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Great Depression Online Archive Issue:

Pouring Lighter Fluid on the Camp Fire

Great Depression Online
Long Beach, CA
July 30, 2010

Inside This Issue You Will Discover…

*** Where’s the Inflation
*** Weimar Inflation Revisited
*** Pouring Lighter Fluid on the Camp Fire
*** And More

Where’s the Inflation

“Despite a long and deep recession, the worst since the Great Depression, the recovery has been rather tepid,” says Frank Aquilla, for Businessweek.com.

“Not since the Great Depression has the U.S. experienced deflation, a sustained dropping of prices and asset values.  Since the Federal Reserve has cut interest rates to near zero and the government has boosted spending significantly to address the current weakness, one would expect a resultant resurgence in inflation.  Instead, inflation has remained extremely low, with the headline consumer price index up 1.1 percent from a year earlier (a 0.9 percent rise if you exclude food and energy prices).”

What gives?

“Velocity,” says Ambrose Evans-Pritchard, for the Telegraph.  

~~~~~~Taxes and Your Retirement~~~~~~

Assume, for the sake of simplicity, that you are going to cash out your entire IRA when you reach age 70½.  In that case, the choice between contributing to a traditional IRA or to a Roth is nothing more than a bet on tax rates.  If your tax rate goes up, the Roth will give you more after-tax spendable cash when you reach age 70½.  If your tax rate goes down, contributing to a Roth will turn out to have been a mistake.  If your tax rate holds steady, your decision won't matter.

Don’t Give Uncle Sam Your Retirement  

~~~~~~~~~~~~~~~~~~~~~~~~~

Paraphrasing from a long out of print book titled “Dying of Money: Lessons of the Great German and American Inflations,” Pritchard says…

“Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money.  This sits inert for a surprisingly long time.  Asset prices may go up, but latent price inflation is disguised.  The effect is much like lighter fuel on a camp fire before the match is struck.

“People’s willingness to hold money can change suddenly for a ‘psychological and spontaneous reason’, causing a spike in the velocity of money.  It can occur at lightning speed, over a few weeks.  The shift invariably catches economists by surprise. They wait too long to drain the excess money.

“‘Velocity took an almost right-angle turn upward in the summer of 1922,’ said Mr O Parsson.  Reichsbank officials were baffled.  They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply.  He contends that public patience snapped abruptly once people lost trust and began to ‘smell a government rat.’”

That’s when all hell broke loose…

Weimar Inflation Revisited

The allure of the printing press was too much to resist in war torn Germany following World War I.  Indebted by reparations under the Treaty of Versailles, Germany's Weimar Republic opted to inflate its way out of debt.  The results were disastrous.

Between January 1922 and November 1923 the wholesale price index ballooned from 36.7 percent to 726,000,000,000.0 percent.  By late 1923 it took 200 billion marks to buy a loaf of bread.

Drawing from another out of print book, “When Money Dies: The Nightmare of The Weimar Hyper-Inflation,” Pritchard continues…

“Near civil war between town and country was a pervasive feature of this break-down in social order.  Large mobs of half-starved and vindictive townsmen descended on villages to seize food from farmers accused of hoarding.  The diary of one young woman described the scene at her cousin’s farm.

‘“In the cart I saw three slaughtered pigs.  The cowshed was drenched in blood.  One cow had been slaughtered where it stood and the meat torn from its bones.  The monsters had slit the udder of the finest milch [sic] cow, so that she had to be put out of her misery immediately.  In the granary, a rag soaked with petrol was still smouldering [sic] to show what these beasts had intended,’ she wrote.”

Pouring Lighter Fluid on the Camp Fire

The velocity of money is simply the average frequency a unit of money is spent in a specific period of time.

For example, a mechanic buys $40 of maintenance supplies and detergents from a storeowner in the morning.  Midday the storeowner spends $50 to have his car tuned up by the mechanic.  That evening the mechanic picks up a $10 case of Budweiser from the storeowner.

Thus $100 changed hands over the day, even though there was only $50 of actual money.  The reason it was possible for the $100 to change hands is because each dollar was spent twice…the velocity of money was 2 per day.  For the day, based on these transactions, the storeowner and the mechanic each contributed $50 in spending to the economy.

But what happens if the storeowner takes the proceeds from the initial $40 sale and stuffs the money in his mattress…and the mechanic, not having earned $50 in tune up services, passes on the beer? 

In this example, just $40 in gross spending would have taken place.

Today, while the money supply has greatly expanded, its velocity is lethargic.  Here’s what we mean…

The federal funds rate is set at practically zero, the Federal Reserve’s more than doubled the money supply, and the government’s running a double digit federal budget deficit.  In other words, the Fed and the Treasury have poured lighter fluid on the camp fire, but the economy lurches along like molasses in February.  The match has yet to be lit.

Following the 2008 financial crisis and credit freeze, banks would rather repair their balance sheets than lend money.  They are given access to cheap credit from the Federal Reserve yet they don’t lend it; they hoard it…they stuff it in their mattress.  And what they do lend, they lend to the Government in exchange for Treasuries.

History has shown that attitudes can change suddenly, and the velocity of money can spike upward.  The lighter fluids already been poured on the camp fire.  Just give it a year or two…an errant spark’s bound to ignite a fire storm.

Sincerely,

M.N. Gordon
Great Depression Online

P.S.  Converting a traditional IRA to a Roth usually means writing a large check for the tax bill.  But by positioning your IRA properly, it’s possible to cut that tax bill by a big margin.

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