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I’m Not An Economist, But…

stockmarketI don’t think you have to be in order to understand what’s going on with our economy.

First, let’s define a few terms.

Inflation is a measure of the relationship between the amount of currency in circulation and the value of our economy. Since our money isn’t based on anything in particular, (that’s called a ‘soft’ currency) we can print as many dollars as we want. This seems great, but the downside is that as dollars become more available, they will be valued less, which means it will take more of them to buy the same goods. Inflation isn’t an automatic product of a soft currency; instead it comes from a government that is easily able to increase spending by increasing the amount of currency. In the short term, everybody is happy as the government can do more. In the long run, once that currency is in circulation, inflation will bring everything back into balance by increasing prices.

On the other hand, of our government had the restraint to only increase the money supply be the same amount the value of the economy grows, then we would have no inflation even with a soft currency. Unfortunately, restraint is not a word often associated with the federal government and spending.

In 2008, we saw the approach of a huge fiscal crisis. Due to a combination of factors, banks were about to start falling over like a house of cards in a fan factory. The short version is that they were using an accounting gimmick to treat debts they purchased as assets, which allowed them to make more loans and collect more interest. When you hear people talking about ‘Toxic Assets’ or mortgage backed securities’, that’s what they are talking about; debt repackaged as assets. Once those debts began to go bad, all of these banks were in danger of failing.

The federal government used TARP to bail out the banks. In essence, the government printed $700 billion dollars and gave it to the banks to help them balance their books.

Now they plan was pretty ingenious because even though the government sold us the plan by saying that giving all this money to the banks would allow them to start making loans again, that was never going to happen. That money had to stay with the banks to keep the balance sheets healthy until the toxic assets were all played out. This had the additional benefit of keeping those billions of dollars out of circulation, thus eliminating or delaying the inflationary pressures that would normally follow.

The federal government then began to try to spur the economy using what they called ‘quantitative easing.’ This is just a fancy term for printing money. The difference was that this time, they couldn’t just keep the money on a bank ledger; they had to spend it on projects to try and energize the economy. That meant that this time, the money had to go into circulation. Again, they came up with a strategy to try and hold off the inflationary pressure. They released the money to banks and allowed the banks to control the flow of money into the economy. The banks turned around and used the money not to invest in small businesses or give out individual loans, but invested in stocks, bonds, and other financial instruments. This allowed the government to claim it was stimulating the economy by investing in businesses while still keeping the majority of the money out of general circulation.

And it had another interesting side effect, one I believe was part of the plan. As financial institutions were given hundreds of billions of dollars to invest, where do you think that money went?

Into the stock market.

And the stock market reacted by raising prices. According to the federal government, the rising stock market values is a sign that our economy is on a strong upswing, but that isn’t the case.

I started this post by defining inflation as the relationship of monetary supply to the value of the economy. If you look at the stock market as a subset of that, the availability of now trillions of dollars in new capital has greatly increased the price of stocks, not based on their intrinsic value, but because their prices have been, that’s right, inflated.

There’s a term for what happens when the price of a stock or commodity is inflated far above its intrinsic value; it’s called a bubble. And there’s one thing all bubbles have in common.

They pop.

The stock market is headed for a major, broad based correction.

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