If you’ve taken any macroeconomics course, you know that inflation is always a topic of choice. People are always concerned that inflation will erode their purchasing power. However, deflation, a general decline in prices which is often caused by a reduction in the supply of money or credit, is typically put on the sidelines.
As expected, you will find dozens of articles about how the recent actions by the Federal Reserve and the U.S. Government will bring unprecedented inflation in the near future.
However, if you pay close attention, you will see that these commentators only talk about how the actions of the Federal Reserve has added tremendous amount of money into the system while forgetting the offsetting effects that have taken place in the economy.
Commentators are forgetting to analyze the situation on a net basis. That is, adding what’s being put into the economy and subtracting what has been taken out.
Some of the added items:
* TARP
* International Swaps
* Bailout of of financial institutions such as Bear Stearns, AIG, and Citigroup.
* Liquidity Operations
All in all, the number adds up to around $8.5 trillion, including guarantees (Source: The Big Picture). This means that the total cost of the bailouts will be reduced if the securities and/or institutions guaranteed recover.
Wealth Destruction:
Keeping in mind that wealth is money; when you destroy wealth, you destroy money.
*Household wealth declined by 18% in 2008, or $11 Trillion (Source: MSN Money).
* Stock Market Crash: As of the end of 2008, $7 trillion had been eradicated from the stock market (Source: Link). There is some-double counting here because some of this is also household wealth, but a lot of this money was also at the institution level (e.g. Pension Funds).
Additionally, there has been more losses since the beginning of 2009.
*Cash Hoarding: The amount of money banks are hoarding (see image below) has reached unprecedented levels. Additionally, household savings has also spiked to about 5%. As a result, a lot of the money the government has poured into the system has not made its way to the economy and has not had a multiplier effect.
Click on image for Full-size
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In sum, looking at the situation on a net basis, the recent government actions are more than offset by the destruction of wealth in the economy. The fall in prices of real estate, stocks, and other securities has wiped out a lot of money and credit from the system.
So, the next time you hear someone talking about how we’re getting run-away inflation in the next 12-18 months, tell them the truth.
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