Balanced Asset Allocation. Lee Bill

      The Fed has the unique ability to print money and buy assets. It can essentially create more money and inject it into the economic machine. Normally the Fed prints money to buy government bonds, which has the dual effect of lowering long-term interest rates and pushing money into the economy. Lower long-term rates along with already low short-term rates help reduce debt service and leaves more money to be spent.

      Many argue that printing money is irresponsible and will ultimately create more problems than it solves (including hyperinflation). Proponents of this perspective may not recognize that nearly every deleveraging in history has ended with printing of currency. The reason is straightforward within the context of the economic machine: The negative feedback loop of the deleveraging process will continue until the cycle is broken with the printing of more money. Spending will continue to decline as credit contracts (remember that spending = money + credit). The debt-to-GDP ratio will get worse because the debt is falling slower than asset values and incomes. This is exactly what happened during the first few years of the Great Depression and in the United States in 2008, and is what Japan has been living through since the early 1990s. In all three cases conditions degraded until the printing of currency ensued. The same process has been repeated across countries over time.

      Along the same lines, a common question is why the printing of trillions of dollars does not automatically result in high inflation. The answer is that the printing of more money replaces the decline in credit to the degree that total spending does not increase enough to cause inflation. Money plus credit equals total spending, and the decline in credit is roughly offset by the increase in money. If there were no printing of currency, then total spending would likely fall significantly (because the quantity of money would not have grown), and deflation would be the most probable outcome. In other words, the printing of money – which is normally inflationary on its own – merely offsets the deflationary conditions that exist at the time. That is why we have yet to see inflation from the 2008 crisis and why printing money may never lead to inflation. The result is entirely dependent on whether too much money is printed. Printing money alone is not a sufficient prerequisite for higher inflation. In fact, printing currency is necessary to keep spending positive while the debt-to-GDP ratio is simultaneously reduced over time. By pumping more money into the economic machine the resulting increase in spending can generate positive growth rates while credit – the normal tool used to prop up the economy – is healing itself from high debt levels.

      The Importance of Balance Always, but Particularly Today

      Today's environment should be observed within this understanding of how the economic machine operates. Prudent portfolio construction should thoughtfully consider the wide range of potential economic outcomes. In a nutshell, the headwinds of deleveraging constrain economic growth and inflation. Unprecedented levels of money printing that aim to produce a tailwind of strong growth and rising inflation are meeting this negative force. Deleveraging versus the printing of currency: these two powerful forces are going head to head. Which will win? We are in uncharted waters and the potential range of economic outcomes is extremely wide. If there is too much printing of money, inflation becomes a high risk; but if there is not enough, deflation may result. More printing of currency is positive for economic growth; however, an insufficient level will be overcome by the deleveraging process and result in low or negative growth. How this dynamic plays out is a crucial input for developing the appropriate portfolio mix for the foreseeable future because of its impact on the economy.