amounts the value of the money they receive in deposits), then you will realize that for banks to survive they must create significant growth in monetary supply in the imminent future if they do not wish to collapse. Significant inflation can be avoided in the interim as long as

(1) The Federal Reserve and the U.S. Treasury continues to throw bad money after bad money by continuing to give trillions of more dollars of bailout money to banks; and
(2) Banks continue to refuse to lend and use their bailout money, aka our tax money, to continue propping up the U.S. Treasury market.

However, one thing is for certain. Banks cannot survive by producing fantasy land earnings based upon delusional internal asset valuation models. When this significant inflationary period arises, and it will, those that have realized that hard asset investments, including gold and silver investments, are the means to create wealth from this crisis, will be richly rewarded. We’re likely to see some downward pressure in the gold and silver futures markets in the very near term and specifically next Monday, but as we move into May and June, this current consolidation we are experiencing in gold and silver markets will likely give rise to the next significant leg higher.

Disclosure: No positions

Comments

[Dave Wrixon:]

Ultimately, dollars are only useful to the extent that they buy goods or assets. As American goods and assets are not particularly attractive at the moment your assertion of a dynamic for a strong currency is a bit bizarre to say the least.

Not only that by purchasing dollars against an ever increasing money supply has to be view as reckless speculation at its worst.


On Apr 23 08:53 AM Tom Colangelo wrote:

> Money supply and Velocity are key mathemetical measurements of what
> is happening, but not why?
>
> I believe that we have two WHY forces at work.
>
> 1) Relative value of dollar vs EURO, etc. If their economies are
> going down the tube faster than ours, then our dollar will be stronger
> in exchange markets and all IMPORTS to the U.S. will be relatively
> cheaper than in foreign countries. In addition, they will compete
> harder for our business (i.e. lower prices), because we will be the
> only game in town, so to speak.
>
> 2) Within our borders, however, we could have significant inflation
> for DOMESTIC originated goods and services, since we will have the
> classic example of more dollars competing for a limited amount of
> those goods and services.
>
> Now we can look at velocity and $supply to measure how the above
> are effecting our economy.

Apr 23 09:23 AM

[SebastianGE:]

Great Article, JS. Once again thanks.
I think everyone that commented this article is right: we will see inflation (worldwide), but noy yet. Some 101 Economics, just to add my humble oppinion here:
The Quantitative Money Theory resumes under this equation:
M x S = P x Q, where M is the amount of money, S is the circulating speed, P are prices and Q production. Under a stabilized period of the economy, the speed of money S stays the same, so whenever M increases faster than Q, P increases. This is what we know as inflation (at least one kind of, cause there are other types).
Since today M increases, but S decreases (as all bailouts are "trapped" into the Banks), as well as Q decreased a lot, you might see P (prices) stay the same or, mostly, decrease too.
But this won´t be forever. That´s when we´ll see inflation.
My two cents.
PS: forgive my language mistakes since english is not my first language.

Apr 23 11:01 AM

[SebastianGE:]

Cetin, i thought the same.

JS, i think you´ve put one word for another in that paragraph.

Apr 23 11:19 AM

[jdl51:]

It's quite possible that inflation may be an issue down the road, but at the present time, with the psychology of the American consumer being what it is, there is no demand for goods and services. Absent demand, it's hard to see inflation being much of a problem for the next few quarters. Add the rest of the world's consumers who are also hurting we're not just talking about a U.S. phenomenon. And now the banks are cutting everyone's credit limits putting a huge dent in purchasing power, still rising unemployment, whole industries going into bankruptcy or collapsing altogether, housing bouncing along the bottom at best and banks unwilling to give home equity loans on deflating collateral all contribute to an increasingly weaker consumer that would have to be the fuel behind an inflation scenario. The markets may feel that the Fed's printing presses will inevitably cause more inflation and start bidding up commodities, but if consumers aren't in the mood to spend it will only result in another commodities bubble, similar to what we had last summer, and with another commodities crash. I think most central bankers would welcome a wee bit of inflation at this point in time to nudge us out of our deflationary spiral.

Apr 23 11:19 AM

[Davinci:]

I was about to add my 2 cents worth about the economy when I realized everyone had a different opinion on how it works.

I am just going to stick to absolute truths and not predict what will happen.

1. Paper money has NO intrinsic value.
2. Gold has intrinsic value and has been money over the last 6000 years.
3. Paper money on the other hand the value of things priced in paper money ALWAYS goes up.
4. Things priced in gold do go up but stay in a wave pattern of over valued under valued that you can draw a flat straight line across. Thus over time prices of things you want seem to be flat when priced in gold.


The above points have been 100% true for 6000 years, thus when gold goes down you should not buy things with your gold you should save gold. When gold goes up in value you should buy things with your gold.

Sure you will never make any money with your gold but you can't lose if you follow the above strategy. Who knows you may get lucky and your government hyper inflates the currency and you can buy whole city blocks. :)

Apr 23 11:47 AM

[Mark A. Sad...:]

This article focuses excessively on monetary aggregates and asset values. While macroeconomists do pay attention to such things they play a relatively minor role in modeling inflation. Furthermore inflation can not really be thought of in a global sense as it is really based on individual currencies.

Macroeconomists don't try to use monetary aggregates to model inflation because the velocity of money is so volatile. And asset prices only play a role in determining inflation through their wealth effect. The standard rule of thumb for the wealth effect of asset values is about 5%. Thus the decline in U.S. asset values by about $14 trillion since 2007 should have a negative effect on aggregate demand of about $700 billion annually. However the potential disinflationary effect of this is contingent on a number of other factors.

The current standard (New Keynesian) economic model of inflation looks at two things: output gaps, or changes in output gaps, and the anchoring of inflation expectations. How output gaps affect inflation depends on how well inflation expectations are anchored. In the United States inflation expectations (core PCE) seem to have been fairly well anchored at about 1.9% since 1994. In the period that preceded that, from the late 1960s through the early 1990s, inflation expectations were not well anchored at all.

During the period when inflation was not well anchored output gaps generated disinflation and so inflation fell (as for example during the early to mid 1980s). On the other hand, when the economy was above potential inflation accelerated (as for example during the late 1960s and during much of the 1970s).

A key reference to consider in this context is the non inflation accelerating unemployment rate or NAIRU. NAIRU has been variable over time. It was over 6% during most of the 1970s. Today it stands at 4.8%. A good rule of thumb for estimating the output gap is Okun's Law. The Okun multiplier for the United States is currently about 2.1. Thus with unemployment at 8.5% in March, the output gap in March was about 2.1 x (8.5 - 4.8) = 7.8%.

Once inflation expectations became well anchored in the mid 1990s, the effect of output gaps on inflation noticably changed. When unemployment decreased core inflation tended to be above core inflation expectations. When unemployment increased core inflation tended to be below core inflation expectations. Thus during this latter period there has been no evidence of disinflation or inflation acceleration, and consequently core PCE inflation has bounced around between 1.3% and 2.3%.

So as long as inflation expectations remain well anchored expect core inflation to be near 2%. With unemployment rising for the forseeable future it should be somewhat below 2%. When unemployment starts to fall it should be somewhat above 2%.

The only reason that we might see core deflation is if inflation expectations become unanchored. Then persistent high unemployment could lead to disinflation. Currently I don't think that is very likely. But it is far more likely than the possibility of accelerating inflation given that we are likely to be experiencing a large output gap for many years to come.

Apr 23 12:28 PM

[Jaysan:]

Wrixon's comment is correct. The monetarists who assumed that an increasing supply of money always causes an increase in the price level forgot to consider the impact of credit (in the present situation, the lack of credit).


On Apr 23 06:59 AM Dave Wrixon wrote:

> This really is only part of the story.
>
> You need to explain the difference between Money and Credit. As I
> understand it the amount of Money in the system is fixed until the
> Fed expands its balance sheet, but the amount of "money" that the
> rest of us have which is largely made up of credit, either direct
> or indirect simply varies with economic activity, and the level of
> lending undertaken by banks. If book values of assets are marked
> down then the amount of credit that can be pumped into the system
> is much diminished.
>
> Further, analogizing to Physics it is not Mass that we interested
> in but Momentum. It is not just the amount of money out there but
> also about how many times that money actually becomes part of the
> means of exchange. Money has been defined as the means of exchange.
> It has no intrinsic value, and its importance it down to the extent
> that it facilitates business transactions. If that is not really
> happening, then to some extent is just lots of bits of paper.
>
> Of course the problem is that to get the money to move you have to
> build up Head. This head is being provided by piling the cash higher
> and higher, but it is still not really moving. Until it starts moving
> it not inflationary, nor does it have much impact on a deflationary
> enviroment. The problem is that when the money does start to move
> then it will tend very rapidly to make goods short due to its shear
> volume. At that moment the Fed has promised that it will make it
> all disappear again, but it is not abundantly clear to me how that
> can happen without cause another huge disjunct in the economy.<br/>
>
> In the meantime the ever growing piles of dollars is not only creating
> the perception that the individual bills are becoming increasingly
> worthless, indeed it must be true. In fact there is double whammy
> going on because the Tax Base that guarantees the dollar is also
> shrinking rapidly. So each dollar holder has an ever decreasing share
> of an ever shrinking pie. It cannot be long before the holders of
> these dollars start to get desperate to lock in the face value of
> the depreciating bits of paper in to assets that do have intrinsic
> value, or to simply get some immediate gratification from them. When
> that happens you have a very inflationary scenario.

Apr 23 01:31 PM

[doubleguns:]

The only bonds you want to hold during inflation would be TIPS.


On Apr 23 08:43 AM User 305589 wrote:

> your argument is valid. however, it should be clear to any observer
> that prices for assets as well as for goods and services were artificially
> inflated due to the credit bubble of the last 10 years. U.s. consumer
> demand was propped up temporarily by inflated house prices (the refinancing
> atm) and this has also propped up prices for cars, computers, refridgerators,
> restaurants, hairdressers - you name it. You will have a strong deflationary
> effect from the negative wealth effect, make no mistake about that.
> recessions are by definiton deflationary and deep recessions have
> even stronger deflationary impacts.
> that being said, the govt with the increased debt load and all the
> unfunded future obligations of about 50trillion $ at one point will
> have no choice but to either inflate or revalue the paper money.
> while i see gold and silver as good insurance against such steps,
> they are not the superior inflation hedge. stable, income producing
> investments like good quality bonds and high quality stocks are much
> better hedges against inflation.

Apr 23 01:31 PM

[clipper:]

A few years ago people were purchasing homes for $500k on various mortgage plans because they percieved the value of the home in line with the price. Today, those same buyers are walking away from those mortgages and commitments because their percieved value of the home is much lower. That is real deflation, its not about M1 or M2.
In your example, what if you had purchased the cars with 5% down and financed the remainder? Now the richest guy on the island has a default and poor credit. The bank is stuck with the note and no market for the vehicles at the purchase price. It seems the only logical next step is to tax the remaining solvent Islanders and give that money to the bank so it can satisfy its lending covenants and continue to lend, thus stimulating economic growth. Of course this leads to the unforeseen result of reducing the market value of the cars further because due to their new tax burdens the Island folk have no money to purchase the cars, even at the deep discount. So the bank, not wanting to write down another loss on the vehicles, makes a deal with a hedge fund to finance it to buy the cars at an inflated price with very little risk ............... Every time the potatoe (did I spell that right?) gets tossed the price goes down. If this process goes on long enough the credit value lost will leverage into M1 and M2. Because this bubble is so big its just not concievable yet .... but neither was DOW at 7000 a year ago.

Apr 23 01:44 PM

[dcb:]

Perhaps it is time to rethink the idea that deflation is such an awful thing. If you aren't getting a raise, are living off of you savings, and are paying for services the value of each dollar increases giving you more free cash. lower energy prices=cheeper gas
If you have spent too much then the value of your debts increases relative to purchasing power.
Avoiding deflation is the way the fed serves the interest of wall street. Since we all know what is going on behind closed doors, this has to be taken in that context as another way to bail out banks without congressional oversight.
As I discussed with my macro professor. deflation hurts those who have gotten us into this mess. Fed policy is designed to help them at the expense of everyone else. (he told me this) (Prof. Ingo Walter, stern school business)

Apr 23 02:25 PM

[Fred Voetsch:]

Like inflation, deflation takes a bit of time to build. In the 1970s inflation became the norm as people came to understand that it was in their interest to spend now before their dollars became worth less.

Deflation already existed in 1929 and so had a head start over ourcurrent period. But now we hear more and more about frugality and we see deflationary pressures creep into every aspect of our economy. Deflation is a spiral that gets stronger and stronger until it exhausts itself.

As long as the typical consumer has lots of debt and little savings while fearing for their jobs this deflationary spiral will build and strengthen and all the talk in the world will not stop it.

Apr 23 02:52 PM

[Dave Wrixon:]

That argument is valid only as long as the guarantees behind the currency maintain their value. In the current scenario, the ever increasing amount of money on the Fed Balance sheet and ever increasing government debt will severely undermine the credibility of the dollar which is not likely to promote hoarding. Dumping the dollar is a more rational reaction. It could well be that things start to deflate rapidly when measured against ounces of gold or barrels of crude or even hogs, but $US dollars? I very much doubt it!


On Apr 23 02:52 PM Fred Voetsch wrote:

> Like inflation, deflation takes a bit of time to build. In the 1970s
> inflation became the norm as people came to understand that it was
> in their interest to spend now before their dollars became worth
> less.
>
> Deflation already existed in 1929 and so had a head start over ourcurrent
> period. But now we hear more and more about frugality and we see
> deflationary pressures creep into every aspect of our economy. Deflation
> is a spiral that gets stronger and stronger until it exhausts itself.
>
>
> As long as the typical consumer has lots of debt and little savings
> while fearing for their jobs this deflationary spiral will build
> and strengthen and all the talk in the world will not stop it.

Apr 23 03:23 PM

[Tony Daltorio:]

Absolutely fantastic article! But you wasted your time trying to convince the deflationists.

Look at some of the comments about a deflationary psychology among the populace. Anecdotally, I have actually seen the exact opposite psychology an inflationary psychology. Even people with little understanding of economics understand that with the Fed creating trillions of dollars of money out of thin air, that money will be worth less. It's the basic instinct - you can't get something of value for nothing (unless you're Goldman Sachs).

Apr 23 03:59 PM

[Craig W:]

I find your argument well thought out and compelling; however, I'm not sure the battle between the inflationary and deflationary forces at work in our economy has yet been resolved.

There is no doubt that the base money supply is increasing at a rapid rate, but we must also consider the fact that demand for base money is also increasing at a rapid rate. While "paper losses of financial instruments that plummeted as a result of this crisis [do] feel “real” to their owners", people have also seen balance sheet degradation as real assets have fallen in value. Additionally, workers fear that their incomes are in jeopardy and rightfully so. As a result, people are shying away from debt and saving more in an effort to repair their balance sheets (In the long view, this is a good thing). This phenomenon results in an increase in demand for base money while creating more slack in demand for debt and for the production of goods and services. These are certainly very strong deflationary forces that can initiate a negative feedback loop.

Inflation will take hold when and if the increasing supply of base money outstrips the increasing demand for base money resulting in a fall in the value of the currency. It is certainly clear that the Federal Reserve and the current Administration are hell bent on achieving this outcome. However, deflation can take hold even in the face of a rapid increase in base money supply so long as the demand for base money rises at an even faster rate. After all, you can’t force people to borrow and spend . . . perhaps the people will continue to repair their balance sheets and refuse the “easy” money as they have over the past months (debt is being destroyed, savings is increasing). To your point, the central banks of the world do not need to create enough money to offset all of the world’s losses, real or otherwise, to cause inflation . . . they need only create more money than is required by the populace. The question is how much base money is required, and will the government, when and if it satisfies the increased demand, have the discipline to shut the printing press down once that demand is met? As “government” and “discipline” seem to be incompatible, I’d bet on inflation taking hold eventually, but I would not be shocked to see deflation prevail for as much as a few years before the inflation party really gets started.

Apr 23 04:27 PM

[Steve Pasq:]

Money seems to have different strengths depending on whose hands it happens to be in. An unemployed person with a dollar can't really do anything except consume its value. On the other hand the 7-11 owner who sold the beer to the unemployed person for the dollar may take the 50% profit and use it as a down payment on another probably less profitable enterprise.

However when the Fed creates a dollar--that particular dollar is very powerful. Because those dollars are put into slightly less powerful hands that can lever them 10-20 times.

The point is that the $50 trillion lost dollars were less powerful than the $12.8 trillion created. The banks will lever the new money by at least 10 times to create $128 trillion more than doubling the losses.

In my book the best thing to do right now is borrow every cent you can via long-term credit and use those dollars to buy gold. When you own gold you have the power of a Central Bank.


On Apr 23 06:59 AM Dave Wrixon wrote:

> This really is only part of the story.
>
> You need to explain the difference between Money and Credit. As I
> understand it the amount of Money in the system is fixed until the
> Fed expands its balance sheet, but the amount of "money" that the
> rest of us have which is largely made up of credit, either direct
> or indirect simply varies with economic activity, and the level of
> lending undertaken by banks. If book values of assets are marked
> down then the amount of credit that can be pumped into the system
> is much diminished.
>
> Further, analogizing to Physics it is not Mass that we interested
> in but Momentum. It is not just the amount of money out there but
> also about how many times that money actually becomes part of the
> means of exchange. Money has been defined as the means of exchange.
> It has no intrinsic value, and its importance it down to the extent
> that it facilitates business transactions. If that is not really
> happening, then to some extent is just lots of bits of paper.
>
> Of course the problem is that to get the money to move you have to
> build up Head. This head is being provided by piling the cash higher
> and higher, but it is still not really moving. Until it starts moving
> it not inflationary, nor does it have much impact on a deflationary
> enviroment. The problem is that when the money does start to move
> then it will tend very rapidly to make goods short due to its shear
> volume. At that moment the Fed has promised that it will make it
> all disappear again, but it is not abundantly clear to me how that
> can happen without cause another huge disjunct in the economy.<br/>
>
> In the meantime the ever growing piles of dollars is not only creating
> the perception that the individual bills are becoming increasingly
> worthless, indeed it must be true. In fact there is double whammy
> going on because the Tax Base that guarantees the dollar is also
> shrinking rapidly. So each dollar holder has an ever decreasing share
> of an ever shrinking pie. It cannot be long before the holders of
> these dollars start to get desperate to lock in the face value of
> the depreciating bits of paper in to assets that do have intrinsic
> value, or to simply get some immediate gratification from them. When
> that happens you have a very inflationary scenario.

Apr 23 05:11 PM

[Steve Pasq:]

Money seems to have different strengths depending on whose hands it happens to be in. An unemployed person with a dollar can't really do anything except consume its value. On the other hand the 7-11 owner who sold the beer to the unemployed person for the dollar may take the 50% profit and use it as a down payment on another probably less profitable enterprise.

However when the Fed creates a dollar--that particular dollar is very powerful. Because those dollars are put into slightly less powerful hands that can lever them 10-20 times.

The point is that the $50 trillion lost dollars were less powerful than the $12.8 trillion created. The banks will lever the new money by at least 10 times to create $128 trillion more than doubling the losses.

In my book the best thing to do right now is borrow every cent you can via long-term credit and use those dollars to buy gold. When you own gold you have the power of a Central Bank.


On Apr 23 06:59 AM Dave Wrixon wrote:

> This really is only part of the story.
>
> You need to explain the difference between Money and Credit. As I
> understand it the amount of Money in the system is fixed until the
> Fed expands its balance sheet, but the amount of "money" that the
> rest of us have which is largely made up of credit, either direct
> or indirect simply varies with economic activity, and the level of
> lending undertaken by banks. If book values of assets are marked
> down then the amount of credit that can be pumped into the system
> is much diminished.
>
> Further, analogizing to Physics it is not Mass that we interested
> in but Momentum. It is not just the amount of money out there but
> also about how many times that money actually becomes part of the
> means of exchange. Money has been defined as the means of exchange.
> It has no intrinsic value, and its importance it down to the extent
> that it facilitates business transactions. If that is not really
> happening, then to some extent is just lots of bits of paper.
>
> Of course the problem is that to get the money to move you have to
> build up Head. This head is being provided by piling the cash higher
> and higher, but it is still not really moving. Until it starts moving
> it not inflationary, nor does it have much impact on a deflationary
> enviroment. The problem is that when the money does start to move
> then it will tend very rapidly to make goods short due to its shear
> volume. At that moment the Fed has promised that it will make it
> all disappear again, but it is not abundantly clear to me how that
> can happen without cause another huge disjunct in the economy.<br/>
>
> In the meantime the ever growing piles of dollars is not only creating
> the perception that the individual bills are becoming increasingly
> worthless, indeed it must be true. In fact there is double whammy
> going on because the Tax Base that guarantees the dollar is also
> shrinking rapidly. So each dollar holder has an ever decreasing share
> of an ever shrinking pie. It cannot be long before the holders of
> these dollars start to get desperate to lock in the face value of
> the depreciating bits of paper in to assets that do have intrinsic
> value, or to simply get some immediate gratification from them. When
> that happens you have a very inflationary scenario.

Apr 23 05:11 PM

[I am not a ...:]

And Finally we come to Z ,Z for Zimbabwe...look and learn what printing more money does and has done for the hundred years .

Apr 23 05:31 PM

[Chris B:]

Three common mistakes:

1) Inflation does not equal changes in the supply of money. It is a long-term increase in prices. See your econ. textbook.

2) The vast majority of the "stimulus" packages went to purchase things (bonds, treasuries, equity, etc.). These were largely transactions, not handouts (the summer 2008 "stimulus checks" on the other hand, were handouts). These transactions are reversible.

3) Assuming that paying 20% over historically high spot metal prices for collector coins will protect your purchasing power from inflation. That will depend on whether your collector coins will, in the future, be in higher demand than the assets that could otherwise be bought with that money.

It used to be considered common-sense wisdom that real estate was the best way to protect oneself against inflation. After all, there's a fixed amount of it and you can always raise rents. In fact, generic real-estate pundits like Robert Kiyosaki advocated buying up residential housing in 2006 on the justification that inflation HAD TO BE right around the corner and that real estate prices were rising because people were finally figuring this out. People who took that advice bought at the peak of the bubble. Might there be a lesson there for gold investors?

Apr 23 05:34 PM

[Jaysan:]

My hedge fund manager pal responds to Kim's column - his response shows the importance of defining our terms more carefully:

It depends on your definition of "inflation." The term he is using is more associated with money supply expansion or "Austrian Inflation" whereas the term most people use is associated with CPI inflation and increasing asset prices.

There is a difference between destruction of the value of the currency and inflation. A currency can devalue versus real money, as all did in the 1930’s, while the basket of goods included in inflation indexes declines, as also happened in the 1930’s. Money supply can go up, as it has since the late 1990’s without much impact on CPI inflation rates too – though the increase in money supply relative to gold leads to an increase in the price of gold that reflects true currency devaluation. Even deflationists here suggest currency being devalued versus gold as Marshallian K increases and the money supply expands relative to GDP. The issue is whether this will be reflected in price inflation gauges or whether price inflation gauge goods will continue to decline.

No one is arguing that the central banks will not continue to expand their balance-sheets – yet if the monetary base soars while the money multiplier continues to plummet, this won’t translate into higher prices of CPI goods, though it will likely translate into higher gold prices a la 1930’s.

His definition of inflation is money supply expansion, which is an Austrian definition. But money supply can expand while CPI goods and many asset values continue to decline.

He also puts too much power in the hands of banks. The lack of credit expansion is also due to lack of credit-worthy borrowers. The level of leverage possible in residential property is now at its lowest level since the 1930’s – where will the borrowers come from to fund this massive credit expansion, even if the banks somehow change their behavior, which is unlikely and still trends clearly toward tightening lending standards?

I agree with his conclusion about gold, but whether we face deflation or inflation from this central bank expansion is not yet clear on a CPI and asset-based basis.

Apr 24 04:25 AM

[Gaume:]

Bingo.


On Apr 23 09:17 AM History Buff 24/7 wrote:

> I think a good point has been made in some of the other comments
> that it's not just the economics of the situation that need to be
> analysed but the psychology. If people stop spending money there
> are real deflationary pressures, no matter what the cause.

Apr 30 11:17 PM