UNDERSTANDING CONTRACTION AND EXPANSION OF MONEY SUPPLY AND ITS CONSEQUESNCES PART 1 – BY Dr. BOBBY SRINIVASAN AND Dr. SUDHAKAR BALACHANDRAN

October 27, 2014 | Posted by bobbysrinivasan << back to blog

The economic cycles we have witnessed in the last couple of decades are due to a host of reasons among which the level of money supply stands out as one of the major factors.
Fact: In around 1997-1998, the enormous amount of dot com companies came into existence and were listed in several exchanges in the US. The stocks of these companies became a unit for speculation. Investors pumped in money in large quantities and used the greater sucker theory to support their decision. In simple terms, greater sucker theory states that there is always a fool (sucker) waiting in line to pick up the stocks from you at a price higher than what you paid. Both the Nasdaq and NYSE reflected this sentiment beautifully. Then, came the landslide. Prices of these stocks crumbled. Yahoo share traded as high as $500 and as low as $5.
According to the data available, trillions of dollars evaporated from the market and nearly 160 dotcom companies perished and the wealth and the investors who speculated were destroyed beyond any imagination.
Action: The US Federal Reserve, then Chairman Dr. Alan Greenspan moved quickly and pushed down the Fed discount rate from a high of 6%. When it all ended the discount rate fell to 1%. This saved the US economy from going into a serious recession.
Consequences: When you pump in so much money, especially when the interest rate fell from 6 to 1%, the money this time became available for speculation and this time into the real estate.
What happened: During the years 2002-2007, property prices shot up in the US by nearly 80%. Everybody speculated by buying several properties. This again ended in a collapse. The sub-prime crisis of 2008 is a sordid remainder of how people’s greed and fear contributed to this economic phenomenon which almost drove the US again into a deflation. The stock markets collapsed not only in the US but in India where our sensex dropped from 21000 to 8000 in a very short period. FIIs took their money and abandoned the then sinking ship.
Lesson learned: Pumping money into the system without sound economic reasons is like playing with fire. Current Abenomics in Japan is a classic case. The Japanese government has already pumped in a trillion dollars to revive the economy from deflation. The government wants at least a 2% inflation before they stopped pumping. You think the economy is showing confidence. No, look at their stock market Nikkei index was 38500 in 1989 and today, in October 2014, it is around 14500. It is clear that sooner or later, Japan will give up pumping money into the economy without any reason. In the last one year, the value of Yen has dropped from 78 to 109, a near to 30 to 40 depreciation.
Now, let us turn our attention to the US in the next blog.

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