Friday, June 12, 2009

Behemoth and Leviathan...

The battle between inflation and deflationary pressures continues. This is one of the major questions for market participants at the moment.

From my standpoint, taxation will be the lynchpin on this issue. With monetary policy at full spigot and not producing the effects the Fed thought it would, as evidenced vividly here, Fiscal policy is the key to understanding the inflation/deflation debate. Monetary policy acting alone is simply not that powerful.

In our fiat currency system, the primary mechanism for monetary growth is credit-driven bank activity. Loans create deposits only constrained by the fractional reserve system employed by our banking system. The other way to create money is to lower taxes and/or increase government spending. Untaxed currency obviously remains "in the system".

Setting aside the issues of the government's ability to manage such a system (because it will not likely get this scenario right...that is an impossibility)

The spending part seems to be progressing (albeit with Congress's characteristic glacial speed). However, these warning from the current administration about raising taxes at this crucial stage is worrying. With the coming implosion (to the tune of another Trillion dollars in my estimation) of several types of residential and commercial mortgage derivatives, deflationary pressures should be offset by lower taxation. Increasing taxes in such a deflationary environment would be a disaster.

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