A tale of two 'flations.

I sometimes receive emails from family and friends trying to understand why I can talk about inflation in one breath and deflation in another.  I have explained it to them in the past but it was some time ago and memories are short.  So I will briefly explain it again here for the record.

The money supply consists of two main components: the monetary base and the debt enabled by fractional reserve lending.  With honest credit/debt (yes there is such a thing), the money supply does not actually increase.  The money is simply transferred between two parties.  Once transferred, the first party can not spend it into the economy until such time (if ever) it is repaid.  The control of the money is given to the second party who can spend it.  Think of it as handing a gold coin from one person to another.  Once out of possession of the gold coin, the lender can keep score about what he is owed but he cannot spend this accounting entry.  Only the person with the physical coin can spend it into the economy.

With fraudulent, fractional reserve lending, the money supply actually increases because when a bank gets its hands on $1 it is allowed to, by law, to create credit in the amount of $10 that is backed by that $1.  The loan is therefore fractionally reserved and the fraction is a very small 10%.  The new credit enabled by this alchemic system spends exactly the same (for now) as do the currency units which make up the monetary base (dollars).  Because of this, the new debt actually increases the money supply in a fractionally reserved banking system.

Right now, the fed is printing up new base money at an incredible rate.  It has not released that money yet into the general economy and the banks are not lending much right now so this new money is simply rebuilding the reserves of banks which have already overextended their past ability to lend.  In other words, the new money helped the banks replenish their capital ratios (amount of base money on account relative to loaned out money that sits on the books as an asset).  The hope was that by fixing the banks capital ratios that banks would again lend money.  But there are not enough credit worthy applicants who are asking for credit.  In other words, the deadbeats all still want a loan but honest consumers are not borrowing as much to consume anymore.

The result is that the banks have been using their new found ability to lend as a back door way to fund the markets.  The banks believe that the federal reserve has their back on this lending via the so called "Bernanke Put".  A put is an options contract which is historically used to mitigate the risk of buying stocks.  Since they believe that Bernanke will support the markets in order to drive confidence into the herd, the gamblers feel that they have a built in "put" provided by Bernanke.  In other words, Bernanke has become their insurance policy against collapse.  This foolish notion assumes that Bernanke is big enough to absorb all the market losses and thus big enough to support the markets no matter what.  Of course, the markets are far bigger than Bernanke.  It is as a herd of buffalo vs. some cowboys that would herd them.  Or another analogy is lions vs water buffalo.  The lions can push the buffalo around most of the time but every so often the buffalo have had too much too often and they strike back with surprising speed and efficacy.

So to recap, we have had growth of the monetary base but a slowing of credit growth and in some sectors we are seeing a decline of credit.  At some point the aggregate credit growth will peak and then turn south.  During that time we can only expect the fed to try to print more money and to do even more radical policy in order to try to prevent a collapse in the overall money supply.  The sequestered stimulus will become unsequestered.  Government will begin picking economic winners and losers.

And so here is the summary of how inflation and deflation can co-exist:

• IN GENERAL, things that are typically bought using cash or which are paid off each month will go up in price because these things are most affected by the growing supply of base money.  They include food, clothing, electricity, etc.
• Things whose valuations have been pumped up by the use of credit will go down in value including homes, cars, and paper wealth assets of all kinds.

The IN GENERAL is thrown in there because the price of some things that you use each day that you do not typically finance, such as gasoline, could well come DOWN in the coming deflation.  Why?  Because oil is treated as an invest-able asset by the money powers.  You might not be buying it on credit but someone else is.  Anything that the crony capitalists have been investing in has been done using leverage.  That means that it is very likely that oil prices are too high simply because they have been bid up not by consumers but rather by leveraged "investors" (gamblers) using low interest rates in order to fund their something for nothing scams.  How else can oil prices have gone up when end user demand has been coming down?  And this is especially true now that Bakken is online.



Click for source of above graph.              Click for source of above graph.


The above examples are only a brief smattering of economic interrelationships.  In other words, the 
whole inflation-deflation thing is complicated and it is presented waaaaay too simplistically to people who have no world view and no economic background or understanding.  In other words, what I would consider to be "headline readers".  These people think they know everything for having taken an economics class in jr college.  They see everything as black and white and thus when they are hit by a shotgun of grey facts they have no clue what is going on and it only detracts from their calm.  It is as if they have entered an economic mine field where every step they take based on their limited knowledge results in an explosion.

The best way to think about x'flation is this:

• If the value of the item is question is primarily driven by the normal supply and demand dynamics of production and consumption then the price will go up in the coming years because the monetary base will be increasing rapidly in order to fight the falling credit.
• If the value of the item in question is primarily driven by the use of debt then expect the price to deflate and perhaps dramatically so despite a rising monetary base because the credit/debt portion of the money supply is a minimum of 10x the size of the monetary base and more like 30-50x the size based on forensics of BK losers like Lehman and others.
• This is why the price of milk will probably go up dramatically even while the price of gas goes down on a relative basis even though gasoline is one of the big inputs to farming.
• Things manufactured in factories that were built using debt will likely come down in price until the excess number of debt-funded factories go out of business.  After that happens, the price of these manufactured items will bottom at a normalized and sustainable level which does not rely on the use of massive debt in order to survive.  After this happens, supply and demand will again rule the prices of these items which means that as the monetary base is increased the prices of them will go up.
• Note the recent action in China where 75% of their solar panel manufacturing industry has now been cut off from easy credit.  Most of the affected players will soon die because they represented excess, debt funded capacity.  Once this is complete (within 12 months IMO), solar panel price will have bottomed and then they will begin to rise due to inflation of the monetary base which will result in higher electricity prices for everyone.  These higher prices will make solar panels affordable on a relative basis.
• The rules that people are using right now for their analyses are those of normal capitalism.  Don't be surprised when they don't work (or in fact work opposite to what was expected).  This will be because we do not have real capitalism in effect.  We have crony capitalism and the rules are different.  It just sounds too conspiratorial for the main stream media to tell the truth and so they will just continue to act clueless as it all plays out.