Wednesday, March 11, 2009

Credit Contraction and inflation, why the banking system fix will unleash mammoth inflation

Analyst Meredith Whitney expects outstanding U.S. credit-card lines – which now total about $5 trillion – to shrink by $2 trillion in 2009 and another $700 billion in 2010. She points out most credit cards were issued when unemployment was below 6%.

Whitney also dispelled the popular myth that America's credit cards are maxed out. They aren't. Just 17% of total credit-card lines were drawn on at the end of 2008. But that percentage will ramp up sharply when credit-card issuers start pulling credit lines from borrowers who lose jobs and fall behind on payments.

The contraction of credit-card lines... the rapid rises in home foreclosures and corporate defaults... the bank failures... These all have the effect of shrinking the money supply.

Most of our money is not created by the Federal Reserve. Most of our money is lent into existence by our banking system. That's why the Fed doubling its balance sheet in world-record time last fall didn't have inflationary consequences.

The Fed's fiat money merely provides the fuel for inflation. The real engine, where $1 is multiplied many times over, is the banking system... and it's broken. The Fed's balance sheet has expanded dramatically since September, but the banks' balance sheets are still contracting as mortgages and other loans continue to go bad. That reduces lending capacity – money-creation capacity.

More capacity will evaporate later this year and next year. Option-ARM loans will hit reset levels, causing more mortgage delinquencies and defaults. Insurance companies will get hit by corporate-bond defaults. (Insurance companies, especially life insurance companies, have been the largest buyers of corporate debt going back to the Great Depression. They're also huge commercial real estate lenders.)

Perhaps the hardest thing for you to believe is that all this credit destruction is good... but it is. Less borrowing means more saving. Economic growth requires saving, not borrowing and spending. Savings is the horse. Borrowing, spending, and higher tax revenues are all in the cart. If you put the cart before the horse, you won't get very far. If you put the horse in front, you can go anywhere you want.

When the banking system gets fixed and the banks start lending again watch out for rabid inflation. Remember $1 of reserves gets multiplied many times (perhaps as much as into $10 of new money creation)since the reserve ratio is a fraction of the actual reszerves.

So the bank lending process will reverse the money supply contraction and all that new money will chase after a much shrunken supply of goods and services.

Bingo!! Up go prices. The next bubble will be started.

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