Michael B. Krause

Positioning for Reflation

Remember the credit-created portion of money supply is not made of available credit, it is used credit. The whole crux of the measurement problem is that the effective credit multiplier has dropped, and conventional metrics can't really tell you how far it has fallen. It is clear if you look at M2 money that the destruction of credit money does not show through these aggregates, otherwise you would see a sharp negative spike down (I believe it is still approximately positive y/y, even if you factor out monetary base growth).

If the Fed's knew how much money had been precisely destroyed, this whole problem could be easily solved by printing and filling in the hole directly (capitalizing the banks). Instead, they are creating programs that are the equivalent of a blind man stumbling around in a china shop. Eventually, they will get it right (and even go past). Since these financial markets have self-reinforcing mechanisms, I imagine that once the trend reverses, it will reverse euphorically, and we will get large one time moves in inflation rates. Those won't be sustainable - we may get 10-20% annual inflation rates for a year or three, but eventually the move will subside. Rate of money creation is just important as actual amount created. If they achieve their goal, they can just subside the rate. The difficulty here is the lag time between all of these behaviors.

Remember, if the Fed achieves an upward revaluation of houses by altering the fundamentals (by changing the long term cost of capital), banks presently insolvent are sitting on a gold mine.

All I can say is this: imagine the credit multiplier is not 10x right now, but 5x. Simultaneously the money base doubled (and will soon have tripled). At the moment, the short run (1 year), we're barely keeping our head above water preventing deflation. In the long run (2 years out), as the supply of liquidated homes clears, we are left with the same monetary base and the fed unable to mop a majority of that liquidity up (since it primarily made up of long term MBS, treasuries, and CDOs traded for treasuries in early Fed programs). The new money base will be 3-4T while the multiplier will recover from 5x to 10x, lets say. Suddenly real aggregate money supply has the means to double once credit starts moving. By the time the recovery starts, it will probably be a lot more difficult to position.

Bank Nationalization and the TARP

Or the flip side: At this rate, you won't be able to buy a box of saltines at .50 because your stocks will continue depreciating, tax revenues will collapse resulting in a repeal of any government income you might consider yourself entitled, and your pension will be worthless because all of the corporate debt it invested in went bad.