On December 26, 2004 a magnitude 9.3 earthquake shook the subduction zone along the India and Burma plates in the Indian Ocean, sending multiple walls of water--some as high as a hundred feet--racing toward Sumatra, Indonesia at a rate of nearly 600 miles per hour. The tsunami, which struck land, took the lives of more than 225,000 people and caused still-inestimable economic damage to the region. Survivors interviewed following the disaster almost unanimously relayed the same grim tale: minutes before the tsunami hit the animals were spooked and flighty and the beach water receded dramatically. Ignorantly, many people treated the receding waters as a spectacle and looked at the situation as an opportunity to venture out and collect stranded fish and shells. They were to learn too late the awesome gravity of the situation.

And yet, unbeknownst to many, an even more devastating tsunami might well be building. And like many in Indonesia the warning signs are now becoming evident, but do we understand what we are seeing, or are we treating it as a boon; are we walking out to collect fish and shells?

Economic Tectonics
Deep beneath the surface of the US economy there is a seismic fault where the Federal Reserve meets the fractional reserve banking system. Unlike sound banking where each dollar loaned is a dollar deposited in the bank in a fixed term maturing account like a CD, this system uses initial capital investments and deposits to pyramid a hundred fold expansion of money in the US economy--essentially printing out of thin air $100,000 for every $1000 of productive money on reserve. The new money is given as loans to individuals and businesses to be paid back with interest at a future date. The Federal Reserve (the Fed) aggressively price fixes interest rates (the cost of immediate access to money) to further embolden citizens to take out these loans.

When a business person, for example, takes out a loan from a bank to build a new facility, s/he signs a contract with the bank to repay the loan with interest after a period of time. As unbelievable as it might sound, the bank from whom s/he burrows the money does not actually have the money to loan. One might ask where the money comes from. With a few keystrokes in the bank computer, the banker types in that the business person now has the money in his or her account. The money, as the banks will reluctantly tell you, is nothing more than the promise of paying it back. The new loan money then is used for architects, engineers, contractors, laborers, suppliers, etc. Once this money is in the hands of this second tier, some money is exchanged further for goods and services and some money is saved or invested in, say, mutual funds, stocks, retirement accounts, etc. This money in the form of currency, savings, and investments makes up what is called M1 and M2. It further becomes a part of the MZM (Money of Zero Maturity)--money immediately available for withdrawal.

The Nature of Inflation
Monetary inflation begins at the precise moment that more money has entered the economy than there are assets in the market. It might be easy to think that if everyone in the US were suddenly one million dollars richer, everyone could buy a million dollars worth of stuff and be better off. As nice as it sounds, this is simply not true. No, if everyone were a million dollars richer, Cars, boats, big screen TVs, etc. would immediately fly off the shelves (so to speak), producers wouldn't be able to keep up with the increased demand for those products, and prices would skyrocket as demand for precious few resources increased. After a short time prices would reflect the influx of new money and everyone would be exactly where they were before the million dollar pay day--only now the purchasing power of a dollar would be greatly decreased.

Though the sums of the loans are different and the number and distribution of the debtors are unevenly dispersed, banks are, indeed, engaged in precisely this practice. With all of this extra money floating around, however, should we not already see massive inflation? The Fed is quick to point out that the CPI (consumer price index) shows that inflation is rather stable, at about 2% per year. Herein lies the insidious nature of the Federal Reserve system. Although money flows like water and appears to be of unlimited supply, natural resources, goods, and workers are not of unlimited supply. The extra money in the economy promotes expansion and investment in areas that are not necessarily sustainable in terms of assets and supply and demand. Nevertheless, so long as consumer and business spending increase with the influx of money and companies can continue to produce at elevated levels, inflation is held at bay. What happens, however, if spending and production drop off?

The answer is that we get serious problems like those found in the current housing market. Massive and unsustainable investment was pumped into the housing market with unending credit expansion and government loan guarantees on both loan principle and interest. As long as consumers were buying homes, building and loaning could continue. However, eventually something occurred which no Keynesian economist appeared to think possible: housing supply exceeded demand, and the market simply dried up.

The housing bubble, however, was just the side effect of an easy-money-credit-crises-earthquake deep below the surface of the economy. And the economy soon began its tumult: unsustainable businesses produced by years of easy-money investments began closing; unemployment began rising; home owners were going into foreclosure; bankers were stuck with houses that no one wanted; eventually banks failed; bailouts ensued and with it a new influx of debt--money printed out of thin air, and the inflation tsunami was on its way.

The Warning Signs
But what are the warning signs of an inflation tsunami? Ironically, the most visible manifestation might well be sudden and sharp deflation coupled with a sharp increase in the strength of the dollar. In other words, look for the water to recede from shore and the height of the water off the horizon to rise. Why might this be? As consumers pull back on spending and burrowing, retailers also pull back with the fear of holding more product supply than product demand. Wholesalers perceive this pull back and retreat. Manufacturers see the retreat and stop burrowing for expansion projects and cut back on production. Parts suppliers see the cut back and then demand reduced quantities of raw materials--iron, steel, coal, oil, etc. along with other commodities. Finally when even raw materials drop production the waters might well be close to nadir.

This Week In the Headlines

"Prices Record Largest-ever Fall from Precious Month" -WSJ
"US Producer Prices Fell Sharply Last Month" -WSJ
"US Steel Layoffs" -WSJ
"Giant Mines Scramble to Cut Output" -WSJ

...but the mere risk [of deflation] puts added pressure on Congress and the incoming Obama administration to quickly advance a large fiscal stimulus plan. It also increases the likelihood that the Federal Reserve will take steps--such as pushing interest rates lower--to boost sagging consumer and business demand.

John Hilsenroth and Kelly Evans. Prices Post Rare Fall; A New Test for the Fed. Wall Street Journal November 20, 2008.