Thursday, March 20, 2008

Opposing armies

In my last post I wrote about how, in the current US financial system, credit is money. It stands to reason, then, that when institutions that used to give out credit start to reign it in, the supply of money shrinks.

So, when mortgage issuers decide to no longer allow zero-down NINJA, neg-am, liar loans, they have reduced the amount of credit in the world and thus shrunk the supply of money. When you have a systematic reduction in credit, because people are trying to decrease the amount of debt they have, then that's called "deleveraging" or a "credit crunch". And just as an increase in the money supply dilutes it ("inflation"), a decrease in the money supply concentrates it ("deflation"). In an inflationary environment, where old dollars are worth less than new dollars, debt is cheap because time will whittle it away. In a deflationary environment, where old dollars are worth more than new dollars, debt is expensive because it grows with time, and cash is king.

As financial institutions reduce their leverage, shrinking the money supply, the Federal Reserve is doing everything it can to counter this by increasing the money supply (diluting the US $). The lower interest rates, the generous lending terms, the swapping crap assets for dollar bills, all increase inflationary pressure. Right now I don't see dramatic inflation or deflation in the US, but I do see extremely powerful forces building for each, and I do not know which will overwhelm the other, or if they will both counterbalance each other perfectly and can both be reduced in sync.


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