Katies Homework

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jerrydon10's picture
jerrydon10
Status: Gold Member (Offline)
Joined: Mar 2 2009
Posts: 442
Katies Homework

I have a new stepdaughter in college (new in that her mother is the love of my life). She is an advertising major and must take an economics course. She is lost...LOL

I offered to help her in this and yesterday she sent me this article that the professor wants addressed.

See if I got it right. I also introduce Chris' work to the next generation, which I do whenever I can. Your comments are welcome, let the thread go where it may....

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Katie:

 

First, it might behoove you to understand some basics of economics so that you have a foundation for understanding the articles this professor is throwing at you.

 

1) Understanding the creation of money:

 

New money simply poofs itself into the economy via debt and here is how it works.

 

I have $1000 I have kept in a dresser drawer for years. I decide it is safer in a bank, so I open an account and deposit it.

 

Now that bank has my $1000. And what do they do with it? They loan it out, that's how they make their money. By law, they can loan out 90% of it and they must keep 10% held in reserve to cover runs on the bank if that happens, etc.

 

So, Joe Blow walks into that bank and borrows $900 of my initial $1000 to buy a stereo from Jim Beam. Jim Beam puts that money in his bank. 90% of it, or $810 is loaned out to Johnny Walker so that he can pay his accountant. The accountant places his $810 in the bank and then 90% of that is loaned out.

 

By the time my $1000 cycles through the loan process it turns into $10,000, $9000 of it just being created out of nothing via the loaning process.

 

So what is backing this green currency we are carrying around? Nothing other than debt.....people owing other people money. That's why we see terms like debt based economy and AAA debt ratings and the like.

 

2) Understanding deflation:

 

So now that you understand that the economy is backed by debt, what would happen if people began defaulting on those loans? Hmmm......The economy would be in trouble.

 

This is what we are going through right now. These defaults began to be seen in the economy in September 2008 in a major way.

 

Banks, through encouragement from the government, had been loaning people with not so good credit (less than prime credit risk) money to buy homes. These are called sub-prime mortgages.

 

After a bank gives you a mortgage it sells that mortgage to Fannie May or Freddy Mac, two huge mortgage processors (now nationalized by the government). These two agencies take the mortgages and bundle them into securities, usually bonds, and sell them to other investors such as insurance companies, private investors or whoever wants to buy them.

 

But these sub-prime debtors couldn't make their payments and these securities became worthless as tons of people began to default on their loans. Those who had invested in these securities, Goldman Sachs, AIG, Bank of America.....etc began to go bankrupt. The stock market crashed as no one trusted in investing in these companies. Money began to dry up in the economy and suddenly the banks found themselves without money to loan. Businesses that depended on credit to operate like Circuit City, went bankrupt. Conversely, businesses that depended on credit to sell their goods like the big auto companies also went bankrupt.

 

And this makes perfect since because if the banks create money simply by loaning it out, then it becomes obvious that when people default on those loans, money is destroyed and sucked out of the economy.

 

Now cars, washers and dryers, boats, motorhomes are sitting everywhere for sale, but no one has the money to buy them.

 

This is deflation which can be succinctly defined as: less dollars in the economy verses more goods for sale in the economy. This is not good for anyone.

 

3) Understanding inflation:

 

Even more to be feared than deflation is just the opposite, inflation. This is defined as more dollars in the economy verses less goods for sale in the economy. Everybody has money and as a result of that, demand for goods and services is high and since there are many buyers competing for the same goods, prices go up. This rise in prices is a symptom of an inflating currency.

 

A friend of mine named Dr. Chris Martenson produced a great video on this subject. Your Mom and I hang out on his forum a lot. In fact, you might want to take his entire series of short courses on energy and economics when you have time.

http://www.peakprosperity.com/crashcourse/chapter-10-inflation

 

So, It wouldn't do me much good if I had $10,000 dollars in my pocket if a loaf of bread is selling for $5000, would it?

 

When inflation gets to the point it is that massive, it is called hyperinflation.

 

The country of Zimbabwe is going through hyperinflation right now. Banks in that country began to charge 800% interest to get a loan. They recently came out with the 100 billion dollar bill and that will just buy a loaf of bread.

 

OK, now we can understand the article. And once we read it, it will become apparent that this is an article showing a decrease in inflation and warning that the European economy might actually go into deflation:

 

"PARIS — The annual inflation rate for the euro area was unchanged over the year to May, compared to a 0.6 percent gain in April, the European Union statistics agency said Friday in a preliminary report.

A breakdown of the data is not yet available, but analysts said the drop was largely attributable to lower energy and food price inflation, while core inflation, which excludes those volatile prices, probably also fell noticeably.

The annual rate of zero percent in May was below analyst expectations of a rise of 0.3 percent, and was the lowest level of inflation since Eurostat started producing comparable data in 1996. "

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Well, that's great news, isn't it? They expected inflation to rise 0.3% but it didn't rise at all. But if this decrease in inflation continues, how far will it go? And did you know that slight inflation reflects a healthy economy that is expanding (growing)?

Further, a debt based economy must always expand to remain viable. The reason for this is that when money is loaned into the economy it must be paid back with interest. Where does that interest money come from? It can only be loaned into existence through more loans. Of course, more interest money must be created to repay those loans and it becomes a perpetual ever-expanding phenomenon if an economy is to survive.

But, inflation measured by core inflation probably isn't that accurate anyway because the term "core inflation" is a method of measuring that purposefully excludes items expected to inflate in price the most. Inflation is measured by tracing the prices of goods over time. A government might choose a basket of food items, the price of gasoline, price of a cell phone, televisions, etc to lump together to use as the inflation indicator.

More on fuzzy numbers and how this works in the U.S. from Chris:

http://www.peakprosperity.com/crashcourse/chapter-16-fuzzy-numbers

"The rate is likely to dip into negative territory in coming months, due to the high base comparison from mid-2008, before turning positive late this year and rising further in 2010, said Martin van Vliet, an economist at ING in Amsterdam.

“The severe contraction in activity has created a huge margin of spare capacity in the economy, which will exert strong downward pressure on core prices going forward,” he said. “There remains a real risk that the euro zone will see more than a whiff of deflation.”

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So an economist is telling us that due to a high base comparison (he is comparing today to economic conditions in mid-2008), inflation will probably dip, then rise and may finally plunge into deflation which can be as bad as severe inflation. Why?

Because I discussed above how mild inflation tells us that an economy is expanding. Deflation suggests that an economy is not expanding but doing the opposite, contracting. If a debt based economy must always expand to survive, isn't a contracting one more likely to collapse? He is warning us that the danger is very real.

"In Germany, Europe’s largest economy, consumer prices unexpectedly posted the first annual decline since at least 1996 this month."

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Is this good news that Europe's largest economy shows declining prices which is a symptom of deflation? Nope.

"Growing unemployment and feeble wage increases are also likely to keep a lid on any significant rise in prices for some time, analysts said.

The most powerful German union, IG Metall, reached a wage deal in November for a 4.2 percent rise through April 2010. The deal by the union, which represents 3.6 million workers at companies like Siemens and Daimler, consisted of two pay rises each of 2.1 percent, starting Feb. 1. The second increase was due to take effect starting May 1, but many firms, in agreement with unions, are deferring it."

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Growing unemployment and feeble wage increases are more sign of deflation. During the great depression years of the early 1930s, the biggest era of deflation we have ever seen in this country, unemployment actually reached 30% of the population.

"Figures from the European Central Bank released Friday showed a further decline in monetary and credit growth. Annual growth in M3, a broad measure of money supply, posted its sixth consecutive monthly decline in April, falling to 4.9 percent from 5 percent in March.

Annual growth in bank lending to the private sector also continued its decline in April, falling to 2.4 percent from 3.2 percent, with annual growth in lending to the household sector and the non-financial corporate sector also slowing."

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Remember me pointing out how we got into the deflationary period we are in right now via collapsing credit? How can a debt based economy expand as it must if it is to survive if the credit is not there to generate more loans which infuses new money into it?

The rest of the article I think is self explanatory. It just shows the other side and indicates that deflation may not occur:

"Still, the E.C.B. continues to argue against the likelihood of a deflationary spiral taking hold. The bank’s vice president, Lucas Papademos, said this week that “temporary disinflation does not constitute a persistent, broad-based and self-sustaining decline in the overall price level.”

The bank’s president, Jean-Claude Trichet, said this month that the inflation gauge would accelerate again in the second half of the year. The E.C.B. aims to keep inflation just below 2 percent.

Separate data released Friday showed that retail sales in Germany unexpectedly grew in April, raising hopes that consumer spending could help support the economy after a record slump in gross domestic product in the first quarter.

Sales rose by 0.5 percent from the previous month in seasonally adjusted terms, the Federal Statistics Office said. Year-on-year, sales fell by 0.8 percent."

Septimus's picture
Septimus
Status: Silver Member (Offline)
Joined: Aug 19 2008
Posts: 200
Re: Katies Homework

Hi Jerry,

Great job !

Septimus

 

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