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Dear Trader,

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Liquidity and Manipulations in Modern Economics
By Brandon Fredrickson
February 7, 2008


Good day! For those of you who could not make it to the previous classes,  the link for the logs are as follows:  http://www.tradingfrommainstreet.com/TradingClasses.html


Economics is a social science that concerns itself with the study of the production, consumption and distribution of goods and services. Pretty simple definition, but it will work well for us to start out.

For our purposes today I want to create an Island Economy. The purpose of this is going to be to illustrate how an economy free of disturbances and manipulations might act, and then show how our modern, meddling central bankers and others create disruptions and manipulations in the economy. Hopefully it will help you understand how to spot them, and profit from the likely result of said manipulation.

Our Island Economy is just going to be called Brandon's Island to inflate my own sense of importance. Hey, if the bankers and politicians can name bills and whatnot after themselves, I can name my own fake island Brandon. To shorten things up though, from now on it'll just be called The Island. We are going to be sort of like the cast of Lost on this Island, except we will get along better, won't have monsters coming after us, and all the assorted things that make for great TV drama.

Ten of you are going to join me on our little boat as we set off to sea. After a few days we are overjoyed to finally be out of the sea and back on land. Since I was your capable captain, you're all very grateful and, as I said, we name it Brandon's Island. (I just want to make sure we all know where we are is all :)

When we land on the Island we have some basic goods with us and we each have $100. The total value of the Island's Economy thus is $1000. After all, we need to start off being fair.  Everyone should be the same here! At least in the beginning.

So, once we assess our situation, we find that certain things are going to be required. We need fresh water, food, shelter and the like. We divide ourselves up into a labor pool and trade amongst ourselves. At no time will the economy be worth more than $1000, since that's all we have between us. So, if the price of say water went up, other prices would have to fall... maybe shelter. That's all well and good until one of our fellow adventurers (just for fun we will call him Uncle Al) happens to be out on his daily hike rounding up fruits and seeds and whatnot for us. Well, slick Uncle Al happens to come across $500 that washed up on shore. He does not tell us about this though. He just slowly starts to spend a few dollars more here, a few more there. Pretty soon he has spent an additional $200 of the new loot. Well, at this point we realize something is up. Since more dollars are competing for the same goods and services, prices will go up. The rate of inflation is now 20%, because the sum of everything has gone up $200, or 200/1000. We now have a $1200 economy.

Obviously we are steaming hot mad about this and we sit down for a survivor type “Tribal Council” to get to the bottom of our inflation problem. We try and try to get someone to admit to being the culprit. Heck, someone even suggests water boarding our lead suspect, Uncle Al, but one of us used to be a writer for the NY Times and threatens to expose us all as heathens when we get back to America if we resort to such dastardly deeds. So, we sit and try to think of a solution. Even though Uncle Al is our lead suspect, he is also the most worthless and unproductive person on the Island, so we decide to create a new job for him. So real economists reading this don't feel bad we won't call him an Economist, we will call him...I dunno, let's say the head of the Fed.

Uncle Al, the Fed Head, sits down and tries to figure out how he can solve his problem. He decides that what he will do is focus on the price of Coconuts, since we all use Coconuts as a source of food, water, building and clothing. We all agree this is a brilliant idea, since we all need to use coconuts, surely the dastardly bandit who has put this extra money into our little economy will be caught this way.

But, our old Uncle Al knows that we are now excessively focused on the price of Coconuts, which he has decided to call CPI for short. What does Uncle Al Do? Well, he decides that as he continues to spend his hidden loot, the one thing he certainly won't be buying is coconuts. He pours another $100 into our economy, so the real inflation rate is going to be another 8.3%, that is $100/$1200. Total economy is now worth $1300, but the price of coconuts did not go up, so he reports that inflation is under control and all is well.

Now, the way the U.S. government avoids actually reporting inflation is even more deceptive thanwhat  Uncle Al bamboozled us all with on Brandon. They will say that well yes, the price of XYZ has gone up, but its sooooooo much better now, it doesn't really even count. And also, well, yes, I know something you need to have like... say gasoline and food... has gone up a lot in the last few years, but the price of Big Screen TV's and Laptops sure has come down.

Now, assuming we had a real economy free of uncle Al and his $500 extra dollars that would be fine, because, as I said, all goods and services can only be worth $1000. The effect of this inflation though is that everyone's dollar is worth less and less every day. So, when the Fed talks about increasing the money supply, they don't even report M3 anymore. What they are really doing is making you poorer in real terms. Don't believe me? Go to Europe and see how much your vacation in Europe costs now compared to what it was even 5 years ago. There are actually tour groups being set up in Europe for people to come to the U.S. now to shop, because its so cheap for them to buy stuff at our stores, since the dollar is worth less and less. The results of inflation have led to the dollar being worth 5 cents, that's correct, FIVE CENTS in 1913 dollar terms. If you have $1.00 now, it's about the same as 5 cents in 1913.

If you would like to know more about the liquidity cycle and how economies work and are effected by government programs and “interventions” I'd suggest reading Ludwig von Mises, Frederick Bastiat, or Friedrich Hayek.






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DISCLAIMER: Trading in commodities and securities may not be suitable for all individuals. Consult your broker or other professional to determine your suitability. The discussions provided by Trading From Main Street are for educational purposes only and should not be taken as a recommendation to buy or sell the referenced security. Past performance is not indicative of future results.


 

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