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December 02, 2008

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Thanks. I think I'm starting to understand this...

Inflation happens when the ratio of money to productivity increases (money supply goes up faster than productivity or productivity goes down faster than money supply).

To increase the money supply either people have to leverage themselves by taking out loans and credit (they borrow money from the banks who, in turn, borrow it from the Fed who just prints it then demands it back plus interest), OR by the government leveraging itself by increased deficit spending (money which it also borrows from the Fed who prints it).

You mentioned in a previous posting that the Fed and the govt. have an interest in having an inflationary environment so they will fight the deflation tooth and nail - how do they benefit from that inflationary environment? I still don't understand that part.

So whether we will get deflation or inflation will depend on how much borrowing there plus how much government deficit spending there is. Is that right?

Assuming that is true, clearly more borrowing by the public is not likely for the next few years I would think. People make money and they can either use it to pay for NEW things or to pay down their debt for OLD things. Right now, people are so leveraged that most money they will earn will go towards paying down debt. So, even if the govt. does drop the interest rate to 0% the way Japan did, people are unlikely to borrow much. I would think that is an unlikely source of inflation. In fact, it will be a strong deflationary force as more money flows out of distribution and back to the banks and other lenders.

But what about government deficit spending?? Right now, it seems President-elect Obama may continue to try to spend our way out of this problem. The bailout is pumping Trillions of dollars into the economy by purchasing preferred stocks or bad assets (an INFINITELY bad idea if I understand it properly).

If Obama continues programs like a second stimulus package and increases govt spending in other ways, won't that be a strong inflationary force?

Also, what if the economy continues to get substantially worse? It is looking more and more likely that lots of companies will go out of business, millions will get laid off in various industries, and spending will decrease as people use their money to pay down debt rather than purchase new goods and services. What happens then?

There are two types of inflation: expansion of the money supply and expansion of credit. Right now the money supply is expanding, but it is being offset by a contraction in credit, netting out to mild deflation. Private credit continues to contract, so the government is expanding its credit borrowings to offset the contraction in private credit. By injecting money into banks as equity, there is a multiplier because banks are leveraged, but again, it's only offsetting the falling value of the banks' assets. The proposed "stimulus" is just shifting demand around and only becomes inflationary if the debt issued in monetized by the Fed. If its borrowed from abroad, we'll run a trade deficit of a like amount and the net effect to GDP will be zero. It supports demand only if its financed by the cash savings of people hoarding cash. Otherwise it crowds out private investment.

I don't think the downward pressure on the economy stops until housing prices are at or below equilibrium, and I think we're still a year (give or take) away from that. That said, the government has taken the right steps to prevent an out-of-control death spiral. I think the real economy will stink for at least the next six months, but that it could have been alot worse.

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