The Simple Explanation of Bailouts, Inflation, and Deflation

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.

Comments

[2bz:]

Absolutely! However, since the Fed dropped its pants from the 5.25% levels putting us well on the road to stagflation rather than a deflationary recession. Flooding the market with money will only further aggravate the inflationary pressures. On the other hand, the collapse of a large number of banks will definitely drive us into a recession in the short term. Fortunately, in the latter scenario new banks will be created which, after the smoke clears, will lend out money and investors confident that the trash has been taken out will again buy equities and debt with confidence.

2008 Sep 26 03:09 PM

[Al-USA:]

Very good article. Informative in light of the push for the $700,000,000,000 bailout.

2008 Sep 26 06:14 PM

[birder:]

AND, since the Fed has dropped interest rates again to near zero levels we can expect more mis-allocation of capital. We might possibly even expect the worst of my fears. Runaway inflation. Zimbabwe here we come. Of course, I think that is exactly what the Fed is attempting to orchastrate. Makes the national debt worthless. I just love it when a borrower can devalue the currency he has borrowed.

2008 Sep 27 10:19 AM

[LouieK:]

Does the lowering of interest rates cause monetary expansion OR does economic expansion lead to a need for increased monetary expansion that then allows the Fed to lower interest rates to be accomodative? If the later, then your thesis falls apart and the Fed acted correctly. The bailout problem lies in the political expediencies of a public policy which wanted to encourage sub-prime mortgage homeownership.

2008 Sep 27 12:04 PM

[LouieK:]

I might add, after watching morning news reports, that apparently hundreds of thousands of mortgages were fraudulently taken out for illegal immigrants. This became a problem when those people, because of the anti-immigration raids recently enacted, decided to go back to Mexico and abandon their American houses.

2008 Sep 27 12:10 PM

[dlaw:]

This Fed-blaming is nonsensical in the face of the obvious fraud that is bringing down these financial stocks.

The private banking system clearly expanded the money supply with fraudulent securities and now the market has lost faith in these institutions.

The idea that a deflationary depression stemming from financial criminality is a good thing is absurd, unrigorous, laissez-faire b.s..

2008 Sep 27 02:08 PM

[2bz:]

LouieK wrote: "does economic expansion lead to a need for increased monetary expansion that then allows the Fed to lower interest rates to be accomodative?"

This should never be necessary. During economic expansion equity rather than debt should be the desirable financing mechanism. See the example of the .com bubble. Lowering the interest rates during a period of economic expansion only leads to (or fans) inflationary bubbles.

2008 Sep 28 06:03 PM

[2bz:]

dlaw wrote: "This Fed-blaming is nonsensical in the face of the obvious fraud that is bringing down these financial stocks."

First, there must not have necessarily been fraud (though no doubt there was fraud), just irrational exuberance (everyone wanted to be a real estate mogul).

Second, the Fed was at the stern and they were, at least partially, the responsible regulator who should have put a kibosh on the fraud as it was occurring.

2008 Sep 28 06:07 PM

[greenspam:]

dlaw wrote: "The private banking system clearly expanded the money supply with fraudulent securities and now the market has lost faith in these institutions."

Basically the Banks increased money supply. Its not just about everyone wanting to be a real estate mogul. Or a commodities speculator buying on massive leverage (credit).
Fed injection of liquidity through lower-interest rates is one measure of (access) money. money Supply = Money x Velocity. Velocity is how fast a given amount of money is circulated in an economy. One dollar that is quickly spent, lent, traded, turned into a note and the note traded.. acts like ten dollars. By creating CDO's and derivatives of derivatives, banks not only created a derivative of money (credit) which enabled credit to be lent at a rapid pace. This rapid lending increased house values, which in turn allowed more lending to take place. This massive credit basically converts into turbo charged Velocity in the Money Supply equation. Both the private and public banks (Freddie and Fannie included) created this massive credit bubble. Once someone questioned the underlying worthiness of the bank's notes, the credit pyramid scheme came crashing and credit dried up. So dlaw is right. The banks created money out of nowhere by creating a massive expansion of credit (increasing velocity).

2008 Sep 29 06:06 PM

[theinlawjosie:]

"This Fed-blaming is nonsensical in the face of the obvious fraud that is bringing down these financial stocks.

The private banking system clearly expanded the money supply with fraudulent securities and now the market has lost faith in these institutions."

Ever heard of the Community Reinvestment Act? If the government didn't force the banks to "expand the money supply with fraudulent securities" and have a Government Sponsored Enterprise (Fannie Mae) back the "fraudulent securities" we wouldn't be in the situation we are in right now.

2008 Oct 03 12:02 AM

[phineline:]

You hit the nail right on the head. it always leads back to the money supply, this is the basic nature and definiton of an economy that isn't based on a fixed value monetary system. everything else becomes a contributing factor. by the way, how would it be possible for the banks to control the money supply? they have some control over the velocity, but any new money always comes from the Fed. And historically, ridiculously, huge deficits create the same effect, gushing new money into the economy. and historically, ridiculously, pathetic trade deficits insure there will be a cheap supply of dollars to buy the securities. It was the perfect storm, and the creators of this storm want upwards of a trillion dollars to "fix" it. Sort of like hiring someone to maintain your house, you come home, it is torn down, all the materials have been sold at a profit, and now they present you with a "rough" estimate on what the repair will cost you[us]!

2008 Oct 03 11:24 AM

[frobnitzem:]

While I agree with you that changes in the money supply are the main cause of the inflation/deflation boom/bust cycle and all its attendant problems, your conclusion that markets are trying to remove the "excess capitol" are wrong. Capitol cannot be removed from the system once it is added except through taxes.
In fact, business-minded people are trying to do the opposite, with everyone scrambling to grab cash and hoard it (10-s and 20-s now, homes later). The 10% reserve requirement means that the money supply can be up to 10x the amount the Fed. actually issed because the money can be lent out 9 times. When banks refuse to lend, the money supply goes down -- even if the US Treasury takes out loans from the Fed. (the process by which money is created) to write checks to their business partners (i.e. bailout packages).
In fact, there is a solution offered for this problem: The Chicago school of economics 100% reserve requirement, with money issed by the government as money, not private banks as debt.

2008 Oct 06 11:08 AM

[Simit Patel:]

hi frobnitzem,

yes, i agree 100% regarding returning to a 100% reserve requirement with money issued by the government rather than private banks as debt. however, the money supply is exploding, and thus this will be inflationary. see the money supply growth:

nimamahdjour.blogspot....

2008 Oct 09 11:06 AM

[Nima1981:]

Hi, I would like to point out that the money supply growth that I regularly post at nimamahdjour.blogspot.... is based on a number that is slightly different from the TMS employed by the Mises institute, which is the one you used above.

It is a much cleaner number because it really only includes what is to be considered true money supply and it is hence a lot more indicative of future market trends.

2008 Oct 13 02:15 PM

[Nima1981:]

An interesting disagreement that I am having with Mike Shedlock right now:

www.economicsjunkie.co.../

2008 Nov 23 05:42 PM