Monday, July 6, 2009

The Massive Inflation of Our Money

I am not an economist, and I really don't want to be. It's dreadfully dull stuff, and my eyes start to defocus after about ten minutes of reading on the subject. Unfortunately it's something we all need to pay attention to, especially in the current depression. And yes, it is a depression.

Here is a link to a much more lucid explanation of the inflation of our money supply than I could ever write:

"How Much Money Inflation" by Howard S. Katz

The key in the above article is the fact that the money supply is larger than the Fed reports, due to the fact that banks (with the consent of the Fed) routinely "reclassify" deposits in order to remove them from the money supply. From Katz' article:

This process of reclassifying bank demand deposits as time deposits is the fraudulent part of the new procedure. Despite the fact that both are called deposits, time deposits are fundamentally different from demand deposits as follows:

  • A demand deposit is money given to a (banking) institution that does not earn interest and can be withdrawn by the person who gives it (the depositor) whenever he wants (on demand).

  • A time deposit is money given to a (banking) institution that earns interest but cannot be withdrawn except after giving notice for a defined period of time (usually 90 days). A time deposit at a bank should be thought of as similar to a certificate of deposit. You can't get your money out for a certain period of time, but while it is there, it earns you interest.

Because of these differences, economists, for many centuries, have classified demand deposits as money but have said that time deposits are not money. A simple example will illustrate the point. Money is that economic good which can be used to buy things. Suppose you go to the store and see an item that you want. If you pull out your checkbook, which is a demand deposit, it will be accepted as money. But if you pull out your passbook to the savings account, then you will politely be told to take the passbook to the bank and get money for it. The passbook is not money (because of the time restriction on it), and you cannot buy things with it.

So even though these deposits are payable as money, they are not counted in the money supply. When they are counted as they should be, Katz reveals that:
Calculating from the end of May 2008 to the end of May 2009, the US money supply has grown from $1.37 trillion to $2.34 trillion. This is an increase of 70%.
So the money supply been inflated by 70% in one year. That reduces the purchasing power of a single dollar by 70%, as that many more dollars chase the same number of goods and services. Our prices have not reflected that yet because there is a lag as that extra money filters throughout the economy. Once that happens though, severe price inflation is inevitable.

I have heard that the Fed plans to pull that money back out of the economy in order to "cool off" the economy before the huge inflation hits. However, that requires perfect timing, and nobody seems to be able to explain how contracting the money supply in an economy where the major problem is a lack of money for lending is going to "help" things. It seems that the Fed has locked itself into a Morton's Fork of either having huge inflation or a powerfully contracting economy, and neither is a good solution.

The real tragedy is that this dilemma was entirely preventable. By taking an interventionist attitude to the problems in the markets, the federal government seems determined to drive the economy off a cliff. An early determination to let the free market work and punish companies (including public companies like Fannie Mae and Freddie Mac) that were engaged in foolish speculation could have allowed the markets to recover quickly, albeit with some pain to investors. But the Fed's unwillingness to allow any pain in the economy has doomed us all to far more than we would have otherwise had to endure.

As a pilot, I like to make aviation analogies, and this is a perfect opportunity for one. When an airplane gets too slow the wings stall. This means the wings lose lift and cause the airplane to sink quickly and the nose of the plane will drop toward the ground. For a non-pilot, the natural reaction is to pull back on the stick to pull the nose up and stop the dive. However, this merely slows the plane more and deepens the stall, until it falls right into the ground. However, if back pressure on the stick is relaxed, the plane stays nose down for a bit and gains enough speed to start flying again. The pilot can then smoothly pull the plane out of the dive gracefully, losing minimal altitude.

The government is pulling back on that stick for all it's worth. As this economic stall becomes worse with each day, those in government act puzzled and mumble about how maybe just a little more back pressure will solve it. The complete lack of faith the government is showing toward market economics and the lessons of history is unfortunately causing those of us along for the ride to look out the window and remark, "gee, those trees down there sure are getting big fast..."

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