Will the $800 Billion Bailout Cause Massive Inflation?

October 2008

by Tim McMahon, editor

Last month I said that the simulated M3 measure of the money supply was indicating that deflation was in the works. See  M3 is Back and Predicting Deflation.

So how will a massive injection of almost $1 Trillion dollars affect the money supply?

If you have read any of the articles on inflation on this site you will realize that the primary cause of price inflation is monetary inflation.  In other words, if the government cranks up the printing presses the price of almost everything goes up.  For more information see What is Inflation? and Inflation Cause and Effects.

So you would think that it is only obvious that a massive injection of money like the recent $800 Billion bailout would cause massive inflation. Right?

Well, that depends...  In normal circumstances like last year (in 2007) an increase in the money supply like that would have resulted in a significant increase in inflation.

But let's look at the bailout in light of the current situation  and see what is currently happening. Obviously in 2008, the big news is that housing prices have been falling and that caused the banks to have problems and that caused uncertainty which caused the stock market to fall.

Ok, so what, you might ask.

Well, if the value of your house falls do you feel richer or poorer? Poorer right? What if the value of your stock portfolio falls?  Same thing you are poorer.  The reason you feel poorer is because some of your wealth just evaporated.  You didn't lose it, in the sense that someone else could find it, or that it was stolen, it just evaporated. Gone, poof! 

That means that the total wealth of the country was just reduced.  The total money supply just shrunk.   So let's take a look at the magnitude of the shrinkage for a minute.

According to Livemint.com the total capitalization of the NYSE on December 31, 2007 was $30.4 Trillion (up from $25 Trillion the year before).  If we add to that NASDAQ's $5 Trillion we're looking at about $35 Trillion.  That covers most of the capitalization of the U.S. stock market.

 So if we assume a 20% contraction in the stock market we are looking at the NYSE and the NASDAQ dropping a little over $7 Trillion dollars in value. 

So even if the government pumps $1 Trillion back into the economy there is still a net deflationary effect.

And that is not counting the value lost in housing prices.  And to make matters worse the mortgage industry took those initial mortgages  and leveraged them using "derivatives" to compound the gains on the upside.  This leverage was by a factor of hundreds of times.  Actually no one even knows the full magnitude of how much compounding went on.  So there could easily be Trillions more of liquidity that evaporated when housing prices stopped going up and began their downward descent.

Leverage can work wonders on the way up but can be devastating on the way down, as many banks and investment houses have found out in the last few weeks.

Unfortunately, our banking system is based on trust.  Banks trust each other an loan each other money over night and trust that when they present checks and bills to another bank they will be paid. But if one bank can't pay that can cause a snowball effect because then the other bank that was counting on the payment from the first bank might not be able to pay either and so on.

So the slightest bit of mistrust can cause all these banks to stop trading with each other or to stop loaning money.  This brings the whole economy to a screeching halt.

So all-in-all a Trillion dollars is just a band-aid on this problem in an attempt to pump some liquidity into the credit markets in an effort to keep the banks from freezing up from a lack of liquidity. And the bailout although massive, will not be enough to turn the tide of deflation attacking the economy.

But you say how can we have all this deflation and a 5% inflation rate at the same time?  See How can we have Inflation and Deflation at the same time?

For more information on how the bailout might actually cause Hyperinflation see the article Why the Bailout Will Result in Hyperinflation.

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