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Modeling Our Fiat World

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Deflation is the only place to go from here.

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In a fiat world, money is printed into existence by the central bank - the Fed, in the case of the US. Given there's nothing backing up this money, it's inherently worthless. However, one thinks of it as real.

In addition to the aforementioned money supply, fractional reserve lending allows credit to be extended by banks and financial institutions on top of that inherently worthless money. Indeed, banks and financial institutions have leveraged credit to base money at ratios of 30-1, 50-1, or even higher.

It's pretty amazing if you think about it: Credit is extended with 30-50 times leverage on inherently worthless paper.

Ponzi Financing

Borrowers have to pay interest on the amount borrowed. However, the interest and the debt cannot possibly be paid back - except by an ever-expanding Ponzi scheme of lending. That scheme can last only as long as everyone believes the debt can be paid back and the market value of that debt keeps rising.

It's a faith based system in which banks extend loans and hold the credit on the books (or in many cases off the books in various structured instruments). The banks are thought of as being well capitalized as long as the value of credit on the books in relation to their reserves meets some ridiculously low minimum set by the Fed.

This is how the system works - using the term "works" loosely, of course.

Day of Reckoning

The day of reckoning comes when asset prices start falling, defaults soar, and the value of credit on the books starts plunging. That day of reckoning has arrived.

And if leverage is high enough, as it was with Bear Stearns and Lehman, the institutions are wiped out overnight. Citigroup (C), Bank of America (BAC), Fannie Mae (FNM), Freddie Mac (FRE) and AIG (AIG) are essentially in the same position that Lehman was - except the taxpayers are funding the bailouts.

Deflation Economics

Conditions today are essentially the same as during the great depression. I talked about this in Humpty Dumpty on Inflation. When I wrote that piece, I listed 15 conditions one would expect to see in deflation; the score was a perfect 15-15. I recently added a sixteenth: bank failures. Click on link to see the conditions table.

Those who stick to a monetary definition of inflation pointing at M2, M3, MZM, or base money supply, as well as definitions that involve prices are selecting a definition of inflation that makes absolutely no practical sense.

The destruction of credit -- coupled with the fact that what the Fed's printing isn't even being loaned -- is what really matters - not some Humpty-Dumptyish academic definition that has no real-world application.

I have long been arguing we're experiencing deflation, based on the following definitions: Inflation is a net expansion of money and credit. Deflation is a net contraction of money and credit. In both definitions, credit needs to be market to market.

Mathematical Model

I can express the above mathematically.

Fm = Fb + MV(Fc)

Fm = Fiat Money Total
Fb = Fiat Monetary Base
Fc = Fiat Credit, the amount of credit on the balances sheets of institutions in excess of Fb

MV(Fc) is the market value Fc

Inflation is an expansion of Fm
Deflation is a contraction of Fm

If only base money was lent out (no fractional reserve lending), MV(Fc) would equal zero. The equation ensures we do not double count credit in Fm.

MV is a function of time preference and credit sentiment (i.e. Belief that one can be paid back). As long as that belief was high, banks were willing to lend.

Because (at the moment) Fc (credit) dwarfs Fb (base money), the system can only hold together as long as there is belief credit can be paid back and as long as there are not defaults. Needless to say, the perceived belief that Fc can be paid back is under attack, both by rising defaults, and by sentiment. That's why MV(Fc) is collapsing.

In other words, the mark-to-market value of credit is contracting faster than base money is rising.

No positions in stocks mentioned.
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