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 Investorwords.com
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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