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Sunday, January 25, 2009

Shrinkage

With the collapse of the financial system trillions of dollars have been wiped off the face of the earth, leaving naught but massive holes in the asset sheets of the banks, investment and insurance companies of the world. It goes without saying that very little of the money supply exists in a form that would fit in your pocket, and economists have labeled accounted money as M1, M2, and in some instances M3. M1 being balances in savings, checking, CDs, still the smallest, but most liquid of the "moneys" in the supply. M2 is where we run into trouble. Asset backed balances (M2) suddenly find themselves standing on soft ground. M2 and M3 supplies are dependent on the value of the assets held by financial institutions, and this number has taken a six trillion dollar hit in the last two years. Deflation is the result. "Real" assets dollar values decline, interest rates shrink to nothing, and the economy stagnates and contracts. The cure is obvious, more cash injected in the system to re-float the system without overshooting the target and bringing on inflation.

All this is a long winded way to say that the current stimulus package is not going to be inflationary, and the real danger is undershooting the target. If the package isn't big enough the first time, then the legislative dance will have to be joined again, without the current political consensus to drive passage.  The answer is to adopt a "too large" package, and give the secretary of Treasury and President the ability to trim it back in the case of an early end to the recession. Congress is loathe to relinquish financial control, but they need to cowboy up and take the one time hit to their power. Perhaps we could trade stronger war making authorization powers to the House and Senate in trade.