[quote=cyphire]Imagine what happens if the market drops in half (which it already did a couple of years ago) the entire value of the decline removes all that value from the money supply. [/quote]
This is not correct. I explained why briefly in the Prechter thread, but here is a longer explanation:
In the aftermath of the severe asset market declines of recent months it is common to hear the argument that all the money printing and stimulative government spending can’t make up for the huge amounts of “wealth” lost in the financial markets. The government could print up $2 trillion new dollars, the argument goes, and it wouldn’t even come close to making up for the $10 trillion of wealth that was lost in the markets.
This argument has two problems. To begin with, of course the government can make up for the lost wealth. They can create as much money as they want. If $10 trillion of wealth (as recently estimated by Merrill Lynch) was lost in the markets, then the government can print $11 trillion. And so on.
But the bigger problem with this argument is its assumption that a given decline in asset prices is equivalent to the destruction of that amount of money. This simply isn’t the case.
This concept is most easily illustrated with an example. Let’s examine the case of Alice, a hypothetical asset owner who I will say owns 1 million shares of XYZ company. Last year, the stock was worth $3 per share. Now it’s worth $2 per share.
The value of the Alice’s stock holdings have thus dropped from $3 million to $2 million. It’s true that Alice is now $1 million less “wealthy” than she was prior to the stock price drop. People usually only look that far, and assume that the stock price decline has resulted in the disappearance of $1 million from the economy.
But if Alice actually wanted to use her asset wealth to buy something, she’d have to sell her stocks first. It’s important to consider both sides of that transaction.
Let’s look at two scenarios. In the first, Alice sells her stocks to Bob before the crash for $3 per share. In the second, she sells them to Bob after the crash for $2 per share. If Alice decided to sell her stock to Bob before the crash, she would be paid $3 million. If she sold the stock to Bob after the crash, she’d only get $2 million.
However, in the first scenario, Bob would have to pay $3 million, whereas in the second, he would only have to pay $2 million. So while Alice is $1 million less wealthy than she could have been had she sold a year earlier, that $1 million didn’t disappear. It’s just that Bob got to keep it. Alice has $1 million less than she would have had she sold to Bob a year earlier — but Bob has $1 million more than he would have had he bought Alice’s shares a year earlier.
In other words, no money has been destroyed — it’s just been moved around. There has been no change in society’s aggregate ability to spend.
Even if the stocks didn’t have to be converted to money to harness their value, but were instead “bartered” for something, the same principal would apply. If Alice were trading stocks to Bob in exchange for food, a decline in stock values would mean that she got less food in exchange for each stock share. But it would also mean that Bob had to part with less food to acquire the same amount of stock.
Prices in an economy go up and prices go down. Relative values change. The decrease in the price of a particular item, even if it is a financial asset, does not destroy the ability to purchase — it just moves purchasing ability from potential sellers of that item to potential buyers.
There are some price-deflationary effects of a widespread decline in asset prices. All the stock holders who were still holding their declining stocks would definitely feel less wealthy than they did before the price drop. It’s likely that they would accordingly reduce their spending and boost their saving, which would exert a price-deflationary effect due to reduced monetary velocity and an increased demand for cash balances. In other words, while there was no change in society’s overall ability to spend, there might well be a reduction in society’s willingness to spend. But this phenomenon is very different than the actual destruction of money or spending ability.
Lower asset prices might also make it difficult for banks holding those assets on their balance sheets to lend new money into existence. But while this puts a potential damper on new money creation, it does not destroy any existing money. This ability or lack thereof to create new money would show up in changes to the money supply — but as we saw in Part I, the money supply is growing at a fairly healthy pace.
So widespread asset price declines do exert price-deflationary pressures via decreases in velocity and banking-sector money creation. Both these phenomena can be dealt with by the government as described in the “Pushing on a String” section above.
But asset price declines do not, as suggested by so many commentators, cause a one-for-one money supply decrease equivalent to the amount of the lost “paper wealth”— or anything even close to it.
