Thursday, March 27, 2008

Tug of war

I recently described the tension between the Fed's attempt to print money, and thus increase the money supply, and the financial system's attempt to de-lever in the face of (now obviously) bad loans as two opposing armies. One side is stoking inflation through all means possible, while the other is shedding bad debt, risky loans, and unsustainable consumption on the grounds that it's, well, unsustainable, and so deflating the overall money supply.

The massive money printing by the Fed over the past 10-20 years has resulted in a US economy that is too small for its clothes, and the question is will it grow into a comfortable fit through getting bigger, or can we shrink the clothing itself? In this analogy, I'm not sure which of the two approaches corresponds to the inflationary or deflationary scenario, although as a net saver personally, I prefer deflation.

Cassandra also sees this situation as a tension between inflationary and deflationary forces, describing it as a "a liquidity tug of war". But whatever happens in the markets on a given day, we are still in the early period of a significant financial realignment.

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