John,

This is an excellent article.
Two quick comments:

I wonder how the velocity of money is going to increase, when banks won't lend to each other. And I don't think they will lend to each other until they trust each other. And they won't trust each other until the derivatives are settled.
Seems to me the economy will be choked until the derivates are dealt with.

A man once told me that you can approximate the rate of inflation, by looking at what the average bank CD rate is. Why? It's about where the average guy will break even.
I didn't like the comment, but it seems to be a good approximation.

that is predominately manufacturing-based, whereby raw materials are converted to higher value-added products, the velocity of money is increased much like that from productivity gains. An economy predominately based upon service sectors is more like your "static island" example, with just shifts in direction of monetary flow, and in a growing population base, effectively dilution. I also submit that the innovations in financial instruments do not create a sustainable increase in the velocity of money, just the impression that velocity has increased, hence, irrational exhuberance, with bubbles bursting on an ever-shortening timeframe, and in direct relation to the magnitude of the perceived value of these so-called financial paper innovations. For this reason, I believe there is no dollar amount of legal tender paper shuffling that can bring our economy back to long term stable GDP growth; not until we invest our monies in the higher value monetary-growing and velocity-increasing manufacturing sectors, with positive trade balances (exports), and right here at home to the benefit of the consumer/spenders.

With respect, my bluefin friend, the velocity of money in the manufacturing sector will be slower than in a service or financial sector; the addition of value, per process, is internalized until final sale (the longer it takes to make the thing, the slower V).

The only sector with slower velocity of money is agriculture; man, that's like watching grass grow !

Mr. Fitzsimmons, but it's the larger additions of value from material conversions that ultimately result in the increase in velocity long term, much like productivity gains, or massive amounts of new money infused, I think. Along the same lines..."give a man a buck, and he eats for a day, teach a man to make a buck and he eats for a lifetime." (I had to throw that in there since you got me thinking of fish.) Anyway, the overall concept of the velocity of money does nothing for me in the long term, it is highly over-rated and only especially important to the short term investor batlling over a rather finite pool of currency.

America became a socialist nation- In an effort to stop the economic depression, Americans forgot about democracy, and adopted socialist policies

Kristina, very few governments are of a pure character, that is, pure democracy, pure communist, pure socialist, or faschist, or even a dictatorship. All of the nations have roads, a social good that benefits rich and poor alike, with the rich moving goods to market and the poor moving along to the next gypsy harvest. It has been pointed out that the reward, in Russia, for being a good Communist, was that you could live as a good Capitalist. The best example of this is that the Kremlin bureaucrats live in state subsidized apartments, are picked up each morning by a Zil Limo and whisked to their offices. Their wives do not stand in long lines for the grocery store in the dead of a Moscow winter, but shop in private stores that carry the finest Western goods. Their children attend private schools, and the family has a Dacha or summer house for their use. If purity of government was ever a priority in the U.S., I would say that it no longer is. You must learn to joke with the rest of us that as the politician said, "when I die, I want to be buried in Chicago, so that I can continue to vote." We are a flawed nation, but we have adopted many ideas that have become our norms, whether as a corruption or as a refinement, only time will tell. We nationalized our automakers for the duration of World War Two, but they went back to cars after the war and now people have to be told such things as there is no evidence it ever happened. I am far more fearful of American use of Guantanimo or Abu Ghrab than I am of the purchase of Fannie and Freddie. Those we can see and ask for accountability, the former we can't. Lastly, it was Deng Zhao Peng of China that encouraged his countrymen to use every means at their disposal, including Capitalist means, to advance the cause of Communism. (True story) While I laughed at first, I now see very clearly that he meant every word of it. By copying the success of Hong Kong and Macau, and spreading it all over the mainland of China, he created the huge middle class and the wealth they now posess, yet by maintaining a strong central government, they have unbelievable economic power and have several times sent "selling-tsunamis" through Wall Street at the demand of a single bureaucrat in Beijing. Ask them if they mind being less than a pure form of government... but put your fingers in your ears before you ask. I fought Communism and Socialism for 26 years, and retired to the midst of a salad-bowl mixture of governance. My confidence is in that the mixture contains all of the seeds of its own destruction, while at the same time being able to right itself in a stormy sea with the ease of a cork. We are not pure, but we are blessed if we remain vigilant.

Dear John,

Good article, clarifying a subject that almost defies clarification. But jumping ahead to your last page, the sentence "But then standards got loose, greed kicked in, and Wall Street began to game the system" is the best & most succint statement of why the system, like it or not, can't be left de-regulated.

Best,
Seamus O'Bannion.

Well said, Walt. The wealthiest class gamed the system to stick it to the middle class taxpayers and bought off the politicians through their lobbyists. While many decry "socialism", they are not prepared to eliminate the police and fire departments, Medicare or Social Security. There are some communal activities and government services that benefit us all and need not be swept up in the "socialist" hysteria! A free market system doesn't mean that we should have zero regulations to limit the abuse. Just wait until all the public pension funds eat their current losses in hedge funds and come to the taxpayers to pay retired public employees. Fools rushed in to get a piece of the unfettered capitalist game where everyone wins all the time. A balanced and fair system requires a lot of work and ongoing diligence. The last eight years showed us the dark side of deregulated capitalism. Don't assume hard socialism is the replacement. Throw the bums out and put back some rules.

Thanks Ed, in my 30 years of supporting Republican notions, I never expected a president like "W", who surrounded himself with cronies and payback appointments. Two U.S. Attorney Generals with no taste for law enforcement, A Secretary of State that let herself be turned away from a summit in Lebanon because the word was that they would not talk to a woman, An S.E.C. Chairman that let bond standards lapse until we bought Fannie and Freddie. The choice of Rumsfeld, who then lied about the war, and fired those who told the truth... the list is long and permeates the story of a president who preached how safe we were, then refused to spend more than 500 nights in the White House because it was a target on 9-11-01. The only way to educate the greedy is to take something away from them, and the power of office is a good start.

You have that backwards, regarding cause and effect. Becoming a Socialist nation is the way to ensure the economy will never recover (to where it should be).

The government should not be involved with the economy. The reverse Midas touch plays out. Fiat money? How about fiat food, fiat health care, and fiat energy. They all worrk equally well.

How would you factor in the over-valuation of assets that the FED is accepting as collateral?

Doesn't this open the door for hyper-inflation?

If the FED loans the banks a trillion dollars, with the same amount of assets as collateral, but later the assets are devalued... that would have the same effect as giving the banks the money in exchange for absolutely nothing.

The assets the FED is currently accepting are likely pretty risky and will have to be devalued. Or, if the banks determine the assets are worth nothing, they could just walk away from the assets.

It seems the FED is taking riskier assets off the banks balance sheets, so the banks won't have to take write-downs. But eventually the FED is going to have to take the write-downs. So we've saved the banks, by sacrificing the value of the dollar.

Also thanks for this article; with all the deflation/hyperinflation debates abounding, this is one of the most educational articles I've read.

Even if the fed buys MBS ext. from the banks and gives them cash they might be unable to find enough people willing and able to take the money...besides when a bank gets money at zero percent or for free in an environment of deflation and crappy consumer balance sheets wouldn't it just make sense to re-invest that money back into a longer-term gov. maturity bond?

ps - AWESOME ARTICLE!!!!!

It seems interest rate will need to increase eventually, and I guess it will be second half of 2009. It is largely accepted that interest rate with stay below 1% for years to come... why?

Volker hiked the rates in the early 80's (perhaps causing a prolonged recession) but this cleared the way of hyperinflation, and brought about (along with many other catalyst during that time) a sustainable recovery that arguably took many years.

Why cant interest eventually go up-- why is it now that many say it is unlikely rate will go up? These are not rhetorical question...

Interest rates can't be raised substantially this time around primarily because of the national debt. We are already paying over 400 billion dollars a year in interest and with the national debt about to explode rising interest rates would just grease the skids for not only the government but a lot of businesses and individuals.

That said, I personally believe that raising interst rates IS the answer. It would be extremely painful in the short run but how else will the consequences of the dire state of our economy be fixed and not just delayed?

It is like we are dying of cancer and will try any quack remedy we can come up with because we don't want to experience the pain of surgery. The longer we wait the worse it gets and ultimately there will be no alternative but revolution and/or war.

You said in the article that "The Fed is going to monetize at least a portion of what will be a $1+ trillion dollar US deficit. They have announced they are going to purchase $800 billion in mortgage-backed and other types of consumer loan assets. That will be a direct infusion of dollars into the economy. That is serious monetization. "

How is this any different from the current trading of US Treasuries for other illiquid securities by the Fed? Specifically, how does the Fed "monetize" the US deficit (or debt, as may be the case)?

This article is one of the best I have read this year. It is beautifully written and easy to understand.

I regret having to spend so much of my time studying economics when I should be running my business but it's obvious to me that I need to get a handle on what the hell is going on and Mauldin is better than most at explaining these things. Incidentally his conclusion ties in with Mish Shedlock's post of December 9 - Huge Demand For Treasuries As Banks Refuse To Lend - so my two favourite commentators are both sending me Deflation signals.

Well I don't understand half this stuff but I'm 57 years old and all my adult life I've watched my government (UK) and yours debauch their currencies and I have this really strong gut feeling that they are going to try to get us out of this hole by doing the same thing again. I cannot draw graphs or write equations to support my view. I have to rely on my instinct. My instinct says inflation. In fact the worse the symptoms of deflation appear to be and the more evidence of it that emerges the more I expect our two governments (and others) to do everything to create inflation. And given their track record they'll likely go too far.

I wonder who will be right.

I too cannot see how the gorvernment/Fed 'remedies' for the current deflation won't ultimately and inevitably lead to hyper-inflation.

At some point this monetization of the deficit has to unleash massive currency devaluation. I personally can't see how this cycle can possibly end any other way.

My only question is how long can the tipping point be delayed...if indeed we haven't already passed it.