Tuesday, November 11, 2008

Money Supply vs Real Goods and Services

On the road this week, so blogging will be light.

There was a great article yesterday (Monday) in the WSJ describing how the Fed and Treasury made decisions through the crises. It was a realistic portrait of decent people, doing their best, in difficult, harried times. Sadly, I cannot find it, but if you have the link, please email me and I'll put it up.

It was also clear that Bernanke and Paulson are fundamentally stumbling around in the dark, being purely reactive, and focusing on making things "go back to the way they were." Even though the "way things were" was suboptimal.

A moment now to talk about money supply and inflation.

Suppose an economy has a money supply of X. Suppose it also has a supply of real goods and services, Y.

If X increases by 10%, and Y increases by 10%, there should be no change in aggregate price indices since you have (proportionally) the same amount of money, chasing the same amount of goods and services. Note that anyone saving money in X has been diluted by this 10% increase in X. I used to think that a perfect, globally balanced basket of currencies would be perfectly hedged against inflation but I was wrong -- it does not protect you from dilution.

Alternatively, suppose X increases by 20%, and the supply of real goods and services increases by only 10%. Here you have dilution as before, and you will also have rising prices show up in the CPI, and thus be termed "inflation" by economists and the press.

The fall in real estate prices and other asset classes has shrunk X. The supply of real goods and services has contracted also, but not as much. So, X has decreased more than Y has decreased. This is why we are in deflation and the economy is also shrinking.

The Government is printing a huge amount of money and giving it to financial institutions. They may also start giving it to automakers. Since both industries are a net destroyer of value, this means that the increase in X will not be met by a concomitant increase in Y. If they "stimulate" too much, then X > Y and we'll get inflation. Maybe a lot. If they "stimulate" too little, then money supply will continue to fall, and we will stay deflationary. If they "stimulate" just right, then any increase in X will be met by an increase in Y, and we won't see a change in prices, but the supply of goods and services will increase.

Please note that all of these scenarios will result in "dilution" and punish anyone holding dollar bills. The Press and economists seem to think that China's current account surplus with the US means that China is in a better position than the US, but they've been exporting real, useful good and services in exchange for paper. I know which I would rather have.

Also, please note that the majority of Government actions to date have focused on supporting particular industries, which guarantees that in the increase in money supply will exceed the increase in real good and services. State owned enterprises that continually hemorrhage money (AIG, Fannie, Freddie, GM, Ford, Chrysler, Citi, Goldman, JP Morgan, AMEX etc.) are inflationary in that the money they get from the Government goes into general circulation, increasing supply, while the goods and services they produce are not commensurate to that increase in supply. This will be dilutive and inflationary (X increases, and the increase in X is greater than the increase in Y).


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