Sunday, September 28, 2008

Meltdown and credit

{{en|Image adapted from Image:MiltonFriedman.j...Image via WikipediaI have a theory that credit is the new "inflation".
Inflation is what economists consider the bogey man of economics. Inflation can destroy an economy by devaluing a currency to the point where it is worthless. Third world countries run this risk and historically, Germany was brought to its knees and cleared the path for Adolf Hitler to rise to power.

The Great Crash of 1930 was the last great tectonic shift in economic theory where John Maynard Keynes explained how to fix the seemingly never ending depression.

The new monetary theory of Milton Friedman told us that the money supply was the critical factor and a money supply that was out of control was a money supply that suffered rampant inflation.

Today, the world economy is subject to a new kind of unbridled growth in the money supply. It's called credit. Where everybody is living beyond their means, where everybody is personally contributing to the exponential growth in the money supply (vis credit feeding the stock market bulls and real estate infinite optimism) that creates never ending rising prices in property and you have, what we have today, a crisis of global proportions.

In the classic economic equation, supply = demand. This makes sense in that each side of the equation is finite. There are only so many resources available at any one time and if demand outstrips supply, then the price will rise for the available goods and demand will decline. Demand is either elastic or inelastic depending on the product but demand is never infinite.
Of course, in the modern economy, where credit makes demand extremely elastic, that is the rise in prices doesn't reduce demand, then we have and unbalanced equation. Credit facilities create extremely elastic demand. The notion that no matter how much you pay for real estate doesn't matter because the price will inevitably go up is an example of this process.
Now consider the investment bankers who have squillions to invest. They can either put their money into the stock market or real estate. Either way growth is expected because everything is going up in value.
Now consider the fact that you don't have any money but you want to share in the ever increasing rise in prices in the stock market or in real estate. It would be silly to miss out just because you are short of funds. Let's borrow some funds and invest in the stock market or real estate. Here is the magic of "credit" at work. The money supply is effectively increasing without any apparent control.
So, in an never ending spiral upwards of stock market values and real estate values, spurned on by the ever increasing supply of credit, it becomes inevitable that something has to give.
Just like inflation where the currency is progressively devalued to the point where it becomes worthless, the same goes for for the money that is being used to finance this never ending optimism. The credit (or the alternative money supply) becomes worthless.
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1 comment:

Small Business USA said...

Fantastic insight!