The Two Faces Of Inflation:

The Two Faces Of Inflation:

I will begin with Credit Inflation which often goes overlooked due to societys general lack of knowledge concerning how the banking system operates. I find this quite odd because people who work so hard for their money don't really know how their banking institution functions. Maybe that's just me, but who knows? Credit Inflation comes about through the practice of fractional reserve banking which in essence is legalized counterfeiting. Let me explain....

Suppose I go to Bank A and apply for a loan of 9 million dollars. The bank agrees to do so if I am willing to pay a interest on the loan. In the U.S., a 10% reserve requirement is necessary. In other words Bank A can loan out the 9million as long as it has 1million in reserves. People refer to this as the money multiplier. Bank A must make a 1million dollar demand deposit at the central bank to originate a loan of 9 million. This is done by "pyramiding" / using other deposits in the bank or from another banks if needed to temporariliy increase the money supply from 1 million to 10 million. All is well and good assuming banks are able to cover losses on loan defaults, also called "loan loss reserves" which have to be earned from profit (the interest collected in the past). Before discussing the ramifications of having a central banking system inadequate loan loss, it is worth taking not of the entire banking system.

1) The money multiplier = 1/reserve requirement. In our case 1/.1= 10

2) Assuming banks remain fully loaned up (which they have to in order to stay competitive) the money supply = Cash + (Total Bank Reserves * The money multiplier).

So What? Well the moral hazard of having such a low reserve requirement + artificially low interest rates (talked about later) = Economic Boom! Well isn't that great? Nothing could be further from the truth because central banking on a fiat money system "paper backed by nothing" makes for a perfect storm that will bring a currnecy to its knees or collapse "hyper-inflation". 

What is an interest rate really? This is what you are willing to give up in the future for something now. In a free market people have everchanging time preferences. When people have a high demand for money (whatever the reason, it could be because they got fired, and need money to support their family until they can find another or a technological revolution has taken place i.e railroads, automobiles, the internet and thus wish to invest borrowed money to earn a large sum in the future) the interest rate will also go up because a constant supply and increasing demand to a rate that tells Joe Blow peoples time preference. This allows entrepreneurs to most accurately forecast the proper allocation for their funds. On the flipside, if a rate is artifically manipulated, as is our case, even great entrpreneurs missallocate large amounts of capital because he/she incorrectly interpreted people time preference. (This is the main cause of artificial booms)

To avoid disscussing a inordinately long Topic, lets go back to the 2000. Alan greenspan cut interest rates from 5 to 1%, which goes against free market principles and  it became more enticing to borrow money becuase people preferred money now instead of the future. The free market would have had rates increasing for the reasons previously discussed. This led to even more massive missallocations of capital- as we are all seeing unfold.

The aforementioned paragraph is where this crisis began in terms of credit inflation. It marked the only recesion where housing prices increased! The Fed Inflated there way out of a recession that should have lasted longer, spurring a unrivaled confidence of the economies strength, which only augmented the duration and size of the housig bubble. This was not confined to residential loans but investment loans, personal loans, etc). As we all know people became enarmoured by the housing market, bidding up prices to unrealistic levels. Banks were making all the loans they could and as interest payments came in, they made more and more loans. This bubble lasted over 4 years and caused  massive missallocations of capital (Las Vegas being a great example). 

Well we all know what happened thusfar but the true crisis hasn't presented itself: the price we have to pay for living far beyond are means for over a decade. Now is where the true wealth destruction comes into play. Over 800 billion of Reserves has been injected into the banking system which is obviously to cover the loan losses. When a stripper turns day trader or house flipper, you know the defualt rate will be significant. To avoid statistics, think about the potential permanent increase of currency due to loan defaults. The central bank's 800 billion covers 7.2 trillion of potencial losses or can now be used to create 7.2 trillion of more loans (which the government is trying to do and illustrated through cutting the interest rate to 0%).  

For those who didn't really understand what the hell I was talking about here is a great article which serves as a great analogy from a mises daily article:

Jaguar Inflation

Mises Daily by Robert R. Prechter, Jr. | Posted on 2/19/2009 12:00:00 AM

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing Jaguar automobiles and providing them to as many people as possible.

To facilitate that goal, it begins operating Jaguar plants all over the country, subsidizing production with tax money. To everyone's delight, it offers these luxury cars for sale at 50% off the old price. People flock to the showrooms and buy.

Later, sales slow down, so the government cuts the price in half again. More people rush in and buy. Sales again slow, so it lowers the price to $900 each. People return to the stores to buy two or three, or half a dozen. Why not? Look how cheap they are! Buyers give Jaguars to their kids and park an extra one on the lawn. Finally, the country is awash in Jaguars.

Alas, sales slow again, and the government panics. It must move more Jaguars, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay their taxes so the government can keep producing more Jaguars. If Jaguars stop moving, the economy will stop. So the government announces "stimulus" programs and beginsgiving Jaguars away. A few more cars move out of the showrooms, but then it ends. Nobody wants any more Jaguars. They don't care if they're free. They can't find a use for them. Production of Jaguars ceases.

It takes years to work through the overhanging supply of Jaguars. The factories close, unemployment soars and tax collections collapse. The economy is wrecked. People can't afford repairs or gasoline, so many of the Jaguars rust away to worthlessness. The number of Jaguars — at best — returns to the level it was before the program began.

The same thing can happen with credit.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing credit and providing it to as many people as possible.

To facilitate that goal, it begins operating credit-production plants all over the country — called Federal Reserve Banks, Federal Home Loan Banks, Fannie Mae, Sallie Mae, and Freddie Mac, all subsidized by monopoly powers or government guarantees — to funnel credit to the public through banks. To everyone's delight, banks begin reducing collateral requirements and thereby offering credit for sale at below-market rates. People flock to the banks and buy.

Later, sales slow down, so banks cut the price again. More people rush in and buy. Sales again slow, so lenders lower the price to 1% with no collateral and no money down. People return to the banks to buy even more credit. Why not? Look how cheap it is! Borrowers use credit to buy houses, boats, and an extra Jaguar to park out on the lawn. Finally, the country is awash in credit.

Alas, sales slow again, and government and banks start to panic. They must move more credit, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay the interest on their debt to the banks so the banks can keep offering more credit. If credit stops moving, the economy will stop. So the government announces "stimulus" programs and begins giving credit away, at 0% interest. A few more loans move through the tellers' windows, but then it ends. Nobody wants any more credit. They don't care if it's free. They can't find a use for it. Production of credit ceases.

It takes years to work through the overhanging supply of credit. Banks close, unemployment soars and tax collections collapse. The economy is wrecked. People can't afford to pay interest on their debts, so many IOUs deteriorate to worthlessness. The value of credit — at best — returns to the level it was before the program began.

See how it works?

Is the analogy perfect? No. The idea of pushing credit on people is far more dangerous than the idea of pushing Jaguars on them. In the credit scenario, debtors and even most creditors lose everything in the end. In the Jaguar scenario, at least everyone ends up with a garage full of cars. Of course, the Jaguar scenario is impossible, because the government can't produce value. It can, however, reduce values.

A government that imposes a central bank monopoly, for example, can reduce the incremental value of credit. A monopoly credit system also allows for fraud and theft on a far bigger scale. Instead of government appropriating citizens' labor openly by having them produce cars, monopoly banking and credit machines do so clandestinely by stealing stored labor from citizens' bank accounts by inflating the supply of credit, thereby reducing the value of savings.

Twentieth-century macroeconomic theory — both Keynesian and monetarist — championed the idea that a growing economy needs easy credit. But this is a false theory. Credit should be supplied by the free market, in which case it will almost always be offered intelligently, primarily to producers, not consumers.

Would lesser availability of consumer credit mean that fewer people would own a house or a car? Quite the opposite. Only the timeline would be different. Initially it would take a few years longer for the same number of people to save enough to own houses and cars — actuallyown them, not rent them from banks. Prices would be lower because credit would not be competing with money to bid up these goods. And, because banks would not be appropriating so much of people's labor and wealth, the economy as a whole would grow much faster. Eventually, the extent of home and car ownership — actual ownership — would eclipse that in an easy-credit society. Moreover, people would keep their homes and cars because banks would not be foreclosing on them. As a bonus, there would be no devastating across-the-board collapse of the banking system, which, as history has repeatedly demonstrated, is inevitable under a system of central banking and other government-created credit factories.

Jaguars, anyone? More credit? Here's a better idea: let's go back to using real money.

Enough Said about that

Lets not forget, the otherside which is a lot easier to fathom. We have 1.3 trillion in FED purchases of mortagage back securities which optimistically speaking may be worth 20 cents on the dollar, The government monetization of the debt via treasury purchases, our 12+ trillion debt to other nations, our unfunded healthcare liabilities increasing hundreds of billions per annum, etc.