US Supreme Court Justice Potter Stewart, confronted with the challenge of distinguishing pornography from free speech or art, famously said, “I know it when I see it.” The same is true with investors and inflationary monetary and fiscal policy, says Dan Denning.

This from The Daily Reckoning Australia:

One of the great criticisms of monetarists (those who believe the largest influence on the economy and trade is the boom-bust phases in money supply via credit) is that they have a tough time proving when an increase in the money supply is actually inflationary. And they never know when or where the new money created is actually going to show up in higher prices.

What good is a theory of credit creation if you don’t know when or where it’s going to end up as inflation? How do you use it to your advantage as an investor?

Well, easy money doesn’t always end up in obvious places, or at least places people would notice it and consider it inflationary. When borrowed money goes to buy stocks, it’s not inflation but ‘asset appreciation’. When other borrowed money goes to buy homes (or to buy securities whose value is derived from homes also bought with borrowed money) it’s not inflation either (apparently) but ‘asset appreciation’ and financial engineering.

But even if the expansion of the money supply doesn’t always show up right away as consumer inflation, it can still destroy wealth. That’s what is happening now in the share market. Assets bought with borrowed money are falling. Credit is deflating.

Meanwhile, investors know that the price tag for Paulson’s plan to recapitalise Wall Street and purge the credit system of bad assets will be massive. It could be US$700 billion. It could be a $1 trillion. It could be twice or three times that by the time it’s all over.

The liability side of the U.S. balance sheet is growing. And what are bonds but securitised tax receipts? We’d say revenues, by the way, but revenues are something a business earns, while taxes are what the government takes.

If people are having trouble paying their mortgage, and businesses run into a recession and have trouble turning a profit, you’ll have rising liabilities and declining tax revenues. The government will make up the difference by printing new money. Gold finally heard the bell and rallied nearly $47, or almost five percent, to close at US$907.

How will the local share market take this? Yesterday, after a brief delay in the opening, shares surged. By the end of the day Aussie investors thought stocks were worth $54 billion more than just a few hours earlier. The market was up 4.5%.

Whether investors really thought that shares were worth 4.5% more -at the zenith of the world’s worst financial crisis since the Great Depression-is a matter of some debate. You know, it could be the short- covering rally we mentioned yesterday. What happens when that runs out of steam? Who is going to buy?

You don’t see huge one day swings in bull markets generally. Stocks tick up and up, climbing a wall of worry. In bear markets, though, you get all sorts of wild rides. The market is driven by sentiment, which itself is driven by fluctuations between fear and greed.

Babcock and Brown-on the day the asset-purchasing-with-debt- financing model died in America was up 54%, for example. Even though you can’t short it any longer, and even though we reckon a lot of shorts were covered, if we were a betting man…we’d be looking for another double-digit move in stocks like Babcock today. And we wouldn’t be looking up.

Source: Inflationary Monetary Policy, a Bit Like Pornography