Saturday, September 15, 2007

Why is Financial Leverage Rising?

Let's say I've got a hundred dollars right now and I'm tempted to go out and spend it. In order to keep inflation under control, the Fed has to give me some incentive to postpone my purchase. It does this by raising interest rates above that of inflation. If I think I'm going to have two hundred dollars (adjusted for inflation) in ten years I'd be very tempted to simply save it. I'd be able to buy twice as much then.

From the early 1980s to 2000, savers (and investors) have been heavily rewarded. Inflation has been tame and anyone with money in the bank (or the stock market) watched their money grow.

So what's the problem?

The money grew! Now there is more money out there that wants to buy more stuff. All we did was postpone our purchases (which is saying a lot in this heavily consumer driven economy). If that money starts chasing oil and commodities then the inflation problem will be worse in the future.

In order for the Fed to control consumer prices it has rewarded savers by printing more money (for them). Printing more money, in the long-term, causes inflation. That's the "conundrum."

It isn't all bad news though (depending on how you look at it).

Not everyone wanted to postpone their purchases (not by a long shot). Credit also grew. Credit allows you to buy what you want now while hoping you can pay for it at some point in the future. Now there is more money (if you think of cheap and easy credit as "free" money) out there that can't buy stuff. It is very hard to buy more stuff when you are swamped in debt. Those who leveraged every last penny of credit into their new house (at the top), may find they can't afford to keep it.

The money supply and credit have both been growing far faster than our population. As long as they both continue to grow faster, then I would argue that leverage must also continue to rise. I see little over the long-term that will change the trend (well, gracefully anyway). Further, savers have been getting the short end of the stick for the past few years. I suspect that will also be a trend going forward. In order for the Fed to continue to heavily reward the savers (as was the case in the 80s and 90s, but most certainly not the 70s), it must abandon those who embraced credit (by pushing interest rates higher or perhaps even keeping rates where they are). I don't see that happening. That, in a nutshell, is why I lean towards the stagflationist case over the long-term.

From March, 2007:

Bernanke: Credit Key to Healthy Economy
WASHINGTON -- The smooth flow of credit is "essential for a healthy economy," Federal Reserve Chairman Ben Bernanke said Thursday, amid continuing concerns about the impact of risky mortgage loans on the economy.

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