Jim Bradley's  Instablog

How so?

The argument is made that many countries see inflation without wage inflation and that therefore this can happen in the U.S. 

The implication is both true and false.

1 - The U.S. ** is ** different than many other countries in that it is the source of the most widely-used currency (supplied via the trade deficit).  The dollar is a worldwide global currency and the deficit represents the "supply of dollars".  That is why "wage inflation" in the U.S. does matter in the U.S. and doesn't matter in smaller countries.  In smaller countries, investors can panic out of the foreign currency and there can be huge price inflation no matter what wages do.

(However, note that dollar-volume is a more accurate way of thinking of the causes.  After all, wages can rise or fall but it must be taken in conjunction with employment to determine the overall effect).

The next logical question is, can investors panic out of dollars? 

Answer: Yes, but as we consider the context, in my view it will appear far more likely that investors do not do so, at least not to the extent presumed by those that say we are soon headed to hyperinflation.

2 - The world cannot get out of dollars without buying U.S. exports.  Think about it.  So far we've been 'exporting debt' (so if there is an inflationary increase in money, the inflation comes back as asset inflation), but to truly get out of dollars, the foreign investor needs to get out of dollar denominated debt as well, so they must buy a good or service which extinguishes their exposure to dollars.  That means (ultimately) buying a non-financial U.S. export.  This is one reason to keep tabs on foreign investment in U.S. real estate.  That is a market that could take the flows of foreign investors wanting to hedge - however that market cannot substitute for dollars settlement as we will see below.

3 - If the dollar goes, many or all currencies will tend to collapse with it.  There is a strong incentive to hold the status quo by the political elite for the benefit of the political elite (control of exports to the U.S. are from the rich employing the poor).  While the dollar could go out of use from sudden hyperinflation, if it did so, the entire structure of benefit for the political elite worldwide collapses.  Unless there is a small group that controls the outcome that would specificially benefit from a sudden dollar devaluation (and what would they do next? - seems like they'd be hunted down), it's hard to make the argument that will be future policy.  It could happen, it's just not logically argued, in my view.

4 - Comparing the U.S. to (for example) Zimbabwe, and saying that a hyperinflationary collapse will occur the same way is extremely inaccurate.  Zimbabwe does not have a premier currency and the political elite in Zimbabwe have far less to lose: they can move their wealth to an alternative currency (such as dollars, ironically). 

While an argument can be made that real estate is a market that can absorb the massive wealth flows, real estate has not yet developed into a money market and instruments for trading titles to sound real estate doesn't jive with the 2 trillion in dollar settlement per day.  Think of this logistically.  Just WHAT has this kind of settlement power except for dollars and T-bills?

There is simply NO market like U.S. treasuries and dollar settlement.  The most likely outcome is a fade, not a sudden hyperinflationary collapse.  That has some implications, as you may guess.

5 - It's crazy, but so far it's true.  Every other electronic currency has more problems than the dollar and has over time proven to be less sound.  That's not saying the dollar is good, but it is least bad.  We'll see over time if the Euro catches up, but to do so, the authorities might have to cause deflation in some countries just to balance the demand by investors for a harder currency.

6 - The collapse of solvency in the U.S. goverment may OR MAY NOT BE price inflationary.  It depends how the gap is financed.  A good country can have a terrible currency and a bad country can have a sound currency.  Convince yourself of this by looking at the various appreciations and depreciations of currencies during both good and badly run governments.  It really does depends on the central bank and how much they supply of transaction reserves. 

7 - Fundamentally, there is a difference between debt and MONEY.  Money is reserves at the Fed and cash which provides for ultimate and final settlement, while everything else is debt (a claim to reserves, not the reserves themselves).  Bank deposits are debt, but function as a generally accepted money substitute, because banks are politically protected entities.  This makes a difference in point eight.

8 - How is a problem that requires inflationary finance handled when price inflation would crack the currency?  Take a lesson from recent events: The Fed gave many bad banks a lifeline which encouraged better banks to fail (being unable to pick up assets at a discount to boost their earnings).  This is ** enforced deflation ** to prevent price inflation ... While the problem could be resolved by "printing money", the consequences would be global collapse with most currencies in crazy volatility.  The most likely outcome is a form of political management which picks winners and losers but maintains the currency.  That means "price inflationary deflation" (i.e. many individuals / entities undergo deflation to keep the price inflation in check - this is functionally the same as price inflation as relative prices adjust, but it does not collapse the currency).

9 - If / when the authorities or market forces develop a new currency that can substitute in large measure for dollars, THEN the dollar is at great risk.  Watch for this, just in case.

10 - If dollars really become unsound (rejected in trade) before there is an alternative, the end of much of civilization may occur.  This is not a joke. The lives of billions of people depend on trade and money is a counterparty to every trade by the necessity of a universal item of settlement.  It would be great to bring back gold to prevent the sudden disappearance of money, but without the political elite falling behind it, it is unlikely.

Now that you have my views on the situation, I hope you've been stimulated to think of the implications in the macro picture.  You should know I own 'cash and gold' (funny how one never has to disclose holding cash...).

Take care and good investing.

Wealth, Then Credit, Then Money, Not The Other Way Around.

Why We Are in More Trouble Than Many People Think...


Average annual wage in 1965 was $4658.72
Average cost of a house in 1965 was $20,700
Cost of Harvard tuition in 1973 was $3000

sources:
(www.ssa.gov/OACT/COLA/AWI.html)
(www.census.gov/const/uspricemon.pdf)
(www.provost.harvard.edu/institutional_re...)

The process of credit creation is straightforward from a top-level perspective:

1 - Banks create the bank money (deposits) to purchase financial assets (bonds)...
2 - Based on the wealth of the borrower (income and assets)
3 - Money serves to "clear" exchanges between depositors at different banks who use "bank money" (deposits) as a substitute for reserves.

Let's take a look at the errors that come from missing these fundamental facts, with an eye to keeping our investment powder dry.

Error 1a - We can put the cart before the horse - in fact we don't even need the horse, the cart will pull itself!  We can print "money" which gives rise to "credit" which then becomes "wealth". 

There is no attempt at rational explanation how this is to occur.  While many articles for the public are written, no prominent economist can explain this in front of their peers, because none of them are willing to say they believe in free lunches.  Zimbabwe is apparently wealthy because they've more "money". 

Error 1b - Banks are credit intermediaries and that is their main function. 

Under fractional reserve banking, banks are credit creators.  Banks remove value from the money (expanding the money supply and diluting the yields of savers), earn a spread for doing so (bank interest earned), while workers and entrepreneurs put the value in. 

Error 2a - The people in government will solve the crisis. 

Keep in mind the market decided to fire a number of these people in the corrections of 1992, 1998, 2001, and 2007, but the government stepped in ...

Error 2b - The government can recover the economy. 

The government is a fraction of the size of the economy.  Can the tail wag the dog or does, even if it takes time, the dog wag the tail?

Error 2c - Deficits are the problem. 

Not true, spending is the problem.  No matter how it's financed, spending consumes resources the market would put to other uses ... after all, what's the point of government unless to coerce people into financing things at a price to which they wouldn't ordinarily agree?  We could rescind the remaining bailouts and support bank deposits (the effective money supply) and let the market decide how to divvy those deposits up! (goodbye bad managers ...)

Error 3 - The government can create something from nothing. 

Since the government is only a transfer agent, it really cannot 'add' anything it doesn't take away from someone else.  And since the exchanges are forced on people, it is always taking more than adding.  No politician is able to explain how a loss to everyone becomes a 'gain' for society.  They just willy-nilly say it is (as if by decree, the laws of nature can be rescinded).  If everyone has to pay the Jones family for goofing off, that is not going to 'stimulate' the economy.  Really it just drains everyone of productive capacity, including the Jones family.

Error 4 - Reserves lead to lending. 

The rhetoric has become so amazingly backwards, even normally 'free market' economists are now yelling about the 'giant level of reserves' which must 'lead to excess lending'.  However, reserves have never been a constraint on lending. 

Think about it.  If you are a bank, you know at what price you can borrow any amount of reserves you need.  The relevant questions for the future are: What yield will I receive if I create the bank credit for this loan?  What are the present and likely future costs of reserves should circumstances require me to provide reserves and how does that influence my decision to expand lending?

Now a bank isn't going to loan if they feel they are not going to make money, and they will be especially careful if they've precious little capital to lose, and even more careful if they are just scraping by in cash flow terms.  And borrowers aren't going to borrow if they feel the results are going to hurt them.  While things can change, reserves simply make no difference in this part of the situation. 

Error 5 - Money flows tell something. 

Money doesn't 'flow' anywhere.  It is in someone's possession at all times.  When a person buys a stock, two people agree on a price and money moves from one person's account to the other and the stock ownershiop goes the other way.  At no time is there a 'flow'.  Do we talk of 'stocks flowing into the money market'?  Do we talk of cars or houses 'flowing into the loan market'?  Imagine listening to the ticker commentary and hearing "there's a lot of aluminum on the sidelines ready to zoom into the bank deposit market!" ... it just makes no sense.

"Money on the sidelines" is just the same error.  Money is always 'on the sidelines' because money is in someone's possession!  It is not true that everyone can run their cash balances down.  Everyone can try.  Person A can spend quickly and person B can sell quickly and then spend quickly.  Lots of exchanges occur, but in the end, the same amount of money exists and prices are higher.

Error 6 - Slack in the economy is fixed by more money if the authorities increase money by deficit government spending and the Fed prints the difference. 

Imagine that we find that a new giant US Casino is a loser and cannot recoup the money put into it.  In an effort to help the Casino, the government starts giving away money.  How does this help?  The Casino is a loser and only can temporarily be supported by an illusion of 'excess funds' which soon disappears. 

This effect occurs whether or not overall prices rise or fall.  The 'inflation / deflation' debate is about what to do with cash, but since it is aggregative, it has less to say about the fact that some prices are abnormally high and others are abnormally low because of government intervention.  This of course makes profit and loss calculations in error and precious capital is wasted (imagine your revenues and expenses being off by 30% but you didn't know in which markets ... how can businesses calculate profit and loss under those situations?).  That this basic fact is out of reach of so many commentators is a sad testament to the level of analysis.

7 - We can solve our correction by stimulating 'velocity'. 

First off, the concept of 'velocity' being an independent cause of anything makes little sense.  It's like saying the 'tires push the car' and when the car doesn't move we need 'more tires'.  Yeah?  What about the engine?  After putting on twenty more tires we're still sitting in the desert dying of thirst. 

Bottom line, velocity is not the cause of anything, it is a result of things ... trades!  The idea that if people make 7 exchanges a year rather than one exchange a year, and when exchanges fall, there's too little 'money' .... directly follows from this fallacy.  Wealth drives exchanges, and in a fractional reserve banking economy, credit and money follow. 

The problems have come from banks and entities that believe borrowing short and lending long is the norm, and that all this yield curve leverage is for 'free'.  Well, there's a risk side to that, and it's nonsense the Fed makes poor people pay for disastrous money market management by large entities and banks, but that's the breaks.  Imagine if the gains in productivity went to workers as prices fall by 70-80% over the last 20 years rather than rising 100%.  We'd have people with 2x their income in real terms rather than going backwards!

8 - Prices steady equals all-okay. 

If prices should be going down by 10% (productivity increasing), holding prices steady is a disastrous policy as it channels funds into 'financial assets' that have no business whatsoever receiving new funds.  If that's the policy, why not channel funds into the hands of the common worker?  This is a democracy, right?

Incredibly, ALL these fallacies are on display today.  In my view, recoveries just aren't going to be real until the government lets the market fire bad managers.

Enough of that.  WHAT TO DO:

First off realize that the little guy is going to be toasted.  So far it's been a near political free-for-all.  A rational policy is to get everything you can as quickly as possible into the most solid assets you can and to engage in business 'off the radar' ... meaning a currently legal business where the exchanges aren't directly government controlled (and thus potentially hurt) but still are providing an essential good.

Keep in mind, the government may cut off a lot of support (in inflation adjusted terms) to many individuals as times get tougher.  That means a whole lot of people are going to get hit, and that includes a lot of government employees at some point as well.

Since the Feds are facing disaster on both sides of the inflation / deflation debate, consider splitting the bets in a timely manner, as the Fed is more likely to oscillate policy.  When everyone is talking inflation, hold more cash.  When everyone is talking deflation, buy up cheaper assets.

Keep in mind, the current administration is bent on raising taxes, which cause about 3x the destruction dollar-for-dollar.  In other words, $1 in taxes causes $3 in economic shrinkage.  It could even go worse if we're kicked when we're down.

Be aware that our country is now borderline or (perhaps over the line) fascist.  This can take a very dark turn as history shows.  If you've the means, have an exit plan for your assets and family... just in case.  The wealthy already do.

Hopefully this article is some balance to the happy smoke coming out these days.  I wouldn't bet hard on the recovery and we will not recover in real terms unless there is enough savings to fund a recovery, which probably doesn't exist.  We need to make changes in government more than ever.

Good luck in your investments and personal goals.

Note - Jim holds a position in Gold ETFs.  You can find out more about him and see other commentary at www.j-bradley.com and see his profile at www.linkedin.com/in/jamestbradley

Why Everyone Is Wrong About Inflation and Deflation

Let's face the facts about the inflation / deflation debate:

1 - No one really knows or can possibly know what the "endgame" will be ...

2 - The goal for investors is to be "future independent" as much as possible: a strategy that wins in nearly any market.

Consider the real issues facing the authorities right now

1 - If they allow significant price deflation banks could fail in great numbers, and then they may be forced to really monetize which could ignite hyperinflation

2 - If they push in significant price inflation, the currency will collapse, and they may be forced to really deflate to bring back confidence (the "austerity" plans)

In sum, the Fed is facing a cliff on both sides of the path.  They will try and stay in the middle.

That means the Fed will end up OSCILLATING policy between price inflation and deflation with a bias toward whichever risk (U.S. government creditors or the banking system) they perceive as the greater.

Now consider the dollar.  It is bad, except:

1 - Everyone else is in real trouble and in more trouble than the U.S. !
2 - The Euro is the only substitute in tradeable size against the dollar, and Europe is in real trouble!

The financial elite hold far more wealth in financial dollar assets than they possibly can hold in real goods.  How are they going to hedge the risk that things might get out of hand if the dollar "must" devalue?

Let's get a quick answer.

You might note that savvy market players, with the help of the central banks, can push markets to extremes and this helps the nimble set up to benefit from the other side (sell high, buy low). 

Consider the fact that, in 1998, the real estate tax exclusion was quietly passed and the Fed subsequently allowed huge increases in mortgage credit.

Now, what is the ONE market, that recently was busted, that can take the kind of money flows that the big boys have stored in financial assets?  After all we are talking trillions ...

Hmmmmm.

In other words, the big boys can prepare for the risk of devaluation by buying cheap real estate and stocks of banks "that will survive" at near dirt cheap prices.  This offsets the risk that things get out of hand (necessitating rapid price inflation) before (if) a global currency is introduced.  If a solid global currency is introduced, THEN, in my view, the dollar is really toast.

So how to invest?

1 - Buy gold.  It will benefit from a collapse in assets AND from devaluation.  Note that the dollar price of gold has almost nothing to do with "price inflation" and "price deflation" (convince yourself of this by noting the huge fall in the price as inflation continued for decades).  It is more sensitive to whether there is a solid foundation under dollar assets - and the foundation can be broken by EITHER a higher risk of price inflation or price deflation.

2 - Hold cash. 

3 - Determine when your income is (1) price inflation advantaged or (2) price inflation disadvantaged or (3) price deflation advantaged or (4) price deflation disadvantaged.

For earners in industries that are doing well in price inflation and price deflation, hold medium amounts of real estate debt.  Since income tends to hold steady, price deflation means other expenses drop and the debt is affordable; if there's price inflation there's an increase in income allowing a real return.  This can take the place of some gold investment.

For any other combination, lean toward more cash, severely limit use of debt, build up a cushion, gain alternative income sources, and put some money in gold or alternatives like gold that are not someone's liability.  While you may decide to bet on one side of the market, the premise here is that it is difficult to know the outcome.

4 - Keep in mind that the authorities face real trouble with both price inflation and price deflation, so they may administer "survival" (they already have) and let some financial institutions fail which will curtail the price inflation effects when giving out lifelines financed with printed money.

5 - Remember, the purpose of the Fed is to benefit the banks and elite finance.  They do that by providing a market for treasuries so that Congress can overspend.  But now that the Fed can issue it's own perpetual debt (paying interest on reserves!) the next step is to insulate themselves from U.S. government control and U.S. government insolvency.

6 - Remember, the most logical outcome is OSCILLATION of price inflation and price deflation.  When one seems to be reigning, operate with the other side in mind.  In other words, during high and slowing inflation (indicating a peak), accumulate cash invested in shorter term assets in preparation for price disinflation.  During price deflation, pick up bargains.  Worst case, you will likely do better than those that believe the trend will be in one direction.


Good luck investing.

Note - Jim holds a position in Gold ETFs.  You can find out more about him and see other commentary at www.j-bradley.com and see his profile at www.linkedin.com/in/jamestbradley

In 1998, median house prices in San Diego were $207,000.  In 2005 they were $604,000.  With 20% down, the monthly cost of the $207,000 house was 995 (Principal & Interest), and the monthly cost of the $604,000 house (P&I) was 2902.

(Case-Shiller shows San Diego index in 1998 of 78.23 running to a top of 250.34 in Nov 2005, which is worse than this example). 

Say housing (P&I) is 40% of the average budget and the "rest" of the CPI accounts for 60%. 

Let's take a look at a graph using a simple method.  We'll take housing price changes each year and weight that and add a 'core' inflation rate.  New mortgage payments are directly proportional to housing values and unless a person stays in one house for life, they will see an increase in housing expenses when they move, which can be imputed backwards to the accelerating cost per year.  This of course assumes interest rates, which influence the monthly payment, have an 'average'... which they don't - but interest rates also tend to follow inflation so we'd be wise not to use that as an input to determine inflation. 

Here is a graph month by month using the national figures from Case-Shiller to impute the change in monthly payments adding to a 60% weight of trimmed mean CPI.  We use the trimmed mean assuming it is a good base case for core inflation which cuts off 8% of the higher and lower values, as those values probably represent restructuring rather than overall inflation.  No attempt was made to 'rebalance' the basket of goods or to correct for the 'owner equivalent rent'.  This doesn't really 'double count' because we are trying to get the base case and add on a more accurate figure for housing.  The result:





Bottom line: on the way up, about 8.5% for 7 years, on the way down (so far) about -5% for 2 years... not only for San Diego, but also for many other areas.

I hope you've enjoyed this article.  You can find Jim Bradley's profile at www.linkedin.com/in/jamestbradley and more at www.j-bradley.com

Jim Bradley holds no positions (stocks, bonds, etc) in regards to this article.

When bank loans are paid off, deposit money is extinguished.  This is in contrast to an individual who extends a loan with money they possess where a pay off is a return of transferred funds.  This is because the banking system creates deposit money when it extends a loan, and extinguishes that deposit money upon pay off of the loan.

So what happens in a situation with massive loan pay offs such as several million foreclosures? 

Answer: Money is drained from the system ...

The Fed has been preventing money contraction from the recent financial correction.  There are four issues.  (1) Bank capital is lost from bad loans and when bank capital is exhausted, the bank shuts down reducing the generation of new loans (2) Depositors (especially large corporations) can lose their money unless the government increasingly bankstops insolvent banks (3) Loan pay offs in greater dollar volume than new loans is a de-facto shrinkage of the desosit 'money supply', and (4) Existing banks have a cash-flow problem even with support because operational cost in some cases exceeds diminishing income.

#1 and #2 were handled by various means: FASB changing the rules on non-performing loan pools so that a mark-to-market insolvent bank can continue operations and depositors are backstopped by various capital injections and FDIC expansion.  (Capital injection was by no means the best course of action.  Deposits are only 65% of liabilities and the authorities could simply have let a number of banks go into BK, converting the non-deposit liabilities to equity and then providing support for the stronger banks that remained.  This would create a more prudent banking system in the future).  #4 we'll skip.

Let's focus on #3.

For #3, the Fed must create as much 'new money' as is being extinguished by mass loan pay offs.  If a bank lends 100K and loses 40K, the losses are absorbed by bank capital and then covered by government support.  However, the pay off of 60K by foreclosure is a drain of funds unless a new loan is generated that replaces the 60K. 

Just how large is this effect?  Consider what happens if 10% of the $14.4 trillion mortgage universe were to foreclose at 50% of the original loan amount and no new loans replace the pay offs.  10% x 50% x 14.4 trillion = $720 billion.  In other words, the mass pay offs that occur when foreclosures start moving can be a huge money drain as existing deposit money is extinguished from loan pay offs.

The Fed's willingness to monetize is what will relieve this pressure so that more cash buyers will enter into the foreclosure market, as there is no longer a drain of funds that would put further downward pressure on the market.

That promised $300 billion in monetized funds which has so far stimulated a growth of 19% in M1 ($245 billion) doesn't look so big, does it?

Assume with 3 million foreclosures 10% are bought with cash at 200K each.  That's $60B.  In all likelihood, we will see far more foreclosures.  So the total 'monetization' might indeed be higher, depending on the technical factors of loan issuance.

And consider this, the Fed has liquified some of the banking system's interbank lending market so instead of banks borrowing reserves from each other, some have reserves at the Fed on account.  Since CHIPS clears north of 2 trillion per day (www.chips.org/home.php), that is going to soak up some of the reserves.  While we could have a real problem in the future, the 'hyperinflation' isn't so clear now, is it?  Nor is it clear that the Fed is forced to keep rates low and thus cannot continue to sequester the reserves.

Without a real breakdown of composition, limits, and purpose, it's hard to get a handle on how much support is being offered and to whom, and thus it is not very possible to look at the Fed's balance sheet and get an idea how tight or loose they are.  The only real possibility is looking at deposits and cash and estimating the monetary effects given current production and psychology.

Let's take this one step further.

Consider the banking system to be one big bank.  You bring money to the bank and the bank owes you back the money.  However, since everyone is banking at this 'one big bank', all payments are simply transfers from one account to another. 

This bank will extend loans by creating new account balances rather than acting as an intermediary between a saver and a borrower.  Why?  Because the bank makes a higher profit by offering new loan money rather than having to pay a saver a (higher) yield.  The value in the new money is gotten by diluting the existing base of money ... the bank is in essentials extracting wealth from everyone and lending it, irrespective of whether those people save or not.

Question: Then why would such a bank pay interest on deposits?

Answer: To reduce the amount of transactions money so that deposits do not devalue against goods (price inflation).  That would invoke a (political) backlash against the bank.

This accurately describes our present banking system if it were looked at systemwide, especially since the Fed now pays interest on reserves.

So as you can see, as the underlying monetary contraction from these events play out, the Fed is responding with an opposite policy.  While we may indeed suffer major price inflation some time in the future if the government continues to prevent losses and makes other policy errors, that has not been made clear.  Current policy is not as price inflationary as many have said. 

But as always, it is a good idea to hedge both sides - just in case.

You can find out more about Jim at www.linkedin.com/in/jamestbradley and his website at www.j-bradley.com

Jim holds no positions (stocks, bonds, etc) in regards to this article.

We'll use terms that are practical and simple: "money" is the funds used to settle the purchase of goods and services, "price inflation" is a basket of trade weighted average of prices rising, where the basket is infrequently changed (or else there would be a downward bias from substituting less expensive, lower quality items), and "monetary inflation" is the expansion of 'money' used to make purchases, irrespective of whether that new money finds it's way into prices quickly or not.

Since we are considering money to be 'spendable funds', a deposit balance in a bank qualifies as money, because it can be transferred to another account (by check or other means) even though this balance is technically bank debt (the bank owes the depositor reserves).  This makes sense because if deposits were to collapse, spendable funds would shrink, and we would undergo severe price deflation.  The bank deposit balance also is expected to be redeemed at least at par under all circumstances.  Clearly bank deposits are used economically as 'money'.

For our purposes then, money is spendable funds which are cash plus deposits.

First question is then, is money (cash plus deposits) rising or falling? 

Answer: it is rising slowly.  You can see total deposits by looking at commercial bank liabilities, line 31: www.federalreserve.gov/releases/h8/curre... and cash by looking at the Federal Reserve Bank's liabilities (currency in circulation): www.federalreserve.gov/releases/h41/Current/ and by observing the charts of deposits below:







While total bank credit after a mark-to-market writedown may be contracting, the liability side is not going to contract as the Fed will "print" as much money as is needed to cover bank liabilities should there be a need for it.  The fiscal authorities will further backstop the deposit liabilities (partly by FDIC, partly by capital support, and partly by Fed assistance) on the bank's balance sheet.  We can reliably conclude that deposit growth is not likely to significantly reverse despite the value of bank assets not covering those deposits.

An important side question: since deposits are in large measure generated by new loans which are re-deposited, how are deposits kept stable if most banks are not extending loans to replace the loans that are extinguished (by defaults, by short-payoffs, and by normal payoffs)?

Answer: government guarantees are absorbing bank losses on old and new loans (note the backstop of FNMA and FHLMC and the large numbers of loans for FHA done through banks).  Government guarantees allow replacement of those loans extinguished by default or by payoff.

In addition the Fed purchases bonds that finance the government spending deficit with new money.  Since this is an injection of income without a corresponding drain, deposits continue to grow.  Concurrent with this, the Fed has provided increased reserves so that interbank clearing will still occur despite banks fearing the solvency of other banks.  Banks do not need to rely on another bank having the power to borrow reserves or have discountable paper to ensure clearing occurs.  For now, this money has 'papered over' the clearing problems of an insolvent banking system and FASB has fallen in line by allowing banks to hold items on their books at par that really are not worth par.

What determines whether a particular bank will fail is then the net cash flow accruing to the capital account and the size of the reserves if the net cash flow is negative.  This is one major reason banks are not going to sell inventory of bad loans as quickly as would be expected, because the losses would have to be 'realized' in the capital account and the bank would then be forced to cease operations.

It is important to realize that over time the activity of papering over losses severely weakens the banking system.  There are two categories of entities: those that put value into the currency and those that take it out.  "Printing money" is taking value out if it funds poor assets in comparison to the yield gained, (a worker puts value in, someone else takes a portion of that work for each new dollar printed that funds a bad or too-risky endevour).  Printing money to cover the bad actions of banks makes the economy weaker and the banks stronger in the short run, but everyone becomes weaker in the long run.  The banking system cannot exist independently of a good economy; neither can the government for that matter.

Second question: Who is getting the expansion of new money? 

If new money is not 'disbursed', despite a large dollar amount of total support, general price deflation can still result.  Taking a look at Q/Q growth in tax withholding shows a massive contraction in income.  This correlates with the implosion in sales tax receipts of those states that collect sales taxes.  In this area, officials, if they believe in Keynesianism, have failed by that criteria to disburse support widely enough to stop the contraction.  It is likely, however, without government stimulus, GDP would be revised to another minus 6%, rather than the smaller losses being posted.

Third question: what does market psychology say about the effect of an expansion of funds? 

An excess supply of money does not necessarily create a positive rate of inflation.  Why?  Consider what you personally would be doing right now if you earned a spare million dollars as a one-off event.  First thing, seeing so many people 'on the street' or being forced into living with relatives, you'd probably pay off or buy a house which would replace a bank loan for that property with reserves that go to the bank.  The bank, failing to find many good borrowers in this climate and fearing negative cash flow, would not fully expand those reserves into new loans.  Instead, the bank will park the reserves at the central bank to earn interest until such time as good borrowers or good collateral can be found.

The rest of your fortune you might spend purchasing a bank CD and use the interest to help you survive, or seeing the darker future for many skills, perhaps fund yourself to go back to school to attempt to hedge against losing earning potential in the future.  It is unlikely you'd squander the funds on consumptive spending (which is good!).  None of these activities are very price inflationary except to schools of good quality versus their cost.  Higher cost schooling, in contrast, has been hard hit, as the funds and the payoff for going to top-notch schools was very much driven by the bubble in finance.  The road to success has become much narrower using old strategies.

The overall effect of psychology can be seen already: a large increase in bank reserves residing at the central bank for transactions, an increase in volume of low-cost and intermediate schooling, and less of the new money exchanging hands in the economy.

The expansion of money thus drives down interest rates to zero and the economy slows until such time as enough entities fail from negative cash flow, decreasing the drain on resources until the economy can self-fund.  One school of thought is getting this over quickly is better (in other words, avoid the situation in Japan).  Another school says that could create secondary effects which would make the correction worse.  Either way, in very few cases is new borrowing going to occur except for essentials like for home purchases and then only with stringent guidelines.

A good proxy for spending can be seen by looking at retail revenues at organizations such as Wal-mart, Target, Costco (Sam's Club) and other large retailers.  Note that upscale retailers are likely to do more poorly than discount stores when things are tough.  Wal-mart was an excellent leading indicator (clearing of inventory at local stores and slowing revenue) of the subprime problems, but the stock price wasn't a good indicator because of the shift in consumer buying from higher-end to discount stores benefitted Wal-mart.  Also keep in mind, the stock market is frequently one of the first asset markets to undergo price inflation from new money, meaning stock prices can be very misleading and are not usually as important as financial data.

The behavior change of the consumer has occurred not because there isn't enough 'spending', but because people do not collectively believe (and accurately so), that there will be a sustained recovery until adjustments are made so that income matches expenditures. 

While it is comforting to believe that the government can simply 'print income' and offset a depression, this is not the case.  Capital spent on things such as a top-notch education for financial engineering cannot be shifted quickly to other fields without significant funds, effort, and time.  An educated person in finance can't quickly shift to used car mechanics and be productive.  Since the ‘collateral’ for money and government finance and bank loans is production, the overuse of monetary stimulus will spiral us down.

This illustrates an important side point: there are REAL economic realities that must be addressed that can't be papered over.   There is a shortage of productive activities to adequately pay down debt in real terms and the debt must either be reduced by markdown (better) or price inflation (terrible, as price inflation would destroy and withdraw additional savings that fund recovery).  Until many lower-valued activities cease, the economy cannot properly recover.

There is one other piece of the analysis that is important - the global situation.  Will the international concern about the collateral backing the dollar (U.S. government solvency and the productive base that funds it) drive the value of the dollar independently of the collective behavior of the U.S. citizens?  The answer, I believe, is not quite, because although the dollar is bad, it is not so bad as many other countries.  However, there are enough nuances to require another article, which I will post soon. 

Suffice to say at present, unless there is an unbelievable amount of new money stimulus widely disbursed that is sufficient to shift a decent percentage of psychology, it is increasingly unlikely that price inflation will occur, and more likely, since the Fed has arrested the expansion of its balance sheet and the fiscal authorities appear to be slowly spending the stimulus, that the reverse will continue to occur.

In summary, we can look at four things to determine the future direction of inflation:

1 - The expansion of money: cash and deposits (Commercial bank deposits, Cash on the Fed's balance sheet)
2 - Composition of new money as shown in incomes (Q/Q tax withholding, State sales taxes)
3 - Psychology of spending versus saving (Composition of spending) and the continued need for correction (existence of too many entities that cannot self-fund)
4 - International situation in respect to the dollar (soon to be posted under the title What's Coming Next With Government Finance?)

Finally, it's worth repeating, since it is so often mistaken, that a recovery is entirely something different than money mechanics.  The economy cannot recover without the real production necessary to generate good collateral for loans.  In this way, we MUST take a correction so that valued production and new lending can occur.  Resisting the correction indefinitely results in a Japan-like situation, where they have even 20 years later, not fully recovered. 

You can find out more about Jim at www.j-bradley.com and www.linkedin.com/in/jamestbradley

Jim holds no positions in regards to this article.