Random thoughts...

The thought occurred to me: What is the relationship of collateral to comsumeables with regards to inflation? What prompted me to formulate this question was wondering why Great Britain, with a strong currency, has a bigger inflation problem than the U.S., with a very weak currency.

Maybe the cycle works like this: 1. Money supply and credit is loosened. 2. Collateral values expand, based on the availability credit. 3. Inflation spreads to consumeables if money supply isn't tightened. 4. When money supply is tightened, collateral values (especially bubbles exceedingly dependend on credit) start to shrink. 5. Credit losses prompt credit tightening. 6. If the money supply is loosened to prolong the bubbles, inflation in consumeables skyrockets, because there's nowhere else for the money to go. 7. If the money supply is tightened, we get deflation and falling collateral values will be joined by falling consumeable prices.

Sounds good. However, I'm making several assumptions that I need to think about more. 1. I Assume that consumeables and collateral have a different relationship to credit. Actually, that's a good thing. They better be different. You can borrow against collateral, but not against consumeables. 2. I assume that collateral values are not included in inflation. Granted, but the whole point is to highlight the differences in the behavioral of collateral and consumeables in regards to money and credit. 3. I assume that an increase in the money supply without a corresponding increase in credit affects consumeables but not collateral. This is not necessarily the case. An increase in the money supply will also affect collateral values. However, the consideration of size is extremely important. In the modern credit cycle, the expansion of credit dwarfs the expansion of the money supply. Correspondingly, collateral needs a huge increase in the expansion of the money supply to inflate because it costs so much more than consumeable goods. 4. ??? (don't know, but I'm sure there are more...) I'll try to add to this later. I like it.

Now to attempt an answer to the U.K./U.S. puzzle that prompted this theorizing. This is a tricky one. A strong currency attracts foreign capital, which creates more cash in the system. On the other hand, imports should be cheaper. This cash is what is increasing inflation in the U.K. On the other hand, in an import economy, (the U.S.) a weak currency should increase inflation as the $ buys less. However, in the US, because the currency is weak, credit growth has outpaced money supply. Money, but not credit, flows to overseas investments. In other words, the weak currency emphasizes credit (and therefore collateral prices) at the expense of money supply (and inflation in consumeables). In the UK, the strong currency increases money supply relative to credit. Therefore consumeable prices are out of control. We see the same thing in Australia and New Zealand.

How about Japan? Does our thesis explain the condition of a weak currency, and an extraordinary campaign of credit and monetary expansion. Absolutely. Because the currency is weak, any monetary expansion leaves the country. In fact, the Yen is so weak that the money is still leaving before it has been created. That is why they still have deflation.

This explains an until now thorny problem and floods it with light: why out beloved central bankers were so happy to devalue the dollar, while at the same time talking tough on inflation. They want a weak dollar so that they can walk their tightrope of keeping credit relatively loose (compared to the rest of the world) without stoking inflation through an increasing money supply.