The Skip Bureau

Most people aren't aware that there are two common types of inflation. One, the classic definition of inflation, is monetary inflation. This simply means that the money supply is growing. The money supply encompasses anything that might be convertible to cash at some point. So, a new fractional loan, where the amount of real money backing the loan is less than the amount of the loan, is an increase in the money supply so inherently inflational.

The other type of inflation is price inflation, which is commonly used as a proxy for money supply inflation because, due to the price curve, they obviously go hand in hand at most times. But not always. Let me explain.

First off, fractional banking. Our banking system hasn't been on a real gold standard for a very long time. We issue money when the treasury says so. We issue debt through the Federal Reserve Bank, which is a 'lender of last resort', meaning that the fed lends money when money isn't available elsewhere. The idea is that when business runs out of money to do a given thing, they can get it from the fed and thus avoid having to simply forego that thing for lack of capital. Theoretically, this should lead to a more stable economy and more jobs for everyone. What it actually does is cause inefficiency and a bubble economy.

See, that money the fed loans out like a firehose goes into banks. These banks are allowed to loan, right now, over 100 times as much assets as they have. This means that every dollar they borrow from the fed they can loan at least $100. In case you were wondering where easy credit came from, there it is. This is called 'fractional banking' and is generally considered to be a good idea if kept low enough to not endanger the financial health of the bank. In the case of the current system, the banks do not have to worry because they can always borrow to cover bad loans.

Now, it is argued that this is not inherently inflationary because the loans go to buy goods and services that have value so the value of the goods and services offset the value of the money created out of thin air. This is true, to a point, of price inflation, so long as the scheme does not get out of hand. If the money is actually going to necessary things and if the rate of monetary expansion does not exceed the rate of production expansion, you're ok. In other words, as long as the total number of dollars does not grow faster than the total number of things you can buy with dollars, we are ok.

It has also been argued, by me, even, when younger and dumber, that a little inflation is good because it drives investment by reducing the value of liquid assets and thus driving capital investment. I, of course, no longer hold this view.

Both of those arguments confuse price inflation with money inflation. It is easily possible for the money supply to inflate at a faster rate in real terms than the production of the economy and still not see serious price inflation. This is happening now to some extent.

Here is how it happened. The fed lowered rates during the run up to the dot-com explosion. People took loans out on their houses at the low rates and bought stuff, stuff they would have done without or bought out of income. They took their income and played the stock market. This is part of why the market went on such a tear.

This is, basically, the stock market sopping up the excess credit. Now, due to wage increases and improvements in efficiency, prices actually went down during this time. So, we had monetary inflation and price deflation for some periods of time.

Then the bears set in and the market crashed. If you were wondering where all the money came from that was lost, it came out of income displaced by debt. This means that people now have greater debt without the compensating assets. This is value destruction. With money quite scarce, prices fell. So, we had price deflation again. But, unlike a true recovery, in which money would flow out of the stock market into a revitalized bond market based on higher interest rates, the fed lowered rates, so, once again, money flowed out of equity in houses into another bubble.

This time, it was the houses themselves. People are bidding houses to silly prices using loans written on fed credit. Once again, except for housing, energy, food and insurance, inflation isn't really all that bad, but monetary inflation is off the charts. All that money is now finding its way into seriously overpriced real-estate. We're seeing double-digit price inflation in real-estate with no double digit increase in income. We're seeing housing stocks trade ridiculously high.

And, then, two hurricanes hit, raising the spectre of direct aid to this market segment. This means more money into an already tight real-estate market. Now, conventional wisdom says that what goes up must come down, or, to use an economist's catch phrase, everything regresses to the mean. Those house prices have to come down at some point because even the most creative loan can't have a payment larger than the income of the borrower.

In some areas, the lender is counting on the increase in value as part of the payment on the loan, thus creating partial-payment mortgages that will become serious problems if the market even stops going up.

What kind of serious problems? Well, when a market crashes, it takes with it price inflation, meaning you can often buy stuff for pennies on the dollar, but it does not necessarily remove monetary inflation, meaning that all those outstanding loans are still due. Well, only an idiot would still stay in a home with a million dollar mortgage that is now worth $200,000, particularly if he just got laid off because his company is feeling the crunch of nobody having any money.

What he will do is walk away from the house. Now, the bank has to sell that house in order to recoup cash so that it does not become insolvent. It ends up unloading it at 30% below its market value, or about $160,000. It must now raise rates to cover its losses. This will raise the price of capital, meaning bonds will go up, meaning that companies will have to charge more to cover the increased price of their carrying balances. In the short term, the market would be badly mauled. In the long term, we'd all be better off.

Is this going to happen? No. The fed WILL step in and loan more money to keep bonds low. It will bail out banks that have written bad debt. It will prop up the housing market and the stock market with all its might. Foreign investors will continue to pull out of the US. Asian markets will continue to sop up dollars until their own currency begins debasement or must be allowed to float free of the dollar. The dollar will continue to decrease on the international market, causing prices to creep up in the US. Inefficient corporations will still have access to bridge loans to keep up their barely legal activities. Oversight boards in the SEC will still act as if they reduce fraud when fraud is the only way to make a buck.

How long can this go on? As long as the Asian countries let it. When they stop accepting dollars but start demanding some other currency or gold, we're screwed. That's when the real inflation sets in. Even worse would be for those foreign exchange banks to start selling off all the dollars they have. They'd turn the US into an essential island overnight and drive massive price inflation as so much of our economy is based on imports.

They have good reasons to not do this, being as how it would ruin their economies as badly, if not worse, than it ruins ours. In a word, there is no way out of this.