Inflation/ Deflation

The Narrator said in my comments section…
“Isn't a housing crash deflationary? A credit crunch, a lot of defaulted debtors and underwater debtors and out of work RE people certainly would reduce spending.”

This is a more complicated subject than it would first appear. Technically a lot of bankruptcies, if left to their own devices, reduce the money supply. Just as the fractional reserve system produces money exponentially, bankruptcies are the reverse affect of this.

However, our government deals with bankruptcies and every other crisis by providing liquidity. This means that the government offers an increased rate of sovereign debt in the form of treasury bonds, bills, and notes. This has an effect of increasing the amount of “leveraged” money in the money supply.

Let’s break the problem down into its component elements.

What is “leveraged” money?

“Leveraged” money is the money that is created through borrowing. This means that even though the money supply has gone up, there is an income stream that goes against this money in order to pay it back. Under normal conditions “leveraged” money is considered non-inflationary.

So then, what is “real money”, or money that is not “leveraged”?

“Real money”, is money that does not have an income stream against it to pay it off. This can take the form of savings, assets that are free and clear of debt obligations to name a few types. This money has a finite buying power and an increase in “real money” debases the currency.

As the world progresses the population increases, factories are made, goods are produced, and services are needed. This is what we call an expanding economy. The more productive, the amount assets are worth in “real money” terms goes up.

This would mean that if you had a finite amount of “real money” the value of each dollar bill would increase with time as the world became more productive. However, since these factories and other improvement are paid for through debt, and this debt is eventually paid for, the “leveraged money” becomes “real money”.

So this has the effect, since by using a fractional reserve system that money is created exponentially, of diluting the value of “real money”. Therefore as the economy expands exponentially, the money supply expands exponentially.

If the economy expands faster than the supply of “real money”, then the value of money increases. If the supply of “real money” expands faster than the economy, then money devalues. If these two forces are unitized, then the value of money keeps the same buying power.

Why “leveraged money” is not considered inflationary?

Well, in moderation it is not. The new money created goes against a new factory or something that increases the economy. If the asset that the “leveraged” money goes against hasn’t appreciated overly due to uncontrolled speculation the amount of the loan is fair. The money is then trapped in the deal. Hopefully, the bank has made a good investment risk and will be paid back.

Here is the problem, if speculators have increased the price of the asset, then the loan amount is incorrect, this leads to asset inflation. Speculators overly increase the price of an asset by lending too much money into an industry or asset class. This causes an exponentially larger amount of money to chase a limited amount of assets.

That is just the first problem. Since speculators paid too much for the asset, the borrower may not make enough money to pay back the loan. If the borrower cannot service their debt they become insolvent, which can lead to bankruptcy. Bankruptcy has the opposite effect and contracts the supply of “real money” at an exponential rate. If too much money is lost the lender themselves may default on their payments and go into bankruptcy.

Uncontrolled lending increases inflation in the assets that the loans are targeted against. However, due to the “velocity of money” this can increase the prices of goods and services as well. As asset prices go up, so do workers incomes in that industry or asset class. The people spend more money on goods and services. Since goods and services are priced according to the willingness to pay for them, their prices also go up accordingly. It just takes time for the money to float down to that level of the economy.

So how wouldn’t a housing crash, a crash in the price of an asset, be deflationary, and increase the value of the money.

Due to bankruptcy and foreclosure, a decline in the value of housing would reduce the amount of “leveraged money” and the same amount of “real money”. Therefore if a home cost $500,000 with 10% down or $50,000 of equity for a loan amount of $450,000. Then lost 20% of its value during a foreclosure sale, the value of the property would be $400,000. This would mean that there is $100,000 lost in the deal. The owner loses $50,000 of equity and may still owe $50,000 of unsecured debt. If the owner cannot pay this debt then the lender loses $50,000. This money goes against the lenders core assets.

So if a bank has $1,000,000 in core assets, the bank can lend up to $10,000,000. Now the bank has $950,000 and can lend up to $9,500,000. If the bank has $9,550,000 in outstanding loans, the bank must now find a way to repair its core assets. The bank must be very careful in making additional loans or face insolvency. If the bank experiences too many bankruptcies and the bank cannot service their debts or payments, the bank may go into bankruptcy itself.

Now, how does the Federal Reserve handle this situation with mass insolvency of banks. If too many banks become bankrupt the financial system is destroyed. This is due to the exponential nature of money creation using a fraction reserve system. The Federal Reserve would have to try to take over the underwater mortgages. It would do this by purchasing these mortgages from the banks. This would have the impact of monetizing the bad debt.

What is monetizing the debt?

Monetizing the debt is the act of creating new “real money” to purchase debt. This debt is then diluted into the “real money” supply. The government would then sell these properties for what ever it could get for them. The government would most likely sell the loans as well.

This would have the effect of first increasing the amount of “real money” into the system by making the original “leveraged money” into “real money”. Then through borrowing, this real money is used to further increase the amount of “leveraged money” into the system at an exponential rate.

Therefore the value of the money would go down exotically as the amount of “real money” increased exponentially. This will cause inflation of the dollar or a decrease in spending power of the dollar.

The final answer is, even though a housing crash may be initially deflationary, it will lead to massive inflation of the dollar as the government tries to save the banking system.

Will this work, can this save the housing crash, and more importantly, the banking system?

In short, No.

Why the hell not.

Banking has changed in the last 20 years. Our banking system no longer is the only major entity that is creating “leveraged money”. With advent of modern derivatives, lenders have been able to take mortgages and turn them into bonds called mortgage backed securities (MBS). These MBS’s are sold on the international market. Many countries use these MBS’s as core assets for their banks.

American also has a negative trade balance. This means that when we buy goods from other countries, we receive these goods and they receive dollars. They have so many dollars that if they were to trade these away to other countries the value of these dollars would devalue.

This is not that bad, however, the US dollar is also the world’s reserve currency. This means that many countries use this currency as a hedge against fluxuations in their own currencies. If the dollar devalues, than their core assets devalue, this can lead to a banking crisis in their own countries.

In order to prevent this situation from happening, these countries buy US debt in the form of our sovereign debt, corporate bonds, and MBS’s. This causes these countries to obtain even more assets that are terms of the US dollar.

If the US monetizes this much debt as to save the banking system from the housing debt, then the US dollar shall devalue. This will cause all financial instruments based on the US dollar to devalue. Therefore other countries banks to go into crisis as their core assets devalue.

Why the hell should we care anyway? Screw those losers.

When lending institution goes into crisis they must get rid of assets in order to maintain their fractional reserve. This means that they must shed corporate bonds, stocks, and other assets. They are also likely to not honor their debt with other banks throwing these banks into crisis.

Hedge funds, which borrow billions from banks, leverage their investments 20 to 30 to one. Even small changes can destroy these investment institutions. This will cause the hedge funds to become insolvent and bankrupt.

Now, since the US has saved the housing crash by monetizing the debt, it has now gone back into crisis as other outstanding debt is not honored due to global insolvency.

Remember, the US is not the only country with a housing bubble, most of the G-8 countries also have housing bubbles. All of these bad debts just boomerang back at you through the equities and derivatives markets. There is just no way to avoid it.

There comes a point where too much money is at risk. At that point, due to the mechanics of the fractional reserve system, there is no way to save the banking system. If the banking system goes the currency goes.

Chromatic Dispersion