Saturday, April 5, 2008

Printing, Cash, and Credit

Cash is going to be worthless because the government is printing money like crazy. Just look at all the inflating prices each time we go to the supermarket, or pump gas.

Not! Such would be a misconception, one not uncommonly espoused in some form or another on the blogs. The rate of printing over the last few years has been less than historical patterns (meet FRED). So what gives? What accounts for huge increases in sales and prices of residential real estate, commercial real estate, and stocks?

That would reflect the monetary expansion from credit, which is distinct from currency. In other words, there can be a huge expansion of credit, without necessarily printing any currency, or the banking system can print a lot of cash without extending any credit. Either way, or in any combination, money is injected in to the system. Credit has greatly expanded over the past few years, while the creation of base money, as the FRED graph shows, has been decelerating.

Credit may feel a lot like money, in the beginning. It’s easy to confuse them. You can spend it like cash, and so people who borrow a lot are probably feeling pretty rich when they first get it. Over time, however, credit reveals itself to be very different. Once it is spent, it becomes a liability that you have to pay back. Very often sensible adults see the acquisition of credit as prosperity, rather than liability. Just look at Japan.

So, just because there has been a recent expansion of the money supply does not mean it came about by printing. It could have, and did, come from credit originated by fractional reserve lending.

So long as base money continues to hold about even, the fallout from the credit bubble will be deflationary as asset prices correct to their fundamentals.

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