8:08 PM 9/16/2008
I have a question.. several actually.
1) with the bankruptcy of Lehman, does this mean the M3 money supply goes down?
If that is true, does that mean deflation, and not inflation will set in?
I'm not sure I can answer this perfectly. But I'll give it a shot. I'm going to refer to M3 as little as possible, because I'm not sure in this case where to draw the line that separates M3 from actual wealth.
Whether the M3 money supply falls depends on how much the government or the Fed gets involved. If the Fed buys Lehman's bad assets (or loans them money collateralized by worthless assets) — which it has already said it would do — it increases Fed/Government borrowing — thus increasing the effective money supply in a similar manner to when a bank makes a loan. This increases the virtual money supply, without creating any additional value. Thus, each dollar of the newly increased money supply is worth less. The Fed will have to borrow the money, and will ultimately have to pay back the money it has loaned to Lehman with taxpayers' dollars. (Unless Lehman can magically pay the Fed back all of the money it loaned out.) But even if Lehman does pay the money back in 10 years or so, it still expands the current money supply by the amount loaned out, and creates inflation proportional to the amount of money loaned out.
If Lehman was allowed to crash without a taxpayer-funded handout, it would eliminate much of it's debt, and eliminate the virtual dollars that debt represented, and would
the virtual money supply at least some. If Lehman simply went bankrupt, it would shrink the money supply by an amount proportional to the amount of debt it could not pay off through liquidation. But the money supply shrinkage would be less in dollars, than the actual amount of Lehman's losses (I don't really know how to determine the actual money supply shrinkage, since total national wealth is around $56 trillion
1 , several time the amount of our $12-14 trillion M3 money supply.)
Lehman's total assets were something like $600 billion, and the capital supporting it was something like $30 billion. So a complete collapse would cause a money supply shrinkage of much less than $570 billion. But the $570 billion fall in fake wealth, by itself*, would increase the value of the dollar. Real wealth would be exactly the same. But it would be represented by $570 billion less $$. (*"by itself" meaning without the indirect effects of any market psychology, such as buying and selling of other assets caused by the Lehman bankruptcy.)
Other entities that owned some of Lehman's debt or stock would lose money. Though the primary loss in other entities should be accounted for by their share of the $570 billion loss, they would lose additional money as shareholders in their companies sold off stocks and debt as their own company's share prices fell. This is the so-called ripple effect. It's impossible to estimate how much artificial paper wealth would be lost due to this effect. But NO
real value would be lost as these other companies' share prices fell. Only their artificial overvaluation would fall. Again, there would be less dollar-denominated/dollar-measured wealth, but with NO loss in real wealth. (A stock certificate is a piece of paper with no intrinsic value.) There would be less $$ representing an un-changed amount of real wealth. Without the intervention of any market psychology effect, the shrinkage of the $$ that denominate a constant level of real wealth would cause deflation.
However, overwhelming market psychological factors
would come into play. Investors would be less confident in $-denominated assets, and would tend to sell the dollar and $-denominated securities. Thus, despite the fact that each dollar would now represent a larger fraction of the US's real wealth, the dollar would probably fall in relation to other currencies.
This might even be a case of where US price inflation declined, while the foreign exchange value of the dollar also declined. The dollar might buy more in the US, while buying less overseas.
I think so, but not by $700 billion. It
does mean, however, that aggregate national wealth shrunk by $700 billion. (In current dollars, not real dollars.) Again, the best estimate of our aggregate national wealth was around $56 trillion in March 2008. The -$700 billion
would shrink the number of dollars representing our total wealth. The % shrinkage of our dollar-denominated wealth would be 1.25% ($700 billion ÷ $56,000 billion = 1.25%) I'd speculate that the money supply would shrink by a similar amount. Again, the $700 billion loss in the stock market denotes absolutely NO loss of real wealth. All that disappeared was $700 billion of completely fictional wealth. In theory, every dollar should buy about 1.25% more than it did. (Sticky prices, however, prevent this from happening in the real world.)
I think you're right about the inflation and the deflation.
The sickening part of this is that the inflation will be born equally by all taxpayers, while it was AIG who created the inflation, and AIG alone who profiteered by creating the inflation.
And since inflation redistributes wealth upward to those who get more of the inflated dollars, deflation redistributes wealth downward, and away from those who lost more inflated dollars. Deflation hurts the rich more than the rest of us, especially if it's due to financial asset contraction.