Friday, November 14, 2008

Fiat Money's Unexpected Outcome

Many experiences with fiat -- or paper -- money have made people think it must inevitably lead to inflation. This is what happened in the U.S. during the War of Independence, Weimar Germany and Zimbabwe.

But a more complex truth is emerging: Fiat money can produce extreme DEFLATION rather than inflation. Why? The answer is relatively simple: Central banks don't just "print" money. Under the concept of "fractional reserves," banks lend more than they hold in deposits, which brings new money into existence.

In less sophisticated economic situations, such as 18th century USA or Germany immediately after a war and famine, governments printed money which drove up the price of everything from bread to cab fares. But in advanced economies like the USA today or Japan in the 1980s, this money was channeled into "responsible" purposes, like funding office buildings, houses, stocks, and, of course, mortgage-backed securities.

This drives prices of these specific things higher. Instead of having inflation in common consumer items, we get inflation in assets -- BUBBLES.

When these bubbles inevitably pop, it contaminates bank balance sheets and causes losses in capital markets. In the case of Japan, banks curtailed all lending. In the case of the USA, where financial markets have replaced banks, market participants liquidated positions in things like asset-backed securities. Both events have the same outcome: less lending, less credit, deleveraging, recession and deflation.

The key difference appears to be that in the case of Weimar Germany or Revolutionary America (or even the USA during WWII), the government literally printed the money to pay for day-to-day stuff. This caused inflation in food, wages and other goods. In contrast, in the modern financial-market economy, it causes asset appreciation.

The difference is in the degree of financial intermediation. If there's a bank or some other kind of lender, they provide funds for assets. Even when banks helped to finance people's vacations, in reality they were providing something like a second mortgage on an actual house, so they were actually financing an asset.

Another key aspect of this is the role of trade and foreign capital flows. This provided a base of capital in both Japan and the USA, which wasn't present in Weimar Germany etc.

I have more evidence about the extent of the yen carry trade. I am beginning to realize what a massive phenomenon this was. Only government could make a mess this big. In this case, it wasn't even our government -- it was Japan's.

Going forward the U.S. will lever up to "stimulate" the economy, we may wind up creating money that is spent on stuff, such as wages. The big question is whether that will produce true inflation.

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