Debt, is this not the Great Depression?

I was on the Federal Reserve website checking out the major holders of debt in the United States historically. Both charts that I created show basically the same data. The first though shows the difference in the amount of debt over time, though it is nominal terms not real terms. The second just illustrates more lucidly the amount allocated to each type of provider. There were no data from earlier, but we can generalize that the banking system in the Great Depression looked a lot more like the 1943 data than the 2003's data points.

So it is obvious that the financial system has evolved, not in the Victorian sense that evolution necessarily means for the better, just that it has mutated. Securitized pools which do not exist in the data until the end of the 1980's come to make up over 30% of debt extended in its halycon days of 2003. A securitized pool is a pool of debt instruments for instance mortgages, or credit card debt, or automobile debt, or just general loans. These are sold to investors, usually pension funds, mutual funds, etc. The idea is that these instruments should be safe but yield more than comparable government bonds or AAA corporate bonds. These pools also allow the end borrower to borrow more cheaply than had investors not bid up the price they would pay for these structures.

The reason to make the distinction between the two eras or even to look back at how the debt market has evolved is that the response of the players should be different as well. When a bank in the 1920s and 1930s funded itself via deposits and then constructed a loan portfolio of assets it was subject to a risk of concentration. The first part of the concentration risk was that since there was no FDIC the deposits were not insured, so if all the people of the town came asking for their money at the same time there would not be enough cash in the vault to meet their claims. The second risk that stems from the first, was that if the financial system was in dire enough shape for people to be asking for their cash deposits back it meant that the economic system was in arrears as well with unemployment sure to follow. Thus, the loan portfolio (mortgages, small business loans) concentrated in the area in which the bank was would probably not pay back all the cash flows it was expected to generate. These are the reasons that the social safety net was constructed with unemployment insurance and deposit insurance.

So, what can be expected of the banks to do now? Well, banks will keep on doing what they have been doing. Making loans where it is profitable to do so and winding down bad loans. It is instead the securitized pools that worry me. Some of those pools were brought back onto the originating banks balance sheets, which then ties up their regulatory capital, thus decreasing their lending. Now a securitized deal cannot even be done without a guarantee from the Federal Government backing it. If we lop off the 25% of debt structure of the United States it will be hard to recover back to normal and "normal earnings and revenues." It's what PIMCO has been saying for awhile now that a new normal may be in store.

Inflation

The quantity theory of money describes inflation and has a long history dating back to thinkers in the Renaissance. Coepernicus among others noted that as gold arrived from the New World the price of goods rose. Thus the theory expounds that there is a positive relationship between increases in the money supply and prices of goods and services.

An easy example would be coffee. Imagine a Dunkin Donuts as it started in the 1950s, it charged a nickel. Now to buy that same cup of joe it costs 2 pieces of silver ($2.00.) Is it because the coffee is better, or because people enjoy it more? Nope, according to the theory, your dollar's value is less, so before a 20th of a dollar got you some warm goodness now it costs two. So how did the dollar come to be valued less? Isn't monetary policy off the gold standard?

It wouldn't be economics if supply and demand were not involved. The money supply is based on the Federal Reserve through its operations including its open market operations. Again, it buys bonds to increase the money supply and it sells them to decrease the money supply. For the next example it is assumed that the Federal Reserve keeps the money supply constant. The money demand however is controlled by people. Some factors that affect how much money people want to hold are: that availability of credit through credit cards, the availability of withdrawing funds either through an ATM or from a bank's teller. Underlying this idea though is the cost of goods/services because as they are priced higher than people must carry more cash for daily transactions. Since the people carry higher balances with higher prices than the demand for money is greater.

Here is a chart.

The blue line is the fixed money supply. The Red line is the Money Demand. The demand line curves downward because as the value of money falls or conversely the price level is higher people desire a larger quantity of money. The equilibrium is shown by the dotted line it is where the price level and the value of money intersect.

Now as the Fed performs open market operations, say buying treasury bonds, it will increase the money supply. The next chart shows the money supply parallel shifting out (from blue to orange.) This cause the value of money to fall and thus price levels to rise.

It is important to note that the fundamental economy has not been affected by this injection of money. The capital level has not changed, the labor productivity has not changed, knowledge is static, everything in short is held constant. However, because there is now more money chasing the same amount of goods then prices must therefore rise.

This brings up another point, that prices should not matter or restated that there exists a monetary neutrality. If prices double, then so should wages because the inputs for the good/services include labor, thus everything should be equal in the long run.

Now back to MV=PY or V=(PY/M) so the velocity of money should equal the price level times real output divided by the quantity of money. During most times V is stable, however, during financial crises this does not have to be so.