Another economic concept for Klahn to ponder....

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http://members.forbes.com/forbes/2007/0702/031.html

Digital Rules
The Economy's Trillion-Dollar Question
Rich Karlgaard 07.02.07, 12:00 AM ET

The bottomless pool of liquidity around the world is the business story 
of 2007. It drives everything: low borrowing rates, high stock prices, 
buybacks, hedge fund growth, the private equity boom. So here's the 
trillion-dollar question: On balance, is the global cash glut mainly the 
result of the U.S. Federal Reserve's loose monetary policy (think of all 
the world's currencies that are pegged to the U.S. dollar), or can it be 
explained by a new force--rapidly rising prosperity around the world?

I debated this recently with Forbes.com editor Paul Maidment. We agreed 
that the answer is "both." Monetary policy is too loose, yes. But rising 
prosperity is real, too. The global economy has grown by a quarter since 
2002. The world has up to a billion more people in the ranks of the 
middle class than it did a mere 20 years ago. So the question is not 
binary: loose money or rising prosperity. Since both are contributing to 
the global liquidity surplus, the question is, which is contributing 
more?

The answer matters. If loose money is causing the global liquidity 
surplus, then both economic growth and the bull rally are resting on 
thin ice. But if rising productivity, prosperity and profits have 
brought on the glut, then the boom is durable.

Cheap Dollar or Global Awakening? 

Spiking commodity prices everywhere imply a cheap dollar. Sure, you can 
argue that robust industrial demand in China and elsewhere drives oil 
and aluminum prices. But does that drive gold prices? Silver prices? No. 
Therefore, rising commodity prices across the board have something to do 
with a cheap U.S. dollar and all those trashed currencies that are 
linked to the cheap dollar.

But the prosperity explanation for the growing global glut also carries 
weight. In 20 years global prosperity has created scores of millions of 
newly wealthy, as well as a billion or so new members of the middle 
class around the world. Astonishing. Revolutionary. We are just 
beginning to understand it.

As I was thumbing through the Financial Times recently, I came across a 
letter to the editor by Marc Chandler of Brown Brothers Harriman and Jim 
Glassman of JPMorgan Chase (nyse: JPM - news - people ). They were 
responding to a May 24 Financial Times article by Alan Ruskin, entitled 
"A Weak Dollar Is the Driving Force Behind Global Liquidity." Chandler 
and Glassman's response:

"We believe there is a more profound development: the global awakening 
that is lifting global living standards by more than any other human 
endeavor, and the economic liberalization enabling economies to make 
more of their scarce resources. Underpinning this development is the 
integration of half the world's population into the global market 
economy, and the deepening and broadening of the capital and derivative 
markets."

This question--cheap dollar or global awakening?--is a huge deal. If the 
cheap dollar has mostly caused the global cash surplus, then the endgame 
is not a happy one. Stagflation. Followed by a Paul Volcker-like 
response. Followed by recession. Pen your own scenario. It's hard to see 
a soft landing or an easy way out. But if Chandler and Glassman are 
right--that the liquidity surplus is mostly due to a global awakening--
then the good times aren't over. We're in for a long boom. Maybe the S&P 
will hit 2000 in two years.

Recently I posed the question--cheap dollar or global awakening--to two 
of the smartest guys I know: David Malpass, chief economist for Bear 
Stearns (nyse: BSC - news - people ) & Co.; and Arjuna Mahendran, chief 
investment strategist for Credit Suisse.

Malpass says, "Both are correct. Central banks are the starting point 
for the liquidity. [But liquidity is also] provided by efficiency gains 
and innovations in the financial system, as well as by the robust gains 
generated outside the financial system. As people and companies produce 
more they are creating more lendable resources, adding to liquidity." 
Malpass is optimistic about growth: "The huge new pools of liquidity--in 
corporations, central banks, petro-dollars, private equity, hedge funds, 
foreign savings and the U.S. household sector (the largest pool of 
liquidity by far)--will take time to use up. We expect more U.S. and 
global growth in 2007 than the consensus, in part due to this overhang 
in liquidity."

Malpass worries about inflation, but he thinks the U.S. economy is 
strong enough to take the medicine of tighter Fed policy. He rejects the 
idea that Americans are living beyond their means, suckered by teaser 
mortgages and in hock to makers of 60-inch flat-panel TV screens.

Mahendran says, "Rising prosperity seems the key to the growth in 
liquidity. Growth of the middle class in emerging markets is for real. I 
reckon China could have a middle class the size of the total U.S. 
population by 2015, and India a similar number by 2025."

I also posed the question in my Forbes.com Digital Rules daily blog:

"Why can't it be a little of both? Look at commodity prices. They're out 
of control. Evidence of excess liquidity. On the other hand, very little 
of that commodity cost seems to be getting into final goods prices. 
Evidence of productivity." 
"Cheap capital necessarily builds excesses in credit, liquidity and 
expectations, and it pummels risk aversion to a silly oldfangled 
convention. I mean, how many consumers could handle three months without 
a paycheck?" 
"Easy money enables reckless borrowing and spending that inevitably 
provides an economic stimulus, but this will not last." 
My blog readers are more cautious than Malpass or Mahendran. What do you 
think? Write me at publisher{at}forbes.com.

Read Rich Karlgaard's daily blog at http://blogs.forbes.com/digitalrules 
or visit his home page at www.karlgaard.com. 

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