That’s Worth A Dollar
Except when it isn’t. Which it almost never is.
You see, when the Fed creates a dollar, it doesn’t even exist until somebody, somewhere borrows that dollar. Then a bank writes the loan, creating the dollar in question. Immediately the dollar is worth more than 100 pennies, due to the interest being generated by the loan. If the loan has a 5% interest rate, then each dollar in the loan is worth 105 pennies (to the economy).
But it doesn’t stop there. That dollar is left as a tip on a restaurant table and is spent by someone else, perhaps to pay a bill or buy some drugs. Then whoever owns the dollar spends it again and so on, on down the line until the dollar is eventually destroyed for one reason or another.
Generally speaking, a healthy economy’s dollars will always be worth more than 100 pennies, because in a healthy economy that dollar moves around, being used over and over by different folks. That’s called velocity.
Deflation occurs when the value of a dollar added to the economy produces less than a dollar’s worth of wealth. It seems impossible for this to occur, but it is indeed possible and is one of the things the Federal Reserve Bank tracks very carefully. Below is their chart of M1, the multiplier effect of a dollar in the US economy. (As an aside, notice when the M1 started it’s downward journey? That’s the effect of one man: Alan Greenspan.)
M1 can decline for many reasons, the most obvious one being too much debt in the system. When there’s too much debt, loans get scarce. Without loans, those ‘billions of dollars’ in stimulus don’t exist yet, and so those dollars cannot be spent by all those folks who would have been spending it.
So money gets more scarce, and the same folks who just a few years before were eating out every night are starting to buy dried beans in bulk. Instead of a latte they drive past Starbucks sipping on the travel cup they brought from home. Whether they’re hoarding their cash or just don’t have it anymore doesn’t matter. The fact that matters is that the cash is not being moved around. The velocity has ground to a halt.
Same thing happened a long time ago. There was a time in US history called The Roaring 20s – remember that? The movies all paint it up to be a time of unbridled economic prosperity, but the truth of it is slightly different.
What actually happened was that the economy took a dive between 1917 and 1920, and the Federal Reserve, then only 7 years old, opened the floodgates to the money supply. They dropped interest rates to practically nothing and credit skyrocketed. Similar to the easy credit so rampant over the past 20 years or so, by 1929 all you needed was a non-verified signature and the loan was yours.
We know how that turned out. The market dived in 1929 and then dived again in 1933.
The chart below shows the economic supercycle for the US over the past 100 years or so. The parallels between the 1920s-1930s and now is uncanny. Noting that the cycle touches the bottom of the chart only twice (roughly 1920 and 1981), and trying to account for the lengthening of the time spans between intermediate reversals (real recessions), it still seems to me that we should’ve crashed much worse after 1999.
That we didn’t suffer a worse crash in 1999 is most likely the result of actions by the Fed. They jumped straight into the ‘exceptionally low” interest rate scheme and we’ve been there ever since. In the early part of the last decade(2002, I think) Greenspan stood on a stage with Bernanke and announced that the Fed’s goal was to “blow a bubble in housing”.
Well, they did that and more. To blow the bubble in housing they had to blow a bubble in credit, and when the the credit bubble burst, it took the housing bubble with it. And why did the credit bubble burst? Because fraud was inherent, built right into the bubble. Look at the facts: AIG, Lehman, Goldman, BofA.
You might agree with what they’ve done. You may believe, like they do, that the mathematics behind finance and economics can be controlled.
You may, indeed, be captive to such hubris.
Just remember one thing. What goes up, does indeed come down.
Unless it goes up with a velocity strong enough to overcome the natural forces of nature. And then it’s gone.