The Simple Explanation of Bailouts, Inflation, and Deflation

by: Simit Patel

Yesterday the US Congress has announced that they agreed to the terms of a large bailout package -- something we've been seeing a good deal of lately.

This should beg the question: what causes a need for bailouts?

To put it simply, money supply. Here's a step by step breakdown of how an economy can go from healthy to being in need of bailouts:

1. Let's assume a starting point where the money supply of an economy is appropriate -- meaning there is roughly the right amount of money relative to the productive capabilities of that economy.

2. Then let's assume that from this starting point the money supply is expanded. In an economy with a central bank, one way this can be done is by keeping interest rates too low. For instance, starting in 2001 and leading until June of 2003, the Federal Reserve cut interest rates 13 consecutive times, taking them from 6.5% to 1%. The impact of this on the money supply can be seen below.

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3. Money supply expansion creates a short-term boom, as there is new capital in the economy that makes for a warm investment climate. Unfortunately, though, because the money supply has been expanded excessively relative to the productive capabilities of the economy and its appetite for consumption, the result is often what is referred to as malinvestments -- investments made in projects that were too capital intensive, but only seemed profitable and appropriate at the time because the money supply was excessively expanded. In the United States, this led to an excessive number of houses being created and purchased -- something now referred to as the housing bubble.

4. Of course, an excessively expanded money supply devalues a currency and leads to inflation, and thus creates pressure to raise interest rates. In other words, the market is trying to correct itself, and return the money supply to an appropriate level. And so after taking rates to 1% in June of 2003, the Federal Reserve raised rates 17 consecutive times, until they reached 5.25% in June of 2006. This reduced the ability to finance and purchase capital intensive investments -- like homes -- and thus we saw the housing market begin to collapse, with demand drying up and housing prices falling.

This leads us to where we are today.

Depression: Inflationary vs. Deflationary, and What It Means For Traders

The market is trying to remove the excess capital that was injected into the market, and return the money supply to a reasonable level by forcing bad investments to fail. This naturally causes asset prices to fall, particularly in areas where the malinvestments were made (housing, financials).

If the market were left to its own recourse or with minimal intervention, we would have a deflationary depression. This would result in a tightening of the money supply, which would likely strengthen the US dollar, and affect correlated markets accordingly -- meaning sending oil prices and gold prices down (this is of course assuming that all other factors constant -- i.e. demand and supply of oil -- were to be held constant). Areas of malinvestments -- most notably the housing and financial sector -- would represent opportunities for short sellers. 

When bailouts do occur, it is an attempt to expand the money supply, so that the pain of deflation does not need to be experienced. This results in further currency devaluation and inflation.

By properly understanding the true causes of bailouts and the consequences of government actions, traders can most easily find opportunities in trading sector ETFs accordingly.