On the Bubble

I haven't blogged much about inflation, because it hasn't yet become a big mainstream topic, but I think that it's an issue that is going to be on our collective minds over the next few years.

Why? Here's a very simplified explanation.

The United States is printing money at a rapid rate. When that happens, there are more dollars in supply. When the supply of something goes up, its value goes down.

There's also the demand aspect of the dollar's value. In the wake of the credit crisis, the demand for US dollars shot up. With everyone scared out of their minds, the US dollar seemed like a safe place to be. With no one wanting to put money in stock, houses, bonds or other investment vehicles, they kept their money in US dollars. This kept the dollar's value high.

But as soon as the economy calms down, the demand for dollars will go down. This is already happening, as cash is moving into the stock market, driving stock market prices higher. When the demand for dollars goes down, and its supply has already shot up, you have a perfect recipe for inflation. The dollar loses its value.

What makes things really bad though is the fact that for many individuals and institutions, cash isn't just what is in our pockets -- it is an investment. We don't think of cash that way, but many individuals and institutions see cash as a "position," in the sense that they have some assets in cash, some in stocks, some in bonds, some in funds, etc. Right now, many people have all of their assets in cash because it's considered the safe place to be. But when people begin to perceive cash as losing value -- when inflation begins and a dollar today is worth fifty cents in a year -- they move away from cash -- as an investment -- even more quickly. This causes the demand to drop further, and the price to fall further, which makes people more scared. This is how you end up with hyperinflation. It's not that a government prints so much money that the supply alone creates an enormous drop in value. It's the belief that the value is going down in the future that causes people to flee a currency, which creates an inflationary spiral.

In essence, what we have today is a cash bubble. A bubble is caused, in part, by a sort of whacked out "demand" side of the equation. The demand for tee shirts and TVs is relatively stable because the price you pay is based on what it's intrinsically worth to you -- the pleasure or enjoyment you get out of what you're buying. But the demand for dollars or stocks or bonds or options contracts isn't based on the enjoyment you get from them. They are just paper. Instead, their demand is based on price expectations and price comparison -- what you believe they will be worth in the future or what they are worth in comparison to your other investment options at the time. This makes the dollar, which is just paper, especially vulnerable to a "bubble." Bubbles aren't caused by people all thinking "man this asset has gotten a lot more valuable." Instead they are caused by people thinking "man this asset is going to be at a higher price a year from now."

Now compare this to the real estate bubble. As bad as that bubble was, it was tempered by the fact that it takes a while to build new homes and homes have some intrinsic value. Purchasing a home isn't purely an investment decision. Cash, on the other hand, has no actual intrinsic value. You can't eat cash or sleep in cash or swim in cash, although episodes of Duck Tales would have you believe otherwise. [Actually, Scrooge kept his assets in what looked like gold coins, which is a whole other story. There's also the matter of his lucky dime, which while technically a form of cash had an extra value based on properties other than its cash value. But ignore those factors for now.]

Cash is more instrincally valuable than some other investments in the sense that unlike stock certificates, it's an extremely liquid asset. In fact, unlike stock certificates or bonds, it's so liquid that I can exchange it without any fuss for ten boxes of Captain Crunch at the local Stop N' Shop. (Well, they might question my eating habits, but they'll take the money.) So it also has a sort of backstop. But if questions ever arose about accepting cash, or if the dollar was so ruined that only other currencies were trusted, that inflationary spiral would really take off because cash's value as "the asset that you trade in for cereal or other things you want" would be eliminated. When you add to that the hyper-networked nature of society, allowing these decisions to be made even more quickly than before, it could be an ugly future.

So, that's the depressing, potential hyper-inflation post of the week. Since I believe this will be a big issue in the future, with ramifications on all of the exciting new technological advances that I discuss in this blog, I thought it was worth a post. Apologies in advance for any inaccuracies in the economics there -- I was a political science major.