Money Does Not Grow On Trees

The market is expecting Mr. Bernanke to provide another 50 bp rate cut tomorrow, bringing Fed funds to 3.00%, well below inflation. What is the Chairman trying to do? Simply this:

(a) Prevent adjustable rate mortgages from re-setting higher and so ease the immediate pain in housing and,

(b) Create inflationary pressures to counter - as much as possible - the deflationary spiral that has already started in credit and asset markets.

Point (a) is self-explanatory, but point (b) requires further elaboration.

First, let's look at asset markets and consumer spending.

Economists, and the Fed's own econometric model, estimate that asset wealth has a direct 5% effect on consumer spending, i.e. for every $1 increase or decrease in asset wealth, people adjust their spending by 5 cents. This link derives from two sources: the psychological "wealth effect" (I feel richer, so I can spend more of my income and save less) and using assets as collateral to borrow and spend (I can "unlock" my wealth and spend it now).

As of the third quarter of 2007, American households owned $21 trillion in real estate and $11 trillion in equities. A 10% drop in housing prices and a 15% drop in equities would thus result in a reduction of approximately $187 billion in consumer spending, or 2% of personal consumption expenditures. This may not sound like much, but in fact, there has never been a year (or even a quarter) when US consumers did not increase spending in absolute terms, the Great Depression excepted (see chart below, click to enlarge).

Personal Consumption Expenditure, Percent Change From Prior Period

During other slowdowns growth in earned income and less saving carried people through, allowing them to keep spending until things turned around. Not now: the saving rate is already zero or negative, and wage growth has been very meagre, averaging 3% nominal for 25 years (currently 3.7%).

In other words, people were already spending more than they made and their wages were stuck. Only way out was to borrow in order to increase spending, but the credit crunch has now made this more difficult. The credit crunch begat the asset crunch, which is quickly turning into a spending crunch. Spiral down..

So, Mr. Bernanke, who cannot control wages, can only do one thing: drop interest rates so fast that people will be tempted to borrow again, hopefully assuming more debt than what is being destroyed right now (write-offs, abandoned houses, etc.). Because - and make no mistake about this - the destruction of debt is the destruction of money, and the destruction of money leads to deflation, by definition. Money does not grow on trees, after all - it can only be created via borrowing.. Here's my own version of the Money Tree:

$$

$ Now $
$ Hear This: $

$ Money is debt. $
$ No debt, no money. $
$ Less debt, less money. $
$ Less money, less inflation. $
$ Even less money, is deflation. $
$ Because $
$ "Inflation is always and everywhere $
$ A monetary phenomenon." $
Milton
Friedman

If people and businesses won't or can't borrow, Keynes said the government should, and thus keep the flow of money going, i.e. create a fiscal stimulus. I find it amusing, and highly instructive, to observe how quickly the supposedly most laissez faire US administration in 75 years dumped classical economics and embraced Keynes. Oh yeah, in calm seas everyone is a salty mariner, but let the boat rock a little and watch as they scream and scramble for the life preservers...

OK, bottom line...

Here's a simple assignment: You are Ben Bernanke. Now, create inflation.

Note: it is a lot harder than you think, and please don't just say "run the printing presses".

Feel free to use the comment section.