The Oil Drum

I would define inflation as an increase in the money supply relative to available goods and services. Price increases are a only symptom of too much money chasing too few goods and services.

During the recent expansionary years, we have seen large asset price increases as a result of the money supply increasing, but monetary expansion has not ignited a wage-price spiral as it normally would due to downward pressure on wages from international wage arbitrage and downward pressure on prices from globalized trade.

Nope, That’s Not Money

Prudent Bear’s Doug Noland has for years been pointing out that one of the drivers of the credit bubble has been the ever-broadening definition of money. As the global economy expanded without a hic-up, more and more instruments came to be used as a store of value or medium of exchange or even a standard against which to value other things—in other words, as money. Thus mortgage-backed bonds and even more exotic things came to be seen as nearly risk-free and infinitely liquid. In Noland’s terms, credit gained “moneyness,” which sent the effective global money supply through the roof. This in turn allowed the U.S. and its trading partners to keep adding jobs and appearing to grow, despite debt levels that were rising into the stratosphere. For a while there, borrowing actually made the world richer, because both the cash received and the debt created functioned as money.

What is beginning to happen now is the converse - the definition of 'money' is tightening, as confidence in exotic credit instruments created through financial alchemy is ebbing quickly. The result is a reduction in the effective money supply, which is leading inexorably towards a very painful credit crunch. We cover this progression at TOD:Canada twice a week.

With a few months of hindsight, it’s now clear that debt-as-money was not one of humanity’s better ideas. When the U.S. housing market—the source of all that mortgage-backed pseudo money—began to tank, hedge funds found out that an asset-backed bond wasn’t exactly the same thing as a stack of hundred dollar bills. The global economy then started taking inventory of what it was using as money. And it began crossing things off the list. Subprime ABS? Nope, that’s not money. BBB corporate bonds? Nope. High-grade corporates? Alas, no. Credit default swaps? Are you kidding me?

No longer able to function as money, these instruments are being “repriced” (a slick little euphemism for “dumped for whatever anyone will pay”), which is causing a cascade failure of the many business models that depend on infinite liquidity. The effective global money supply is contracting at a double-digit rate, reversing out much of the past decade’s growth.

Just as price increases eventually follow an increase in the money supply, price decreases (at least in nominal terms) will eventually follow a decrease in the money supply (deflation). Once all those fancy derivatives that make up such as large percentage of so many portfolios are actually marked to market rather than to model, then exactly such a downward readjustment of asset prices will occur over a relatively short space of time. A firesale by even one troubled institution can be enough to taint an entire asset class, with cascading effect.

But here’s where it gets really interesting. The reaction of the world’s central banks to the freezing-up of the leveraged speculating community has, predictably, been to create massive amounts of new fiat currency and hand it to the banking system. They’re not dropping twenties out of helicopters yet, but functionally it’s the same thing. By swapping dollars, euros and yen for no-longer-money bonds that are plunging in price, creating some paper profits where there once were catastrophic losses, the Bankers hope to revive the animal spirits of the leveraged speculators. Specifically, they hope to stop the financial community from going further down the moneyness checklist and eliminating any more instruments.

But you don’t forget a brush with death that easily. The process of debt reclassification has a momentum that a few hundred billion new dollars won’t stop.