IS IT COST OR PRICE THAT MATTERS?

Old weight scaleMuch has been made of the Federal Reserve’s plans to inject fresh liquidity into the financial markets. Even I must concede that the scope of the infusion, or the price, is greater than imagined. None the less, it was equally predictable. The choices available were limited to either a 1929 style Depression or a 70s style inflation. Before proceeding let us examine the necessary result of the current conditions.

Conservative estimates peg $45 trillion, as the total amount of bonded registered debt. This is in the form of various types of instruments and a great many more that aren’t even counted. Consider this against an estimated $16 trillion money supply, and it seems apparent that everyone can’t have their money at once, in total. An abrupt unwinding occurs in which equilibrium is reached. In this case somewhere around 30 cents on the dollar. The downward spiral of asset values that accompanies such a liquidation has been well documented throughout the financial ages, the most recent being the 1929 style Depression. That would be the cost of inaction. The summation of the nature of this phenomenon is too few dollars chasing too many goods.

Production spirals downward as supplies are reduced to meet lessening demand. Price cutting for market share is ruthless and general malaise envelopes the business community, no expansion, layoffs, and cost cutting are the order of whatever business activity occurs. These are the environs of the late twenties and early thirties and at some point balance occurs. With a fixed money supply constrained by gold, there was simply no way out. Too many claims against not enough money, people don’t get paid.

Nervousness about asset values causes wholesale liquidations of every type of instrument and bankruptcies resulting in payments at much less than 30 cents on the dollar, are offset by voluntary payments in excess of 30 cents on the dollar. The reverse equation entails a 1977 to 1987 style inflation. By creating enough extra money to speed along and lubricate the liquidation process the FRBNY can help to mitigate the painfulness of the liquidation while preventing the cascading failures that result from such a panic .isitcostorprice_chart_4q2008

While it is difficult to characterize this as hyperinflation, even that has new corollaries. Either a Weimar German style hyperinflation replete with wheelbarrows full of money to buy a loaf of bread or the new standard of hyperinflation, the Zimbabwe Dollar with its billion dollar biscuits. This inflation will be a kinder gentler inflation with dollar value losses on the order of 40 percent. We can likely emerge with a portion of our financial skin intact. What will be missing in my opinion is the utter collapse on the other side. The dollar will retain its position as the worlds reserve currency and the power of the FRBNY will be enhanced and cemented.

Chart on this page summarizes the net cost ($4.2 trillion) of the bailout and the injection points.

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