When actors in the economy default on their debt isn’t that effectively the same as destroying money? My understanding of why the dollar is currently up in value vs. other assets such as stocks, commodities, and foreign currencies is because once large institutional investors (like banks) realized their morgtage backed securities were worthless they were forced to sell other assets they might have otherwise taken a long position on. Everyone doing this at once puts more demand on dollars and the price goes up.
So if the Treasury creates this “bad bank” or whatever they want to call it, isn’t that effectively deflating the money supply? If the money supply is decreased by one act, and then increased by the same amount by another, won’t the impact on aggregate prices be zero? All that would happen is a transfer of wealth from the US taxpayers to whoever gets the newly created money first, rather than a transfer of wealth from current US dollar holders to whoever gets the newly created money first.
My question is, does the huge amount of write-offs impact the huge amount of new money creation?
You probably want to read Reisman for a full description of monetary defaltion/destruction in the current fiat money system: http://mises.org/daily/2926
As for whether things are coming out to zero or no, it’s really hard to say. What is used as a medium of exchange is not bank reserves. Bank reserves have soared in the past 6 months and so, for the time, we don’t have any significant price inflation or deflation. If the banks eventaully decide to start lending on the basis of those reserves though then there is the potential for massive inflation to hit… it all depends what happens with the commercial lenders. At the moment they get 1% from the Fed for sitting on their hands and they’re all feeling a bit tender and risk adverse, so that’s exactly what they’re doing.
I wonder exactly what the motivation was for the Fed paying interest on reserves. About the only thing I can think of is that it is a way to pump money into the system without lowering interest rates (which can’t go below 0%)… so it allows them to inject money even when money is free to borrow. Bah, it’s a hair brained system anyway.