Money and Markets
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From: Money and Markets
Sent: Saturday, February 07, 2009 4:28 AM
Subject: An epic battle being waged
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Saturday, February 7, 2009
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An epic battle being waged
by Jack Crooks
Dear Subscriber,
There is a battle being waged now in the world of economics. This
battle is fierce. And no matter who wins, the impact will be felt far and wide.
I dub this epoch struggle: "Godzilla vs. King Kong"
I'm not sure who will win, but I do have a favorite.
What I'm talking about is the intellectual and tactical battle
concerning the best way to deal with the nasty recession engulfing us from a
monetary and fiscal policy perspective.
There Are Two Basic
Schools of Thought Here ...
King Kong School - Intellectual Leader is Milton Friedman (Money
Supply Theory)
Basic Premise: In order to keep the current recession from turning
into a depression as we witnessed in 1929, the government must stimulate the
economy with massive amounts of money so that we can enhance and increase
consumer demand.
This is where Mr. Bernanke and President Obama's advisors reside.
Godzilla School - Intellectual Leader is Irving Fischer
(Debt-Deflation Theory)
Basic Premise: In order to keep the current recession from turning
into a depression as we witnessed in 1929, the government must step-back and
let the invisible cleansing hand of the market wash away the debt before any
real economic growth can again take hold in the economy.
Here is the outline for this theory:
1.. Debt liquidation leads to distress selling
2.. The amount of deposit currency falls and the velocity of
currency in circulation slows
3.. Prices plunge and the dollar rises
4.. Business values fall further
5.. Corporate profits tumble
6.. Output, trade and employment take a header
7.. Pessimism and loss of confidence spread like wildfire
8.. Hoarding becomes commonplace and the velocity of currency
circulation comes to a standstill
9.. Complicated disturbances erupt in the rates of interest: a
fall in the nominal rates and a rise in the real rates
My Favorite -
The Good Old Godzilla
And for this primary reason ...
When debt levels reach such huge proportions in an economy, pumping
more money into the system is ineffective because the velocity of money
declines.
Let me explain the term "monetary velocity" and how important it is:
Monetary velocity means how fast money is circulated in the economy
- the speed in which it is spent. And it is a key measure in the definition of
economic growth.
Now stay with me ... while I explain this simple equation:
M x V = P x O
M = Money Supply
V= Velocity
P = Price Level
O= Economic Output
Ben Bernanke and those in control of U.S. economic policy believe
that if the "M" in this equation is lifted, it will impact prices (reduce the
deflationary scare) and output (economic growth) accordingly.
But here's the rub: When debt levels become so huge, people get
scared. They save, hoard and use their money to pay down debt. They don't take
on more debt or run out and spend more just because the money supply has been
increased by the government.
In fact, more money pumped into the system only adds to the total
debt in the economy, and therefore prolongs the downturn.
The practical policy is to accept the fact that "V" shrinks
dramatically at times like these - thus we have the big dip in "O" (output) and
"P" (prices).
Here is How the Market
Cleanses the System ...
Debts get paid down; reserves are rebuilt with increased consumer
and institutional savings. This provides the eventual pool of capital for fresh
growth.
At a time of major risk aversion, the world will flock to its
reserve currency - the U.S. dollar.
And once the debt is removed, monetary velocity "V" increases to
more normal levels; therefore tinkering with money supply isn't necessary.
Sadly, I think, all governments are on the side of King Kong. And
their flood-the-market monetary policies may make this global recession a whole
lot worse.
So from a currency perspective I think it means this: We will be
locked in a sustained period of risk aversion (rising unemployment, deflation,
and sovereign debt defaults) as this crisis plays out. And in a world of major
risk aversion, that mantle rests at the feet of the world reserve currency -
the U.S. dollar.
Best wishes,
Jack
P.S. Are you hungry for the latest on what's going on in the
currency markets? Then be sure to check out my blog.
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