The Economic 800lb. Gorilla in the Room

Everyone is talking about tight credit, greedy capitalists, overpaid CEO’s and a real-estate market that’s starting to crash yet again as the reasons that the recovery may falter.  While four months ago I fully believed that a double-dip recession was guaranteed, the risk is still there and has as much to do with something no one is talking about: Americans are getting frugal.

In October “Going Galt Without Realizing It“, we discussed some of the drivers for Americans putting more into savings, using cash instead of credit, and reducing their debt loads.  Now, First Command Financial published its financial behaviors index that gives statistical reality to our analysis.  What no one is talking about is why this is so important to understanding a stagnation or retrenchment in the U.S. economy.

America operates on a fractional reserve basis.  In over-simplified terms, the central bank loans 3 banks $10 each.  The rules allow each of those three banks to loan $100 against that original $10.  That’s $270 of money out of thin air.  Just figure that those banks loan money to other banks and how that could exponentially create dollars from nothing – money is getting created out of thin air at each step.  This creates inflationary pressure – as more money gets created each dollar increasingly loses value and purchasing power.  That’s the part everyone has been talking about.  The more money the Fed pushes out the door, the more inflationary pressure should result.

What no one is considering is what happens if no one bothers to borrow the money?  That original ten bucks.. stays $10.  The additional $270 never shows up.  That’s $270 that never makes it into the economy.  This counteracts the Fed’s inflationary money-printing by not allowing the fractional part of the reserve system to have as much of an effect.

To be fair, frugal Americans aren’t the only cause.  Credit card companies are becoming more strict with applications and lowering credit limits, banks aren’t lending as freely, home equity has become non-existing for up to 25% of home owners who are now under water on their mortgages.  Credit is becoming less used both due to supply and demand.  The result: deflationary pressure.

So why aren’t we seeing massive deflation?   We are, it’s just masked by a dollar being weakened by poor monetary policy (inflationary pressure) and rising food and energy prices (actual inflation due partly to the weak dollar).

Eventually one of these two monetary influences will win out.  One of the two will give in first, the question is which.  Will the Federal Reserve Board roll back it’s loose monetary policy first or will Americans give up on being debt-free.  If the Fed tightens and Americans continue to take on less debt, deflation is a real possibility.  If Americans give up the whole Galt thing and go back to deficit spending on cars, TVs and the like and the Fed remains loose, we could see serious inflation.

Which way it goes depends on the tug-of-war between monetary policy governance and the character of the American consumer.  When the Fed talks about carefully unwinding stimulus efforts, they are talking about this interesting relationship between the American borrower and the reserve’s monetary policy.