Deflation before (hyper)inflation?

Economics Economics Questions
1

Debt destruction will be greater than anything that the Fed can print. We’re going to see massive debt default and the destruction of bank balance sheets which will result in crushing deflation since defaulting on loans is a form of credit destruction. Credit was expanded during the bubble so much that it’s impossible to repay because there is not enough wealth in the real economy. Banks will stop lending, people will stop spending, etc. The government is using QE to try and stop this from happening but it’s going to happen no matter what they do. After this we will see the money that was created to try and stem this event make its way through the system causing massive inflation.

I’ve seen this argument around the internet lately and laid it out as I understand it. Thoughts?

2

Three points:

  1. Debt destruction is not nominally greater than what the central bank can create. The central bank Zimbabwae is an example of the damage the central bank can do.

  2. The credit lost by banks is only an issue in that the central bank will force any holders of currency to pay for the defaults by banks through inflation.

  3. The only body that can really cause the mess here is the government trying to fight this so called deflation by creating money and by over regulation of the banking cartel. Left to itself the private economy would stick lenders who had credit defaults and then individuals or groups of individuals with money would see opportunities to lend it and then do so.

3

I agree and disagree. I agree that this is a possible scenario, I disagree that the economy will necessarily play out as you say it will. Don’t forget that banks are holding massive amounts of “excess reserves” at the Fed and that the Fed could manipulate interest rates in order to unleash these “excess reserves.” As far as I see it, right now we’re experiencing some serious inflationary pressures which are kept in check by the Fed’s policy of paying interest on excess reserves. Is it possible that we’ll fall into a deflationary death spiral as the economy turns south again, banks fail, and demand for money rises through the roof? Yes. But it isn’t necessarily so. It all depends on the government’s response, ultimately. Negative interest rates on excess reserves, for example, could unleash an inflationary tsunami, as could a tax on money holding, large government deficits (think: $2 trillion+), and quantitative easing.

4

True, I’m just throwing this out there. I’m not sure what actions the US government could/would take. The top five banks own 96% of all notional derivative value - which is 202 trillion (or 1 quadrillion). It’s a ticking time bomb, when they go we’re doomed. The Fed has been propping the big 5 up by QE but as soon as they stop buying MBS from the financials all the QE money that was flowing into equities (the guys at Zero Hedge dug a little and found that there was no corresponding drop in money market accounts to explain the rally) will stop and we’ll see another crash. It could very well be the trigger that could send us into a monstrous deflationary spiral.

But, as you said, the US government/Fed could do many different things and alter the situation completely. Either way it’s going to destroy the US dollar.