DEFLATION OR INFLATION OR WHO'S GOING TO FINANCE THIS MESS?

The chart below indicates the relationship between US Public Debt and Gross Developed Product (GDP) of the USA from 1919 until 2008. The ratio peaked in 1946 (World War II), and slowly declined until 1981. It took 35 years to “pay down” the debt created during World War II. Notice that during the great depression the ratio actually fell in 1929 to 16.34% and then rose to the 40% level until the War started. By 1985 the ratio was higher than the pre war level. Our Government (like the American Consumer) love’s borrowing money and blowing it. I estimate that the current US Public Debt of $10 Trillion will rise to $18 Trillion by 2009. I am also assuming GDP drops .79% to 14.4 Trillion in 2009. If the “creation of Government Debt” is greater than a net $8 Trillion and/or the GDP drops more than my estimates, the ratio will be worse. The Ratio by 2009 will be higher that the War high.



The point is not, gosh wowee; look at the spike in the chart; but rather, who’s going to buy all these Bonds? Remember, after the War started, the USA was the odds on favorite to win the War. Of course after the War, the USA controlled the free World, and was the most prosperous power on Earth. The US Dollar was Gold.

We have a much different structure today. We have managed to transfer our “Wealth” to other Nations that have a vested interest in our Economic system (Russia, China, India, Brazil, the Arab Countries, etc). If you ran the Chinese Government’s financial system, would you feel comfortable holding Dollars and Dollar denominated investments? I think not! The World is awash in our dollars and Treasury Obligations.



The Chart above shows what Economists call High Powered Money (HPM) and/or the Monetary Base. HPM is the sum of Currency in Circulation and Bank Reserves.
Increases in HPM allow the Banking System to “print money”. Note that the current HPM total sets a world record high.

What does this mean? The USA is printing money big time. How does this process manufacture money? There are three parts to the printing of money; The Central Bank (Federal Reserve), Commercial Banks, Savings and Loans, Credit Units etc, and us. The Federal Reserve controls the Bank Reserves portion of HPM, and we control Currency in Circulation. Every time you deposit currency in your bank account you increase HPM. Conversely, when you withdraw currency from your bank account you decrease HPM. It was the mammoth withdrawals of currency that accelerated the Great Depression and led to collapse of the Banking System.

The Federal Reserve is allowed to write checks to buy assets, or loan money, without any constraints. Banks, as a generalization, are required to deposit with the Federal Reserve a “reserve” which is defined as a percentage of their Demand Deposits (the money they owe their depositors). The table below illustrates what happens if for example the Federal Reserve Buy’s $100 of US T-Bonds in the open market. The same example could be used if a depositor placed $100 in currency into their bank account.

In the example below the Reserve Requirement is assumed to be 10%. Note that the simple purchase of $100 of Bonds expands the money supple to $1,000 and increases credit (loans receivable) to $900.



Monetary expansion is merely a pyramid game. However, when the bubble bursts, we experience the reverse. All the bad credit blows up. When credit expansion blows up, asset values blow up. The contraction then feeds on itself

In October and November HPM increased $532.637 Billion dollars. The reserve requirement is about 10% so the theoretical expansion of the money supply is 10 times or $5.326 Trillion and the expansion of credit is $4.794 Trillion dollars. To put this into perspective M1 (money supply) in October was $1.46 Trillion. This ladies and gentlemen is a whopper! Our money creation is now on crack!

There are several points to make at this point: (1) the expansion of this process does not happen quickly. Each bank must want to loan money, and it takes time to complete a loan. (2) there is leakage to the expansion of credit.

However, the bail-out is not over. Billions and Billions of dollars are going out the window to banks, credit card companies, auto manufacturers, and anybody else who is “too big to fail”. All under the “headline” of preventing Deflation.

In my opinion, we are in a deflation mode. The unwinding of credit and the collapse of its related assets could take many years. The investment strategy in deflation is to stay liquid and out of debt. For example, by paying more than the minimum payment on your mortgage earns you the interest rate charged. Unless your mortgage rate is less than the 10 Year US T-Bond of 2.657% I suggest you double up.

When all the money creation is through, we will finally be confronted with Inflation. When Inflation takes hold we finally return to the wonderful days of leveraging and spending money like Bozo’s. Hang on, you will survive. Uncle Sam to the rescue!