Today it is easy to spot the Crowd. They are all on their knees outside the doors of the Federal Reserve waiting for the Fed to expand its balance sheet — to create more liquidity — or as some financially illiterate politicians believe, create more money.
Actually, a good many financially illiterate economists and Wall Street types also believe the Fed expanding its balance sheet and creating more liquidity is the equivalent of creating more money. It is not. And it is important for investors and traders to a) understand creating liquidity is not the same thing as creating real money and b) understand that many people, the inflation Crowd, do not understand this.
And you can make money understanding what they do not understand. Bear with me.
The general belief is the creation of more liquidity by the Fed will eventually lead to inflation. This assumes this liquidity goes into the general economy, circulates around and is used to purchase goods and services. The more liquidity, the more spending and therefore the price of goods and services rises.
Why? Because the amount of money available is chasing a fixed supply of goods and services that increase in availability at a pace slower than the creation of money. This is an antiquated view of monetary theory, the equivalent of the radio at a time when HDTV is the standard or automobiles that start with a crank when they now start with the touch of a button (a feature I hate, by the way) Oh, these Luddites also believe the creation of more liquidity is the path to destroying the U.S. dollar.
What the Crowd doesn’t grasp
Here is why they are dead wrong.
1) The liquidity created by the Fed is not circulating. It is staying in banks — or is deposited by the banks back at the Fed — and is moving around slowly inside financial markets, not the general economy. The inflation Crowd counters this with argument that one day this liquidity will enter the general economy.
2) The general economy is suffering from massive deflation, not inflation. Home prices are down more than 35%, office buildings more than 40% and so on. Long ago the government decided to measure inflation only by the movement in prices of goods and services. What about assets? If you include assets, the U.S. and many parts of the world are going through a massive deflationary spiral that is equal to or worse than the Great Depression. If what is seen as excess liquidity enters the real economy and pushes up asset prices these prices could still end up lower than they were five years ago.
3) All of this is trivial compared to the criminal neglect of blow-dried pundits desperate for air time and op-eds in The Wall Street Journal, who ignore the radical reduction in credit availability, in the U.S. and around the world, over the past five years.
Classical theory about money supply and inflation was developed when there was no credit for individuals outside of high down payment mortgages and their was no corporate bond market or syndication of loans to small business and so on. The world is in the early stages of a massive, unprecedented reduction in credit that is now hitting sovereign debt and will continue for between a decade and a generation. Credit fuels spending, not liquidity or the crudely measured the money supply (my cockapoo Sumo knows this). And it can easily be argued using second-grade math that the Fed’s easing programs over the past three to four years have been way too little compared to the massive reduction in spending power around the world.
A note for wannabee economists out there: if you measure the Fed balance sheet as a percentage of worldwide credit availability, that balance sheet has been shrinking for more than a generation and has yet to effectively replace the credit withdrawn around the world since the Lehman crash.
4) The notion that we are going to be in short supply of any good or service, other than reliable left-handed relief pitchers, would be laughable if the unemployment rate were not so hurtful to so many people. There is no shortage of labor or productive capacity except a handful of commodities and arable land. The Chinese have more unused steel capacity than there is total capacity in Europe and so on.