Inflation is Everywhere and Always a MONETARY Phenomena: Isn't it?!

How can all these economists keep warning of deflation when the fed has been pumping money into the system like crazy?

Comments

[Bertie Arbon]

Look at the M1 money multiplier - it's 1! They're pumping it in but no ones lending it out. Deflation now...inflation later I reckon.

[Peter Boettke]

It is not "deflation" --- it is regime uncertainty. There is no "credit freeze", government has created an environment that nobody wants to enter.

Our lack of collective understanding on this as a profession is worse than the collective confusion on the collapse of communism.

Time to rethink the discipline when it is so confused on major practical issues.

[Steve Horwitz]

The only possible case for deflation at the moment is that the fall in oil prices has pulled down various measures of the price level. HOWEVER, that is very much "benign deflation" and not something that requires a response by the monetary authority, especially when it's been opening the floodgates the last few months.

Pete's comment above is spot on.

[Peter Boettke]

Oh, and I meant to add --- stop pumping the money supply!!! Isn't the definition of insanity the repeated attempt to do something that doesn't work???

[Zachary Kurtz]

I was going to mention falling oil prices but Steve Horwitz beat me to it... Only in this day and age is falling prices a cause for concern (rather than an excuse to start saving again!)

[Ed Weick]

Pete,

What do you call it when almost everything you own (house, investments, etc) is falling in price?

Especially when our government's induced inflation fangs are into the information content used by decision makers and not necessarily causing prices to rise.

ED

[Peter Boettke]

Ed,

I think we need to be symmetrical (and careful) in our definitions: inflation --- increase in money supply not offset by an increase in money demand; deflation -- decrease in money supply not offset by a decrease in money demand. In those instances, monetary disequilibrium follows.

Regime uncertainty on the other hand adversely impacts market behavior.

So I would not call our current economy as suffering from "deflation", I would say that we are seeing a market adjustment (correction in the housing market and in investments) compounded by government policy failures.

The family of policy errors in this instance include not only monetary and fiscal irresponsibility, but government involvement in markets which they should never be involved in. We have entered an era of "market socialism" without a coherent plan, and financed by deficits and easy credit.

I guess this means we very well may have entered a phase when government stupidity has finally outpaced the Smithian gains from trade and the Schumpeterian gains from innovation.

Pete

[Steve Horwitz]

During the 90s, my brother used to correct me when I used the phrase "downsizing". He'd say "you mean RIGHT-sizing." I think we're seeing the same thing with some of the asset prices right now - it's not that they are falling in a "bad" sense, but that they are "right sizing".

[Dirtyrottenvarmint]

What is money? The Federal Reserve Note is not backed by any material good or commodity. It's just a "promise to pay" by the U.S. Government. I.e. it's a credit instrument. All "money" today is actually just credit.

Financial institutions have credit instruments listed at trillions of dollars on their balance sheets that are in reality basically worthless. As they are forced to stop pretending and write down the valuations this causes a massive decrease in the supply of money and credit. Meanwhile consumers and businesses are drowning in debt and desperately need money in order to pay off their loans. Decrease in money and credit combined with no corresponding decrease in demand for money equals deflation.

The Fed/Treasury actions to date have been the proverbial drop in the bucket. $700 billion of spending? We're talking about tens of trillions of dollars of worthless derivatives and toxic loans here, people. Both Keynesianism and Monetarism have failed.

P.S. I thought this was an Austrian Economics blog? This is pretty basic theory guys.

[Jordan Amdahl]

Bertie is on to something important. Our current monetary system (fiat currency + legal tender laws + fractional reserve banking) means there are a lot of hands on the monetary steering wheel. While the fed is pursuing an inflationary policy, banks are offsetting it by not loaning.

Combine this monetary conflict with the bailout blues, and we get a perfect storm of regime uncertainty. In the medium run, we need to hope that the fed stops trying to "fix" with unexpected inflation. In the long run, the only way to tame the boom/bust cycle is private monies.

[Greg Ransom]

The big issue is who is gaining wealth and who is losing wealth in an ongoing unmolested re-coordination of the market.

Absent the government, the elite financial class is losing massive wealth, while low income folks entering the housing market are gaining wealth.

We know which side the Treasury, the President, and the Fed are in this transaction.

When the financial class has less wealth, the financial class -- and their clients -- have less wealth to bid against the rest of us, and prices fall, to the benefit of everyone else.

We can't have that now, can we?

[Steve Horwitz]

Dirty Rotten Varmint: Can you put your argument in terms of a bank's balance sheet? I agree that many banks are having to write down the value of the loans on their asset sides. But what's the offsetting entry? If those loans don't get paid back, the offsetting entry is a decline in the net worth of the bank, no? What's the monetary effect here?

If the bank gives me a $5000 loan for my business and creates a $5000 demand deposit for me to spend, yes money is created. Suppose I spend all that money. Suppose I pay none of it back. How does my lack of payment on the loan lead to a monetary contraction? (In fact, when I DO pay back the loan, the money supply momentarily contracts - think Loans falling and DD falling - until the bank decides to make a new loan, assuming its reserves justify it.)

Where's the monetary contraction coming from if all you're talking about is a fall in banks' net worth? Or are you just saying that banks are refusing to lend any more after writing off the value of those loans? If so, you're confusing the marginal effect with the total effect. Banks might not be loaning as much as they were before, but that doesn't mean a shrinkage in the money supply unless you can show me the mechanism by which M1 or M2 is falling (esp. when by all measures it is NOT).

[Josh Hendrickson]

Pete and Steve,

The money multiplier of the monetary base is collapsing:

http://macromarketmusings.blogspot.com/2008/12/money-multiplier-again.html

This is largely due to:

1. Uncertainty
2. Interest payments on excess reserves

Regardless of the cause, the decline in the money multiplier causes the money supply to fall, which is deflationary. This would seem to be a basic monetary disequilibrium story. The demand for money is rising, velocity is falling, and thus the money supply should increase to maintain a constant MV (as Hayek advocated). If you look at charts of the monetary base and the money multiplier over the last few months, they are moving precisely in this very direction.

My fear, and I think this is what Pete fears as well, is that when money demand falls, it will not be met with a similar decline in the monetary base. Thus, we are likely headed for another bout of high inflation over the longer term.

[Steve Horwitz]

I hear you Josh, and earlier in the crisis I said the one thing the Fed could/should do is to supply reserves necessary to meet demands to hold money. I also said my great fear was that when the recovery begins, the Fed would not be able to (or be interested in) removing the then-excess liquidity.

My question is whether this process is absolutely deflationary if the Fed is still injecting reserves. If the MZM multiplier is just above 1 and the Fed continues to inject, MZM still grows, no? Now perhaps not as fast as money demand, fair enough, but it's still growing no?

Put differently - given the aggressiveness of the Fed's actions, I'm much more worried about the longer run inflation than any shorter-run deflation. I think the Fed is really trapped here: it has to respond to the rising demand for money but it lacks the knowledge and incentive to reverse those injections when the time comes to do so.

[Kirk]

When many speak of inflation and deflation today, I think the definitions being used are fuzzy, and ofter different from writer to writer.

Pete has been clear with his definitions in the comment above but most are not. It seems to me that most using the term "deflation" are speaking of a fall in the aggregate price level (PRICE DEFLATION). Mankiw seems to use this sense of the word in his Macro textbook. If on the other hand, "inflation (deflation) is always and everywhere a monetary phenomena" then it seems that some are speaking of MONEY inflation (DEFLATION); for example, in arguments such as "deflation is not happening because there is no (money) deflation; rather, the money supply is increasing. A third sense appears to me. With the increasing "moneyness of credit" in recent years, it seems that some who speak of deflation are speaking of a large CREDIT DEFLATION, a large decrease in the aggregate market value of total credit extended. In all the recent writing on deflation, I have taken to wishing various writers would use an adjective (price, money or credit) before each use of the word "deflation" to clarify exactly what they are speaking of.

In my view, we have witnessed in the past few months a truly unprecedented decrease in the quantity of total credit outstanding. That is to say, when all bonds, MBS, ABS, CDS, residential and commercial real estate, etc., etc. are marked to their current market value, the overall credit extended has cratered. To the extent that much of this credit has been (subjectively) perceived to have significant "moneyness" by human actors, then this decrease in credit affects the real economy, at least to some (possibly attenuated) extent, much like a decrease in the actual "inside" and "outside" money would. To the extent this is true, then core money might be growing substantially and yet the overall credit deflation could overwhelm it. This is what, for me, makes the most sense about the argument of those who see a deflation in the cards. The important factor is the credit deflation which seems to be overwhelming the money inflation. The price level deflation is merely an effect.

So I see credit deflation in the short term causing a general price deflation. Longer term, I'm with Steve and think the Fed can't or won't mop up the excess liquidity which will result in price inflation.

On a lighter note, just saw this brilliant propaganda film from the 1930s. "Inflation is our friend." http://www.youtube.com/watch?v=99Dzdc1H0wM (HT: Dave, ShortSaleBlogger.com)

[Steve Horwitz]

Josh: How do you reconcile your claim of a shrinking money supply with this graph of MZM growth? http://research.stlouisfed.org/publications/usfd/page5.pdf

And this on M2: http://research.stlouisfed.org/publications/usfd/page6.pdf

Granted, we don't know what money demand is doing, but those rates of growth are hardly a money supply that is "falling" - your term.

And even discounting the one time jump, commercial and bank credit is hardly in a free fall.

[Josh Hendrickson]

Steve,

Perhaps I should clarify my position.

I am not one of those who is arguing that we are in for a serious bout of deflation. I have argued as much here:

http://everydayecon.wordpress.com/2008/10/30/is-deflation-on-the-horizon/

The flight to liquidity and the collapse of demand have caused a decrease in the price level, but this is not the same as the rate of change in the price level. Also, I do not support the idea propagated by Mankiw, Rogoff, and others that we need to have rising prices. Attempts to raise prices were one of the primary policy goals (and failures) of New Deal policies. Similarly, I stated that the collapse of the money multiplier to 1 could cause a decline in the money supply ceteris paribus. I did not claim that the money supply was falling.

What I am claiming is that recent increases in the monetary base have been justified by the collapsing money multiplier and that while Pete is correct that inflation is always and everywhere a monetary phenomenon, we need to look at both supply AND demand.

I think that we are in agreement that the primary problem is the inflation that is on the horizon.

[Disgruntled Econ Observer]

Allow me to vent a moment:

I'm sorry...no offense to the bloggers here at all...but I have become genuinely distressed and disgusted with economists over the past several months. They are all so wrong and yet they got a million reasons why they are sorta, kinda right. This crisis was so easy to see coming yet they look anywhere and everywhere for root answers expect toward the obvious: monetary policy.

I stare at amazement at what seems to me to totally opportunistic...yet genuine...drivel from a wide variety of economists...mainly of a Keynesian persuasion. This article is yet another example.

As I bop around from Thoma's blog to Krugman's and others while reading stuff Stiglitz and others along the way, I am genuinely and sincerely perplexed at how they rationalize the world, politics, market phenomena and economic events. Watching Stiglitz and Krugman using the crisis to seriously critique free markets totally dumbfounds me. How can they be serious?

Perhaps I missed something monumental that they all know and are so sure of but nothing I've read in my limited reading from Hazlitt to Sowell and Mises sheds the slightest bit of light on anything that guides these economists.

They dominate DC, they dominate TV, they dominate academia and they dominate the first instincts of the "conscientious" human mind that seeks to "make things better". And they seem unbelievably wrong to me....well meaning and sincere but wrong.

And most of all, by some twisted logic of economics akin to asserting that planets revolve around the earth, they think they got it all figured in some totally unfounded and poorly reasoned kind of way while they make Austrians and the like out to be dogmatic, simplistic and off their rocker. And quite frankly, it really bothers me...for lack of a more eloquent way of saying it.

And it seems like nothing can be done about it.

Lately, I've been watching clips of Austrian-grounded Investment consultant Peter Schiff on YouTube. And while I don't necessarily agree with every little thing he says (particularly about the need for more manufacturing), he's generally 100% right about the big picture...IOW...the basics. He gets laughed at by "smarter" finance people yet he's always right in the long run. Youtube is treasure trove that shows how wrong these guys are through the prism of hindsight. And they keep smirking at him.

Peter Schiff's dilemma on TV is a microcosm of the economics debate in this country. It's sad.

Why is it so hard for your way to gain traction?? Is it too simple? Are the implications too distressing or unsatisfying for all the "wonder boy" Keynesian economists with grand ideas? And yes, that "wonder boy" comment was a reference to Coolidge's disparaging remark Hoover.

Like I said, these last few months have totally ridiculous.

[Mario Sanchez]

What makes a 1yr 2% FDIC insured CD any more part of a broad money measure than 1 1yr 0% Treasury bill? And when interest rates are not in the basement, say in 2006, what made that 3%Treasury bill any less money than that 4% CD? Nothing. The asset allocation choices of investors have shifted enough in the past couple of decades that managing Mx has become unwieldly.

Mr Greenspan admitted as much in his famous "irrational exhuberance" speech of 1996: "during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides... Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy.D

[Bill Woolsey]

Inflation (and deflation) might aways be a monetary phenomenon, but that doesn't mean that a rising monetary base is inconsistent with deflation. The demand to hold base money may be rising faster than the quantity of base money. Some of the comments here confuse money and credit, but avoid that red herring. The supply of money isn't the same thing as the total amount of loans. The supply of money is the quantity of the medium of exchange. The monetary base is just part of the medium of exchange. Reserve ratios have increased and the money mulitiplier has decreased. While I don't want to dismiss possible adjustment lags, my judgement is that if the monetary base had not increased, the quantity of money would have fallen a lot. Most measures of the money supply have increased. This might suggest that the increase in base money has overcompensated for the drop in the money multiplier. However, an increase in the quantity of money is consistent with deflation. All that is required is that the demand to hold money has increased by more than the supply.

The concept of the medium of exchange isn't the same as the various measures of the money supply. With the development of sweep accounts and things like overnight commercial paper, traditional measures of the money suppply are especially doubtful. However, even if the measured increase in M1 or MZM reflect increases in the "true" money supply, the demand for money may have changed.

If the demand for money always passively adjusted to changes in supply, or equivalently, velocity always changes to offset changes in the quantity of money, then money doesn't matter, and inflation is not always a monetary phenomenon. Rejecting those claims, however, doesn't imply that money demand or velocity are unchanging.

As for "regime uncertainty," that is also consistent with deflation. If regime uncertainly leads to people choose to hold more money, that is an increase in the demand for money. If the demand for money rises more than the supply of money, the result is deflation.

If inflation (or deflation) is always a monetary phenomenon, then as long as the supply of money adjusts to meet the demand, then there regime uncertainty would not be associated will falling prices.

In my opinion, the U.S. is involved in disinflation. Since we started with low, single digit inflation, we can easily move to deflation.

Generally, I define deflation as a decrease in the prices of currently produced goods and services. I think deflation is caused by a shortage of money at the current price level--the quantity of money being less than the amount of money people choose to hold.

Because of lags, in the impact of monetary disquilibirum, it is possible that todays disinflation is due to monetary disquilibrium in the recent past. So, today's base money performance is consistent with deflation due to a shortage of base money last summer.

[Steve Horwitz]

What Bill said. :)

I almost posted a comment arguing that what we were seeing was "disinflation" but I went for the monetary data instead.

[Mario Sanchez]

Bill: Excellent comment.

How does one measure demand for money and the various components of broad money / money substitutes (currency, reserves, MZM, etc) in a way that is useful for policy? Are credit spreads a useful measure? Are money/wealth or money/net-worth or money/x ratios appropriate measures?

As an old BLS price-index guy, I pay close attention to the mechanics of data collection and compilation for the aggregates used for monetary policy. I can go on for hours about the limitations of the various price indexes and money stock aggregates, although Greenspan did a better job is his 1996 "irrational exhuberance" speech (and even though he apparently abandoned the core priciples articulated in that speech by 2002).

As my post above suggests, and yours also seems to hint at, I am of the opinion that M2 and broader measures are highly fuzzy & over-sensitive to market conditions b/c of various close substitutes - most notably Teasury debt. It would seem that more useful aggregates would focus on immediacy aspects: measures like currency, reserves, 0-maturity / demand assets, followed by some levels of n-maturity time assets. But again, that only speaks to the supply side of the equation, not the demand side.

[Thomas Aquinum]

Not the End of the World

I have been thinking a great deal about money, banking, credit and gold since the near collapse of the world’s financial system during the week of September 15, 2008.

I have scoured the Internet for articles on this subject. Economics books don’t help much. I am not satisfied with their explanations. However, I believe I have nailed the main issue that needs to be understood. The following are some thoughts and observations.

Paper Money and Loaves of Bread

Gold bugs (by which I mean, people who push gold as a medium of common exchange or money) are only partially right. They say world civilization will revert to gold and silver as money when paper money and bank deposits become worthless due to rampant hyperinflation, after a worldwide Weimar Republic type scenario. This assumes that there will be a complete mistrust of governments and the banking industry.

Even if this unlikely scenario (world wide hyper-inflation) occurs, I believe paper money and bank deposit money will not be abandoned. The benefits of paper money and modern banking are just too great. Gold and silver based money requires physical possession, storage, safekeeping services, and transport for exchange in economic transactions (i.e., for making purchases or payment of bills). Note that there have been hundreds of currencies that have failed due to hyper-inflationary money creation (via both the printing of money and bank-deposit money creation), but this has not meant that people have stopped seeing the value of a paper money system and bank-deposit based economy.

People know from the collective experience of the last few hundred years (remember, the pound sterling is 317 years old), that when managed properly, this type of economic organization is superior to carrying around gold and silver. If a worldwide Weimar event does come to pass it will not be the end of paper money and bank deposit money. We will just have a fresh start with a new currency, much like what Germany did after the Weimar hyperinflation. (Sorry gold bugs and survivalists, we won’t all be shooting at each other, and gold will go up but only in terms of hyper-inflated money, not much in terms of loaves of bread).

Money Creation

At this point, the world civilization has sufficient understanding that too much money creation can lead to hyperinflation and make a currency worthless. Note that in modern economies, most money creation is done by the banking system through the process of fractional reserve banking.

Fractional reserve banking is just another way of saying that cash initially created by the government is lent and re-lent many times over (i.e., lent, deposited, re-lent, deposited again, and so on). So the initial cash created is multiplied by the banking system. The economy “acts” like there is more cash than what was originally created by the government, because bank deposits can be used to pay for purchases or to pay bills just like paper cash. The amount of money thus “created” is only limited by the banking industry’s willingness and ability to find credit-worthy borrowers.

Note that it is NOT the government creating the money most of the time; it is the banking system doing it. United States Government-issued paper cash is only 3% of the world’s dollar supply, and its electronic equivalent, the central bank dollar reserves at the FED (sometimes also called “base money” or “high-powered money”) are probably not much more, in percentage terms.

Collateral Damage

So what is the problem? The problem is that the world is finding out that Adam Smith needs to be updated. Economists know that Capitalism works well because the punishment of the marketplace is allowed to destroy bad actors (a la Lehman Brothers). Henry Paulsen and Ben Bernanke tell us that Lehman Bankruptcy started a chain reaction where there was so much mistrust between counter-parties of the major financial institutions that inter-bank lending and other lending “seized up” (almost stopped). If that had been allowed to continue we probably would have had extreme deflation very fast (at the speed of the internet).

Deflation will occur if bank deposits are destroyed. Remember--each commercial bank, savings and loan, credit union or even money market mutual fund that fails would have reduced the total bank deposits in the banking system. Failure of a depository institution means that its deposits cannot be used to make purchases, or pay bills, by depositors of those institutions (i.e., businesses and individuals). Defaults lead to cross-defaults (party B defaults because its counter-party A has defaulted). Cross-defaults on a massive scale, where a money center bank like Citibank is involved, would have led to massive bankruptcies and widespread bank runs.

Therefore, in order to punish bad actors we would have to inflict tremendous amount of collateral damage on innocent bystanders. The Great Depression of the 1930s comes to mind. Adam Smith’s invisible hand works, but sometimes the collateral damage is enormously large.

Is There a Better Way?

World War II was a pivotal event in human history. It did so much collateral damage that near the end of the war, world powers were convinced that all-out total “hot” war was no longer an option, given the current technology. Therefore, world powers started fighting more “cold” than “hot” wars (Roman and Persian Empires probably fought more “hot” than “cold”). The USA and USSR fought mostly “cold,” with some small “hot” proxy wars.

The rules of all-out war broke down in the face of massive weaponry. The superpowers adjusted to the new reality.

Newton's laws break down near the speed of light. Einstein updated them.

Where am I going with all this? Today's world economy, where most of the world's money supply (i.e., stuff used to pay bills and make purchases) is in the form of bank deposits residing in mega-institutions, can suddenly and violently contract if the invisible hand is allowed to dole out punishment in the traditional way to bad actors (in this case, poorly managed large financial institutions). So the trillion-dollar question is... how should Adam Smith be updated?

I will discuss this next time.
http://aquinums-razor.blogspot.com/

Money, Banking, Credit and Gold II

This is a continuation of the earlier essay: Money, Banking, Credit and Gold. In part II I would like to elaborate why I think the resolution to a major banking crises such as the one we are now going through should not be left completely to the market.

Joint Projects – Private Industry and Government

Our currency (and the banking industry) is in reality a joint project between our government (creates physical paper cash money and its electronic equivalent central bank reserves) and the private sector (creates bank deposit money by leveraging the government created money). Many major projects work this way in our vast and highly complex civilization. The airline industry is supported by 50,000 employee government agency (the FAA). The pharmaceutical industry is supported by 9,000 employee government agency (the FDA). The maritime industry is supported by tens of thousands of government employees at the United States Coast Guard and United States Merchant Marine. Various federal and state agencies manage and maintain our federal and state highways. Existence of and proper maintenance of our federal and state highways make our automobiles much more useful. State and local governments provide us with most of our elementary, middle, high school education and a major part of college and post-graduate education. Here is the point: Adam Smith suggested that the government should do no more than defense, administration of police, courts and jails.

You see we have already gone far beyond what Adam Smith had recommended. Why? Because our experience has shown that these government institutions (FAA, FDA, Coast Guard, United States Merchant Marine, Federal and State highway and road administration departments, public school system, public college system) CAN produce far more good than the costs associated to them.

In “Part I” I suggested that leaving resolution of banking crises to the market is like allowing nuclear bombs to explode all over the country (and maybe all over the industrialized world) in order to punish bad management in the banking industry. I suggested that defaults and cross-defaults and bank runs would lead to a nuclear fission like chain reaction causing massive bankruptcies and a huge sudden and violent contraction in the money supply and probably deep double digit unemployment rate (unemployment rate during the great depression was 25%, except now it would probably occur at the speed of internet time). This would be Adam Smith’s way of punishing bad behavior by the banking industry. This road involves tremendous amount of collatoral damage (this is how World War II was fought). I am suggesting we fight cold (similar to the way USA and USSR fought during the “cold” war. I will now relate this to banking industry. Consider the following:

Devil is in the details

The (usually) transparent process of inter-bank lending works so well that most of the time we don’t even think about it. This process has weaned the public off physical paper money. Note that most money (about 90%) now sits as ledger entries on bank ledgers backed by loans (debt). Physical paper money is like having equity in the economic output of United States of America and has no credit risk associated to it. Physical paper money is not anyone’s liability. Bank deposit money does have credit risk associated to it. It is the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than theft and physical loss risk of physical paper money. That is why we use bank deposit money more than physical paper money. Through this (normally) transparent process of inter-bank lending the banking system is acting like a giant clearinghouse (essentially a giant ledger) which clears payments between its customers without physical transfer of cash and keeps track of who has how much money. Note that most money in the world economy is not physical (paper cash or gold) but logical (ledger entries). Also, physical money is equity. Bank deposit money is backed by debt (actually not 100% true, reserves at the federal reserve system are also equity, essentially electronic version of physical paper cash). That difference: paper money = equity in USA economy and bank deposit = debt (meaning bank obligation) causes great confusion.

· You see we have become very comfortable with bank deposit money without thinking much about the credit risk we are taking. Bank failures create confusion and chaos because vast majority of businesses and individuals use banks for convenience (they can write checks rather than handling physical paper cash) and don’t really want to take or think much about the credit risk normally associated with keeping their money (their most liquid capital) at the bank.

· The process of modern banking has monetized bank loans. Think of bank loans as a valuable commodity. A little bit like gold or oil. Of course, you have to worry about the quality of the bank loans (as you would have to worry about the quality of gold or oil). It is more difficult to assess the quality of bank loans and mortgages but the idea is the same. In the current crises we have around (in very rough numbers) $10 trillion of bank deposits backed by about $10 trillion of loans at book value (value currently being carried on banks books). But the book value of bank loans is off course with what will actually be realized (on a discounted basis) from these loans due to the expected rate of defaults. But certainly it is not zero (perhaps it is off by 30% to 40% at most). My point is this: A total meltdown of the financial system is like un-monetizing this $10 trillion of bank deposit money to zero at the speed of light (due to widespread bank runs if a very large commercial bank like Citibank fails and amount of leverage currently in the system this would probably occur in a matter of few weeks). This will cause way too much collatoral damage to our civilization. Imagine, if a thousand years ago 90% of gold disappeared, just vanished, in a matter of few weeks. Prices would then have to adjust to reflect the new scarcity of gold (that is, go down by approximately 90% in a matter of weeks).

· One of the things money and prices do is to help us compare relative values of goods and services. It helps us to see that a gallon of milk is worth two loaves of bread for example. Money and prices also help us plan for the future so we can enter into contracts and conduct business. A sudden huge money supply contraction will throw our economic relationships off balance and create chaos. Debtors will be especially hurt as they will have to pay back in much more expensive dollars or default (the debt burden during the great depression increased by 40% in real terms due to extreme deflation).

Banking Industry’s Contribution to Society

· Lets consider what the banking industry does for the public. There are three major services a bank provides:

1. It provides a “safe” place to hold public’s most liquid assets (cash).
2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).
3. It is a source of loan money (banks evaluate credit worthiness of potential borrowers). Think of this “credit worthiness evaluation” as a service to society. If bankers do a poor job at evaluating credit worthiness they end will up mis-allocating economic resources.

· Note that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk. If banks gave people a choice of 100% reserve accounts. These accounts would have no credit risk. There would still be fraud risk. A bank in desperation for cash could “dip” into the reserves allocated to the 100% reserve accounts. Of course we would make such “dipping” illegal.

· I believe the public (individuals and businesses) should have a choice of 100% reserve accounts that would have no credit risk (like physical paper cash) but does have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, such an account would not earn interest but will most likely have monthly maintenance fees associated to it (essentially an electronic version of a safe deposit box for physical paper cash and would be very much like reserve accounts banks have with the FED). Such accounts if widely used would lessen the impact of bank failures on the economy in terms of contraction of the money supply but would not completely eliminate them. More on this later.

· Lending involves business risks (credit risks). If a customer chooses a non-100% reserve account then they would be subject to losing their money. This forces the public to do some homework before handing money over to a bank (review its credit rating essentially). Of course in this type of setup a non-100% reserve account would probably have to pay a higher return then the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve account there would be no need to impose legal reserve requirements on non-100% reserve accounts.

· There would be clear separation of accounts that have credit risk and accounts that don’t have a credit risk associated to them. The accounts with credit risk can set the interest rate high enough to attract depositors.

· Also, it would be better for commercial banks to not only give customers a choice of 100% reserve accounts (with no credit risk) but all accounts with credit risk associated to them should be setup like non-FDIC insured money market mutual funds. Non-FDIC insured money market mutual funds usually maintain a share price of $1 dollar but do not guarantee it. If a bank gets into trouble it can then simply “break the buck” as a quick resolution to insolvency. Breaking the buck means to set the share price to something less than $1 which would make the bank solvent again. Such a resolution reduces chaos and uncertainty and resolves insolvency quickly without requiring slow and expensive bankruptcy proceedings or expensive FDIC resolutions. Even after breaking the buck chances are the bank will be over-whelmed by withdrawal requests (due to fear of more write-downs and general uncertainty). The government can then arrange a takeover by a healthier bank and it can also limit the losses to the depositors (maybe to something like 25% maximum). The idea is to give enough punishment to depositors of the non-100% reserve account holders so they will evaluate a bank management’s ability to take good risks before handing money over to them. I can see Moody’s, S&P, Fitch and AM Best like rating agencies providing this service. Notice that I am still proposing that a large portion of (something like 75%) of depositor’s money be bailed out (losses socialized). Why?

Money and Moneyness

· You see even the non-100% reserve account would become part of the money supply. Because as long as I can move my money back and forth between the proposed 100% reserve account (no interest paid) to savings accounts to money market accounts to CDs with ease it should be part of the money supply. Economy will “behave” such that all these are forms of money. 100% reserve accounts, savings accounts, money market accounts and CDs would be part of the money supply since they can all be used to pay bills and make purchases either directly or indirectly. Even T-Bills, bonds and stocks and even real estate have some moneyness to them. The harder the asset is to convert to a loaf of bread (due to transaction costs and volatility) the less its moneyness characteristic. The easier an asset is to convert to a loaf of bread the greater its liquidity and moneyness. E-bay and Craig List even give your furniture in your living room a moneyness characteristic by making them more liquid.

· More Later

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I have read in one article that inflation is a sign of growth but seeing things today, I think inflation is over rated. I think it is not the inflation itself that we should focus on but the rate of inflation. It should be noted that inflation should be matched with increase of wage too. Without the other part it would be hard for consumers to catch up with their spending because the value of money is less.
In today's case that US is pumping funds to the ailing markets, inflation is inevitable and the hyperinflation lingers in the air. Instead of economist confusing consumers with theories why not just explain the cause and cost of inflation and where do consumers stand amidst it all.
In the stock market,lucky are those who have invested in inflation -risk immune investments like inflation-index bonds and treasury inflation protected security (TIPS).