Inflation, Deflation, China-Nation

What is inflation?  It is often defined as a general rise in consumer prices.  This is the new definition of inflation that people gravitate towards.  However, if you look up the definition of Inflation in a Merriam-Webster dictionary published before 1980 it will say:  Undue expansion or increase, from overissue of currency.   Inflation should be viewed as the expansion of the money supply.  Deflation, on the contrary is a contraction or decrease in the money supply.  Rising or falling prices are symptoms of money creation or destruction.

To understand our current financial crisis and potential solutions – one must understand monetary policy. 

Money can be created in numerous ways.  The fractional reserve banking system is the most traditional.  Whenever you deposit 100 dollars into a bank, only 10% must be held as reserves.  The other 90 dollars can be lent to somebody as a loan.   The person who receives that loan will likely deposit a large portion of that money into a bank as well.   Let’s say they deposit 2/3rds: 60 dollars is deposited into a bank.   Only 6 dollars needs to be held whereas the rest can be lent out.  As you can see: your 100 dollars has suddenly blossomed into 244 dollars (100+90+54). 

If you needed to withdraw your 100 dollars from the bank then the bank should have sufficient reserves to deliver.  However if 100,000 people wanted to withdraw a 100 dollars each then you may end up with a run on the bank.   The bank would become insolvent and default because it would not be able to honor all its customers.  This is exactly what happened during the Great Depression.  As thousands of banks went under, their assets and liabilities went with them.  The gigantic contraction of the money supply caused a deflationary spiral:

¨ People withdrawing their funds and/or stocks in fear of collapse

¨ Banks become insolvent and collapse

¨ Companies that lost capital from bank failures would go bankrupt

¨ Employees lost their job

¨ Less people could afford to buy goods or make deposits

¨ Repeat

Deflation-debt spirals are very troubling for all.  Backstops were put in place to prevent this from happening again – i.e. the FDIC.  Now a majority of banks are insured by the federal government.   However, insurance only works if subjects are independent of each other.   Unfortunately the US banking system is interconnected and too concentrated.   The four largest banks make up more than 80% of the banking sector (Bank of America, JPMorgan Chase, Citigroup, Wells-Fargo).   These entities have been deemed ‘Too Big to Fail’ which has given them a government safety net in the sake of protecting America’s prosperity. 

Since 2008’s meltdown, we have seen bank bailouts (TARP, 700B), Obama’s stimulus package (ARRA, 787B), Quantitative Easing 1 (QE1, 1.4T), Quantitative Easing 2 (QE2, 600B).   These four economic stimulus packages have totaled over $3.4 trillion and suggest that this time around they will err on the side of doing too much instead of too little. 

If the federal government and the Federal Reserve did nothing, we would certainly enter into a deflationary depression on par or worse than the Great Depression.  Both of these entities have done an adequate job of keeping us afloat but at the expense of the currency.  Since 2008, our money supply has more than doubled.   Interestingly we have not experienced much price increases domestically.  However, that is because most of the goods and resources that we buy come from abroad.  For example, when a Chinese product is sold in Walmart the revenue and profit dominated in US dollars is shipped back to China.  The Chinese banks then exchange the US dollars for Chinese currency (RMB or Yuan).   The Chinese banks can sit on the US dollars or they can exchange them for US treasuries in order to earn interest.  The Chinese have cash reserves and US treasuries totaling over $4 trillion.   For many years now, China has pegged their currency to the US dollar in order to keep exports strong.   In order to maintain the dollar-peg, the Chinese have had to print money in step with the US causing their inflation rate to rise to 10-12% (year over year).  The only way to combat this inflation problem will be to de-peg from the dollar and allow their currency to appreciate.  In doing so, the Chinese will shift from the world’s greatest exporter to the world’s greatest importer because their citizens will have a new found purchasing power.  Consequentially, the flood of US dollars into the markets will cause noticeable devaluation of the dollar.   This is known as the dollar trap because if they allow their currency to appreciate too quickly than they risk destroying the US dollar in which they are heavily invested.  At this point, our government and Federal Reserve System may have exhausted all options and appear to be at the mercy of our distant relatives: The Chinese.