I have promised a treatise on the proper regulation of liquidity in the economy from a perspective of avoiding both speculative credit bubbles and deflationary credit collapses.

There have also been those who disagree with my definition of "money."  I will therefore remove that term entirely, since "money" connotes different things to different people and we'll go through the definitions again:

• Asset: An item that has value of some varying amount of stability.  Examples are a stand of trees, a stack of sawn and finished lumber, a bushel of corn, a house, a car, a CNC machine and a computer.
  
  
• Currency: An abstraction of a collection of assets, also of varying value against those assets.  Often used as a medium of exchange between parties who wish to exchange one asset for another, and sometimes used as an abstracted store of value.  Examples include federal reserve notes and quarter coins.  Some forms of currency are officially backed or mandated for certain uses, but not all.
  
  
• Credit: A further abstraction of currency, but generally fungible with currency in commerce.  When brought into existence backed by an asset, credit is "hard" or "secured"; when not, credit is "speculative" or "unsecured."  Credit always, in some form, requires payment of interest.
  
  
• Interest: The amount one pays for the use of credit, usually (but not always) denominated as a percentage.  The elements of interest are the risk of failure to pay, the risk of debasement of the unit credit is denominated in, the scarcity of credit and the demand for profit on the lending transaction.
  
  
• Liquidity: The amount of currency and credit in an economic system that is available for deployment (that is, is not committed to some other purpose) at any given point in time.

From this we can determine certain relationships:

• The greater the system liquidity the lower the rate of interest, all other things being equal.  That is, the more "free and uncommitted" currency and/or credit is available, the less will be charged for its use in recognition that credit follows the classic economic supply/demand curve.
  
  
• The greater the interest charged the less deployment of credit will take place, and the greater the preference to use credit for productive purposes.  As the cost of credit rises its use for speculative or consumptive purposes becomes less desirable compared to saving the funds required prior to their expenditure.  Likewise, the lower the cost of credit the more likely it will be used to pull forward demand (consume) or speculate.
  

It is generally-accepted that significant inflation or deflation are undesirable. 

During significant inflation goods become more expensive relative to incomes.  If there is sufficient labor pricing power to force coupling of these price increases back to wages, then a wage-price spiral ensues and can quickly get out of control, since labor is the predominant cost for most businesses.  If there is insufficient labor pricing power to force coupling of price increases then the standard of living degrades for the citizens, in severe cases sufficiently to force a material part of the population into abject poverty.

Significant deflationary events, on the other hand, bankrupt debtors as the real value of the currency used to pay their debts rises rapidly.  This can quickly overwhelm their ability to pay, even when that debt was acquired for legitimate productive purpose.  When these entities fail they discharge workers, forcing contraction of GDP which can in turn lead to further insolvencies as purchasing power declines in the population.  This too can become self-reinforcing and lead to significant economic dislocation.

It is often claimed that "hard money" is a natural check and balance on the tendency of fiat currency regimes to "run away" into an inflationary mess as a means of "printing" out of sovereign debt.  The alternative, however (hard money), has a many-hundred-year history of causing forced inflationary and deflationary spikes that are extremely harmful to the economic climate of any nation, as is shown by the following chart found on Wikipedia:

The inflationary and deflationary spikes are caused by the nature of "hard currency"; once dug out of the ground gold, for example, is not destroyed.  When innovations in productivity outrun the ability to provision new currency reserves deflation ensues as the mining rate cannot keep up - the resulting deflation causes business and personal bankruptcies.  This in turn causes a contraction in GDP but that cannot be balanced with a withdrawal of the currency base since it already exists!  The result is a punishing swing between severe bouts of inflation and deflation; this is unacceptable.

Yet the history of our fiat money regime as practiced to date, while perhaps "better" in terms of violence, certainly isn't in terms of bias, which is clearly inflationary, all the time.

Why?

Simple: Given the proclivity of "choice" the monetary authorities will always choose to try to paper over their friend's mistakes!  This requires inflation, not deflation.

Unfortunately such "papering over" ultimately leads to either a Weimar-style collapse or the utter destitution of huge percentage of the population, dependent only on whether wage-price coupling can occur.  As inflation is a "silent tax", so long as it does not happen too suddenly people tend to react much as a boiled frog - that is, they don't realize what's going on until they're cooked!

There are two competing issues - if you permit debt to rise faster than GDP over an extended period of time you will inevitably get a "runaway" condition and deflationary credit collapse.  This occurs because of the mathematical reality of exponential ("compound growth") functions and no amount of tampering can change it if these relationships are maintained.  The following chart demonstrates this phenomena:

But regulating liquidity and thereby preventing this outcome and what is otherwise a mathematically-certain outcome can be done through a ministerial process.  Let's go back to one of the charts I recently introduced - the Market Ticker Ponzi Finance Indicator:

This indicator is simply the arithmetic difference in growth rates between GDP and systemic credit outstanding.  If this indicator is positive then GDP is growing faster than (or shrinking slower than) credit in the system.  If it is negative the opposite is the case.

When the indicator is positive systemic stability in terms of debt coverage is improving, and likewise it is deteriorating when negative.

Since the goal of liquidity regulation is to maintain systemic balance in debt coverage the mandate to be provided as a matter of law to whatever entity regulates liquidity in the monetary system is simple: The Ponzi Finance Indicator must be slightly positive.

Implementation of this mandate is relatively simple, in that excursions beyond a modest negative value (e.g. -1%) denote severe monetary imbalances and produce asset bubbles.  The 1990s Asset bubble in Internet Stocks was produced by the severe imbalance in credit and GDP growth in the mid 1980s that The Fed refused to correct, and the Housing Bubble was produced by the continuation of that imbalance from the late 1990s forward.  The Fed's current policy, indeed, has spawned yet another asset bubble, this time in stocks which are trading at a completely preposterous 140 P/E ratio as of the end of September 2009, or roughly ten times the historical "fair" valuation.  While many will argue that this is an unfair computation given the negative earnings from last year the fact remains that these negative earnings were real; even on a "current" basis of the second quarter alone the P/E is 122.  This bubble, like all others, will burst with disastrous consequences.

The solution to this problem is to place system liquidity regulation under a ministerial regime that is respondent only to the Ponzi Finance indicator (and to further mandate that GDP be honestly reported, as distortions in GDP will of course lead to improper adjustments), both as a matter of law.  This will result in credit tightening on an automatic basis as long as credit growth is exceeding economic growth - that is, so long as market actors are using credit not for investment but rather to engage in ponzi-style consumption measured simply by the objective on-balance results of credit and output rates of change.

Such a change in policy measure will put a permanent stop to the policy of "bailing out" financial institutions through lowering interest rates at the precise time when they have engaged in Ponzi-style financial maneuvers, creating unsustainable credit.  It is precisely this cycle - the political demand to "cover bad bets" made through Ponzi-style financial manipulation, that ultimately, if left unchecked, leads to deflationary credit collapses or even destruction of a nation's currency.

Fiat currency can work, but to do so the liquidity supply must be constrained such that credit growth is never allowed to outpace GDP.  Simple sixth-grade mathematics prove this to be the case, and also prove that when this stricture is violated disaster will strike - we are left only to argue over how long we have before it occurs.

Those who argue otherwise, whether on the public or private stage, are committing fraud upon the public and must be held to account for their criminal acts.