Is a Stock Market Crash Inflationary or Deflationary?

Recently a subscriber asked me the question above, he gave quite correct arguments about how the stock market is “a zero sum game” in other words for every buyer there is a seller, so overall everything should stay in balance.

But as I’m sure you know there are at least 3 ways to measure money supply M1, M2 and M3. Each one includes increasingly broad definitions. From just cash equivalents up to including all sorts of time deposits and Government debts. But what they don’t include is stock valuations, however if the price of your stocks increases you feel richer and are more likely to spend money from your other accounts because you know if you need the money you can always sell your stocks.

So if you buy a stock at $10 and it goes to $20 you feel twice as rich. Has anyone bought that stock from you at $20? No! but it shows up on the credit side of your balance sheet nonetheless. So your net worth went from $10 to $20. and if you multiply that by the billions of shares floating around you have Billions of dollars created out of thin air!

No one has paid for your shares at that price. Maybe 1% of the total float has changed hands at that price, but the other 99% of the people think their shares are worth that much! And in normal times that is exactly how much those shares are worth. Because as long as the market is liquid enough, anyone who wants to, can pick up the phone and convert those shares into cash.

If it can be converted to cash at a moments notice, it is the same as cash and more like cash than a time deposit is. You could even margin them and borrow against that perceived value, so the money exists.

This money does not exist as cash, but as a notation somewhere. Just like the money in your checking account (M1) exists just as a notation on some ledger. The money isn’t really there. M2 and M3 are almost entirely notations somewhere.

But when the stock prices fall all that money magically disappears again! So it is my feeling that rising stock prices creates wealth out of thin air and falling prices destroys it. Simple Inflation and deflation. No shares need to change hands for it to happen.

It really doesn’t have anything to do with the company or the brokers, just the perceived value of the shares. It is a function of liquidity though, illiquid markets act more like time deposits because it may take a while for you to be able to convert them to cash.

Remember when Gold was money? It was a physical asset, and the only way to destroy wealth was to grind it up, mix it with water and make the people drink it, like Moses did in the wilderness. So there was no inflation or deflation (on the money side of the equation) unless something like the California Gold rush happened (i.e. a rapid increase in the Gold supply) or the King decided to mix a base metal in with the coins (creating money out of thin air).

In normal times, things stayed pretty well in balance because the money supply increased slowly (because of new Gold finds) and the goods side of the equation increased slowly as more things were produced, so the equation stayed pretty well balanced. If anything, deflation was the norm because more goods were added to the economy than new Gold was found.

According to  the definition of Deflation is “a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. The opposite of inflation.

So even by definition falling prices equals deflation and falling stock prices helps create deflation.


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