Any Government expenditure can be financed by taxes, debt issuance or money printing. Naturally, the first reaction of the public is to link all these resources that are going to be transferred to banks – particularly in the USA – as a tax-financed transfer. More technically, however, other analysts tend to associate this new spending to a Government debt financing operation.
In the United States, using round numbers, National Debt corresponds to 10 trillion dollars and the Monetary Base (mainly Currency) corresponds to 1 trillion dollars.
Although this subject is not discussed as openly as it should be, we are fully convinced that there will be a major difference if the financing process of the so-called “bank bailing out” will be made either by printing money or by issuing Government debt.
At this point in time, we feel that the famous helicopter story should be taken into consideration. In other words, doubling the monetary base in the USA, by redeeming 1 trillion dollars of US Government debt seems to be the correct and right method to finance the bailing out of the banks and promote the recovery of the economy through the famous money, credit and spending multipliers.
Otherwise, there would be a process that used to be called “crowding-out” of the private sector. It does not make sense for the Government to issue debt (not to mention raise taxes) and sell debt to the public or to the good banks, in order to raise funds for the bailing out process.
By printing currency, the normal process of multiple deposit creation through the “money multiplier” (notice that the so-called M2 corresponds to approximately 8 times the Monetary Base in the USA) will occur naturally, assuming of course a certain recovery of stability in the famous and well-known ratios between currency and deposits (C/D) as well as between bank reserves and deposits (R/D).
It is true that, at this point in time, people might be showing a strong preference for currency under the mattress, due to the lack of confidence in bank deposits. But, given the nature of the Paulson Plan (as well as in other countries), the ratio between C and D (normally around 9%, considering all deposits which are part of the M2 measure in the USA) should go back gradually to this historical ratio of around 9%.
The same comment is valid for R/D, which is normally around 4%. Undoubtedly, in recent months, both ratios might have gone up dramatically. Banks certainly acted like old ladies and decided to hide their money in their vaults and stopped lending.
Just assuming that these ratios went to 18% and 8%, respectively, this would represent an extraordinary monetary and credit contraction, with the money multiplier coming down from 8 to 4. Probably the contraction was not so extreme, but this example indicates the “power” of a money and credit contraction provoked by shifts in these two ratios (C/D and R/D).
In summary, we feel that the Paulson Plan – designed to buy any securities from banks as well as bank shares, and additionally to guarantee all banks debt – will be incomplete and may not work if it is not financed by printing money – yes, the old helicopter story. The Federal Reserve has to buy 1 trillion dollars of Federal Government Securities from the public and the banks simply by printing money. In other words: doubling the monetary base.
And, even after that, it will take some time for the C/D and R/D ratios to go back to their normal historical levels, restarting the money and credit multiplier powerful process.
Depression and deflation are the problems now, not inflation.