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by TheFalcon on July 28, 2009

Currency RainINTRO

The inspector general of the Troubled Asset Relief Program (TARP) will report today that the U.S. liability for all of the bailout plans so far is $24 trillion.  That’ll buy a lot of beef jerky.  Just to put that in context, the U.S. government only collects in the neighborhood of $2.5 trillion in taxes each year!  Let’s face it, the U.S. government is engaged in an orgy of debt issuance, money creation, institutional bail outs and deficit spending, the likes of which have never been seen.

What are your thoughts on whether these actions are inflationary, deflationary, irrelevant or just plain ludicrous?  You can form your own opinion as to the absurdity of it all and leave me a comment.  In the meantime, I’m going to focus on clarifying where the deflationary and inflationary forces at work in the global economy are taking us.


With trillions of dollars being spent, borrowed, printed, loaned, and guaranteed, more than a few people have begun to wonder if the specter of historic price inflation is just around the corner.  Understandably so, as most people generally get the idea that when there is a tidal wave of supply of anything its value will tend to fall.  This is as true for currencies as it is for bananas.  The fall in value is made even worse if at the same time your new ocean of supply hits the market your customers no longer want your product.

The U.S. dollar finds itself in this position today.  Our government is creating a flood of new dollars and debt to address the economic crisis, but this is having the effect of undermining the dollar’s value and therefore the confidence that others have in holding dollars.  So supply is increasing at the same time that demand is falling off, leading to a decline value.  Surely, this is an inflationary scenario with way too many dollars chasing fewer and fewer economic goods.  The Chinese, who hold in excess of $1.5 trillion of their foreign exchange reserves in dollars and treasury paper, seem to be concerned.  Chinese Vice Premier Wang Qishan had this to say today,

“As a major reserve currency-issuing country in the world, the United States should properly balance and properly handle the impact of the dollar supply on the domestic economy and the world economy as a whole,…”

But hold the bus you say!  Aren’t we in the midst of a deflationary crisis?  Housing prices are still falling, the stock market is in the midst of a bear market dead cat bounce after collapsing last year, defaults on debts of all kinds, bankruptcies are increasing, banks aren’t lending, people aren’t spending and the state governments are broke as the economy continues to get worse and people continue to lose their jobs.  Surely this is a deflationary scenario with no one buying or borrowing anything, while those who can are saving and thus demand and prices for economic goods are falling.

So which is it, inflation or deflation?  Could it be that both forces are at work at the same time and that both are at different stages of their development?  In other words, could inflation and deflation be overlapping phenomenon?  Let’s see if we can clear up some things that might make this assessment a little easier.


Let’s start with the definition of inflation and deflation.  These days, almost everyone in the media, government, universities, Wall Street, corporations and elsewhere associates these two words with either a rise (inflation) or fall (deflation) in prices.  This is where the confusion begins, as these are distorted and therefore inaccurate definitions.  Milton Friedman, the famed economist of the Monetarist persuasion, puts it as well as anyone,

“…inflation is always and everywhere a monetary phenomenon.”

“Monetary” meaning, if you inflate (increase) or deflate (decrease) the supply of money (this includes cash and loans), one of the effects of this will be to cause an increase or decrease in prices in the market place.  Most people understand how this works when they think in terms of the stuff they buy in the market place, but it is often lost when it comes to money itself.

This is one of the first observations made at the dawn of modern economic study in the 18th and 19th centuries among the “classical economists”.  It remained a clear and accepted phenomenon until sometime near the end of the 1970’s and early 80’s.  Since that time, it has been gradually obscured by changes in dictionary definitions and misinformation spread far and wide by our academic, journalistic, political, and economic institutions, leading to much confusion on the subject amongst the general public.  Please refer to a previous easy, “Inflation, Disinformation And The Need To Define Terms”, for a more in depth discussion of this subject.

If you increase the money supply and the availability of debt faster than the output of goods and services then prices will tend to rise.  And the opposite is also true, that if you decrease the money supply and the availability of debt faster than the output of goods and services are contracting during a downturn, then prices will tend to fall.  We have witnessed the effects of a savage deflation first hand over the last 18 months or so.  As lending has more or less disappeared from the market place, the goods that these loans would have been spent on are not being purchased, and thus falling in price.


Hopefully, we have clarified the definitions of inflation and deflation.  Armed with these definitions, let’s see if this helps us discern what lies ahead for prices that real people pay for real things.  In 2008, we experienced a massive deleveraging event, which is a fancy way of saying that lending contracted severely.  This is deflation, plain and simple as it results in less money being available in the economy to buy things and this is still going on.  However, the authorities have responded in the name of economic stimulus by pumping rivers of new money into the coffers of selected banks (with the idea that they will lend it) and corporations in the form of bailouts.

Let’s briefly go back in time.  The Federal Reserve has been steadily increasing the money supply (i.e. printing money) since its inception in 1913.  As a result prices have always tended to rise and the dollar’s value decline over time.  (click on charts to see larger versions)

Monetary Base Since 1913

Monetary Base Since 1913

$ Purchasing Power Since 1913

$ Purchasing Power Since 1913

Inflating the money supply has two parts, the printing and distribution of actual cash dollars and the growth of loans and bank balances through fractional reserve banking (i.e. loans created out of thin air thanks to the Federal Reserve Act of 1913).  We have now had almost 100 years of this kind of monetary inflation and the consequences are manifesting themselves in yet another economic crisis.  In particular, the ever increasing debt part of the equation, by definition, has an expiration date attached to it.  In the same way that there is a limit to how much money you and I can borrow and be expected to pay the loan back, there is clearly a limit to how much lending and borrowing a nation can do.

The U.S. has been able to get away with this for such a long time without becoming a banana republic because of the U.S. dollars role as the world’s reserve currency since the end of WWII (to the victor be the spoils).  But this is a topic for another essay and the U.S. dollar global reserve currency status is now in jeopardy.  The savagery of  the deflationary debt spiral which began last year and is still ongoing, is directly proportional to the size of the mountain of debt accumulated over the last several decades.


If you can follow the progression one step further, the Treasury and Federal Reserve are now attempting to stop the deflationary spiral (decline in lending) with the very thing that caused the lending contraction in the first place; by inflating the money supply (both dollars and lending) even faster and to a much greater extent than before; in fact, to a much greater extent than has ever been witnessed in history.  In short, they are trying to put out a forest fire by pouring an ocean of lighter fluid on it.  You get the picture.

To clarify, the money printing and debt creation that the Fed and Treasury are engaged in to provide “liquidity” to the financial sector is an inflation of the money supply.

On the other side of the confusion, the collapse of lending, business income, employment income, and the related value of asset prices (ex. houses, stocks, commodities, kitchen sinks, etc) leads to a loss of available money and credit.  In other words, this is a deflation of the money supply or a decrease in the amount of money available to buy things.

In summary, there are inflationary and deflationary monetary forces currently at work in the global economy.  Now, let’s put events in their proper order for perspective.  We have experienced a century of monetary inflation, ending in a massive debt bubble that finally burst, plunging the global economy into a deflationary spiral which sparked a panicked  governmental response of epic monetary inflation.  Since the price of things is a function of the money supply and with history and common sense as our guide, we can expect equally dramatic movements up and down in price levels of the various goods services in our economy.

Perhaps a useful way to visualize recent monetary inflationary and deflationary events is to think in terms of water (money and debt) collecting behind a very large dam, keeping the water in a big basin (our economy).  Imagine the water rising steadily over time (since 1913), and also raising everything floating in it (prices).  Ever wonder why a dollar won’t buy as much as it used to.  Now you know.  Imagine that in 2007, the water had risen to such a high level that the damn began to weaken and spring leaks (think sub-prime crisis in 2007).  Then in 2008, the damn finally burst under the weight of a century of rising water.  The water (all money and debt) then flooded out of the basin (our economy) causing the water level in the basin to plummet and taking everything floating in it down also (prices of real estate, stocks, consumer prices, Home Depot stuff, etc).  Now imagine that the authorities, who were responsible for pumping too much water into the basin in the first place, then try to stabilize the situation by trying to pump even more water into the basin faster than the water is running out.  That is quite a scene to visualize.  Can you see the futility of such a plan?  Not very bright, but there it is.


It is important to note here that  some prices will rise and some will fall and some will do both.  Can you see why?  Those things that people, companies, banks and governments relied on (mortgages, credit cards, auto loans, bond sales, leveraged buyouts, etc) to purchase will decline in price, because the loans are no longer there to buy things.  These are the effects of deflation.  However, do you remember that $24 trillion we discussed at the beginning of this lengthy essay?  This money has to go somewhere!  And wherever it ultimately goes, it will certainly raise those prices.

The current deflation is of the debt kind and not the cash kind, because the Federal Reserve can print as much cash as it likes, but it can’t make banks lend nor people and companies borrow.  Therefore, it is the assets, goods and services that are purchased or paid for with debt that will decline in value and price, whether they are houses, cars, consumer goods, steel, payrolls, government employee salaries, etc.  That is what we see happening now.

However, based on what we have discussed above, I believe there are historic price increases coming for those assets, goods, and services that are in the direct path of the Feds $24 trillion dollar flash flood being unleashed on the economy.  This flood of money and credit is bound to raise the prices of whatever it touches.

Here is where the effects of debt deflation followed by massive inflation can have very sinister whipsaw effects.  During the debt deflation all manner of industries that mine or make the things that we humans use for food, clothing, shelter, energy, and transportation put the brakes on production both because they can’t get loans to operate their capital intensive (expensive) businesses and because as the economy worsens they produce less and begin to contract operations.  This goes on throughout the deflation period and is a vicious self reinforcing cycle as businesses contract, stop making loan payments and lay people off causing their lenders to fail and unemployed people to no longer show up in the marketplace to buy things, leading to even more businesses going bankrupt which in turn leads to even less of the things we need to survive, thrive and function being mined or manufactured.  In short, the supply of natural resources and production capacity shrinks rapidly.

Well what happens when the dust clears from this deflationary period revealing that the world’s supplies of stuff have shrunk dramatically, and suddenly this reduced amount of natural resources and production capacity collides with a swollen river of new money being pumped into the economy through government and big banking channels?  In short, what happens when there is a lot less stuff to buy and a whole lot more money is available to buy it.  The Germans and Zimbabweans know a little something about this, to name just a couple of countries with experience in the long sad history of these matters.

Unfortunately, there are other factors which conspire to make this picture even worse which will be the topic of future essays.  To mention a couple, there are the effects of Peak Oil (the rapid fall-off of global oil production and new oil field finds) combined with steadily increasing demand for the worlds natural resources coming from Asia in general and China in particular and finally the trending decline in value of the U.S dollar (aka dollar displacement).  These three trends are not likely to be derailed by the current economic downturn.

The Falcon

{ 3 trackbacks }

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July 30, 2009 at 11:32 pm
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July 31, 2009 at 1:45 am
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August 5, 2009 at 1:17 am

{ 9 comments… read them below or add one }

1 alex July 31, 2009 at 2:00 pm

I was enjoying reading your article and i think you have an interesting point of view. It triggers my curiosity and I will research more about this. Hope we can discuss about this topic next time we meet for coffee.


2 Irthcomm July 31, 2009 at 3:16 pm


This is a fantastic primer for those that find themselves scratching their heads, wondering just what has happened over the last couple of years. How quickly we went from boom to bust, leaving the ‘average Joe’ just dumbfounded.

I especially appreciated the ‘dam’ analogy. I think that is an excellent visual description of the scenario we find ourselves in.

I was hoping you might comment on the phenomenon of ‘stagflation’ as well. I think it would be helpful to the lay person to understand what that term means, and where it may fit into the picture.

Keep up the great work!


3 TheFalcon July 31, 2009 at 3:25 pm

Thanks Irthcomm for the detailed comments. I think I will take you up on the stagflation discussion. Hope to see you back here.


4 G. Bowles August 1, 2009 at 1:36 am

Very interesting information. Especially for those of us who find ourselves wondering where it all went wrong. Knowing that it had to be more than just the mortgage crisis causing the collapse that we see. Your background info shows that we have been headed down this path since the formation of the Federal Reserve and that is just scary.
Keep up the good work. I’ll enjoy the class from afar…


5 Christophe August 3, 2009 at 2:45 pm


Insightful, frustrating and depressing. It makes one wonder whether the smartest guys in the room are just stupid or is there something menacing at work. We the people have now purchased the junk bonds of a decade or more of private excess. At first, the administration said “no, no, don’t worry, like private investors Americas will get their money back over time as the value of those bonds rise.” Now, of course, you are getting the first admissions by the administration that this was a fallacy, that those bonds were worthless from the start, and that the only way we will pay off the debt used to buy that junk will be increased taxes on the middle class. That of course is on top of the crippling decline in purchasing power to come, as you note, for those measly dollars that the government lets us keep.


6 Mike August 5, 2009 at 12:15 pm

Great article Falcon, thanks for putting all together in such a clear manner .. great one pager to send to people who are trying to figure out what is going on and why.. I’ve been telling people that the USD is a ticking bomb and for the same reasons as you posted am short it vs a basket of CCYs (unfortunately my writing is nowhere near as good so i usually am much less detailed, but then again i dont claim to be a writer).. i just hope more people see the disaster that is lurking..


7 Kevin Carr August 20, 2009 at 3:37 pm

Thanks for directing me to this article. I still think the US government is trying to cure the deflationary disease with inflation given the way they keep pumping money into the system and this is dangerous to say the least as you correctly mention. I hope we don’t end up with a Germany or Zimbabwe type situation on our hands.


8 TheFalcon August 20, 2009 at 4:04 pm

I agree with your comment, that they are trying to prevent deflation with inflation. Bernanke’s Nov 2002 speech on how to combat deflation seems to confirm this notion. In fact that speech appears to be his playbook. Unfortunately inflation doesn’t harm the banks as much as deflation, hence his focus on deflation.


9 TheFalcon July 31, 2009 at 10:16 am

Thanks for the pingback. I will do my part to keep the conversation going.


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