-- Posted 29 October, 2009 | | Discuss This Article - Comments:

One of the largest drivers of silver prices, inflation is already showing itself.  After the collapse of Lehman Brothers, the US central bank took dramatic steps to curb any future price decline in housing, commodities, and stocks – but the effort was purely inflationary.

What Happened

As Troubled Asset Relief Program (TARP) funds were distributed to major banks to avert crisis, Lehman Brothers was one of the few banks left behind.  It seemed as though the company would be given a bailout, especially as one of the larger investment banks in the United States, but the Fed and Congress decided it would not be worth saving.

The Fed's Reaction

Surprisingly enough, the largest action to stop banks from going under was completed not before, but after Lehman had failed. In less than 112 days, the Federal Reserve doubled the amount of money banks had on reserve through loans, swaps for collateral, and other cash for troubled assets agreements. 

It is important to note that these bank reserves are not just rainy day funds cast aside in case banks need to tap them; rather, bank reserves are at the forefront of lending within the US. Under a system of fractional-reserve banking, banks are legally required to have at least 10% of their assets in reserve, and many operate very closely to this legal threshold.

Why Reserves Are Important

By doubling the amount of reserves banks have on hand, the Federal Reserve effectively doubled the lending power of each bank. The monetary base (M0 money supply) increased from $900 billion to more than $1.8 trillion, allowing banks to effectively expand the M2 money supply from what was around $8 trillion to $18 trillion, thus creating 125% inflation over the course of many months. 

We must recognize how dramatically the Fed tipped the scale. Prior to the collapse of Lehman Brothers, it took the Fed nearly 14 years to double the monetary base – meaning the post-Lehman increase was nearly 40 times faster than before.

What Does Inflation Mean For Silver?

Much of the trickle effect from bank reserves to the economy is dependent on a slight rebound in economic activity. Once banks are again willing to lend, they have the capacity to literally create as much as $10 trillion. This would increase the money supply by 125% and certainly cause wide scale price inflation. For silver, this is nothing but a bullish signal, with precious metals remaining an investor favorite against untimely inflation.

Historical References

One of the greatest expansions of the money supply led to one of the biggest stock market bubbles in history. The stock market rally coming out of the 1987 crash was one of the most ferocious in history. However, most of the rally was only phony money, printed up by an easing of credit following the very much localized real estate bubble of the early 1990s. After the market realized that the rally wasn't built on much besides an easing of credit and venture capital investments into dotcoms, the market faltered – all the while gold and silver prices soared as stocks dipped.

The present economic situation is very much like that of the early 1990s, though stocks still haven't found much of a reason to budge.

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