Cheng Siwei, a leading Chinese economic spokesman was very critical of Federal Reserve Chairman Ben Bernanke’s monetary policies stating, “If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard.”  He went on to say that China is so concerned that they have started to “diversify” their holdings of roughly $700 billion of U.S. foreign-exchange reserves, opting to sell their holdings off and purchase gold as a hedge to the dollar “falling hard”.

This is not good news for the U.S. economy.  China is the largest purchaser of our federal debt.  For years they have been financing our government’s addiction to deficit spending.  China is signaling very clearly that they will be less and less likely to continue this practice because of concern of the credit worthiness of our nation.  If the Chinese credit pool dries up, then the U.S. government will be left with a very limited number of choices:  raise taxes significantly on everyone, print more money, and/or drastically cut government spending.

While Pres. Obama sends Vice-Pres. Biden around the country to tell the American people that the “stimulus is working just as we planned”, I’m left to wonder what the heck their plan is anyway.  As of yesterday:

• The value of the dollar has fallen to the point where global monetary investors are pulling money out of U.S. Monetary funds and placing their investments with emerging markets like Brazil.
• Unemployment deepened with the announcement this week that we are now at 9.7% for the nation.  When you factor in those who have given up on looking for jobs or who can only get part-time work to replace their lost full-time job, we are at 16% unemployment/underemployment.
• Trillion dollar deficit spending has become the new billion dollar deficit spending
• We now learn that taxpayers will most likely never recover $80 billion of the automotive bail-out
• There appears to be no end to the Obama administration’s willingness to spend then tax.

Mr. Vice-President – if all is going “according to plan”, then where is your plan taking us?  China seems to know, do you?

You will hear accusations about greedy business, those evil corporations, and the evil Wall Street investors. But to understand the real culprit of inflation we need to understand what inflation is and what it is not.

Inflation is NOT the rise in price due to supply and demand of goods. It’s not even the rise in prices of products in a certain market segment (let’s say fuel). In fact, the rise in prices during an inflationary period is a symptom of inflation, not inflation itself.

Inflation is simply this, an increase in the supply of printed/minted money. Money is manufactured just like any other “product”. Under normal circumstances, when the government prints new dollar bills and puts them in curculation, it takes an equal amount of old dollar bills out of circulation at the same time. This one-for-one exchange of old bills for new bills keeps inflation in check because there is the same number of bills in circulation.

When the government prints new money and puts it into circulation without removing old money, the value of money decreases due of the increase in money supply. The result of this decrease in the value of money results in the increase of in the price of goods. Note that I did not say the increase of the value of goods, but the increase in the price of goods – big difference.

For those of you who are visual thinkers, picture this. There is a scale that weighs value. On left side of the scale is a bag of groceries. If we could measure the value of the bag of groceries as weight it might weigh 10 pounds. On the right side of the scale is a stack of ten one dollar bills. The value of the ten dollar bills also weighs 10 pounds. The value of the groceries equals the values of ten dollars so the scale is level. Now, we apply inflation – not to the groceries – but to the dollar bills (inflation impacts the value of money, not products). If inflation is at 10%, now our ten dollar bills weigh 10% less – or 9 pounds. The result is that it would take more money on the money side of the scale to represent the value of the bag of groceries. The scale dips down on the grocery side not because its value increases, but because the value of money decreases.

The drop in the value of money because of increased money supply does not just impact the cost of products, but it applies to every aspect of our economy – it will take more dollars to represent the value of products, services, wages, utilities, taxes, … everything.

So, why did I say at the open of this note that a storm is looming. Lost in all the conversation about our economy and healthcare reform is the fact that on March 19th, 2009 the Federal Reserve said it would flood our financial markets with an additional $1.2 trillion. What this means is the government is printing an additional $1.2 trillion and putting it in circulation without taking an equivalent amount out of circulation.

They did this to try to break what they perceived as a financial log-jam of money that is preventing the circulation of money in our economy. Here’s the problem: there is no “money log-jam”… in fact, quite the opposite is true. A log-jam is because the supply of logs is hung-up somehow in a river preventing the logs from being floated down-stream… so the up-stream logs keep piling up at the point of the jam. Break the log jam and logs will flow unimpeded.

But our credit crisis is not a money-jam… it’s a lack of money because we borrowed, borrowed, and borrowed some more. For decades, we as a country have been borrowing more than we are saving. Because we are not saving, the money is not in the banks to be lent out – hence a credit crisis. People have borrowed money against the “perceived value” of their homes and spent it on other “stuff – a practice that was encouraged by the real-estate bubble nationwide. When the bubble broke, the value of home prices fell – but we spent that perceived value in credit borrowing. Now, we owe more in debt then we own in value. So the current credit crisis is not a result of a money log-jam, it’s a result of overextended credit – we’ve spread our money out too thin.

Simply adding money to the money supply will not fix this problem. It may have a short-term impact – it will be ture that banks will have more physical dollars to lend out. But the long-term impact is INFLATION – and lots of it. Like I said, there is a storm on the horizon, and its name is “Inflation”.