Just recently read the article here… thought I throw it out here for thoughts and comments…
I’d also read that too. Explains it quite well for a non-economist.
Comparing it to the current situation I think this is what we are seeing (correct me if I’m wrong).
The following 4 things can cause deflation:
- The supply of money goes down.
- The supply of other goods goes up.
- Demand for money goes up.
- Demand for other goods goes down.
Right now the supply of money is going down is going down because banks are not lending. However, at the same time governments are bailing out banks and companies creating billions of dollars and pounds, so the money supply is actually going up, but not for the people on the street since the banks are not passing that on.
Because less money is trickling down to people because banks are not lending then people are also not buying goods so the demand for goods goes down. This is deflation and the way I see it is the system repairing itself as the price bubble bursts. House prices go down, people are not buying cars etc. Other factors are at play too such as the supply of oil going up because demand for oil has reduced which has burst the oil price bubble. This is being passed on to all good including petrol and food. So in the short term we will see some deflation. However, I do not think this deflation is the problem, in fact in many ways it is good to see prices returning to where they should have been, although its not good for people who are in debt.
However, the real problem then comes from the fact the the money supply is actually going up as the governments print huge amounts of money. This is causing an inflationary push, which is currently being masked by falling prices as a result of the price bubble collapsing as demand goes down. However, once that initial deflationary impact from the price bubble burst subsides, the inflation will catch up with us and we’ll likely see hyper-inflation as a result of the massive amount of money being created.
This essentially means that faith could be completely lost in the currency over the next ten years. A lot of people will suffer as their money becomes worthless and we will likely see some big changes in monetary policy.
Meanwhile reflect on what caused this. Current governments encouraging risky lending from banks and then allowing fraudulent cover-ups of bad assets allowing the price bubble to get far too big. That’s caused the defaltion part. Now governments are printing money to temporarily counter this which in the long run will cause hyper-inflation.
Let me know if this is thinking is right or wrong. I only discovered money was based on debt about 4 weeks ago so still learning 
sheepmoney, I have very limited knowledge in this area (all economics really), but are we sure that the money the Federal Reserve makes up will go past deflation and into hyper-inflation? Is it possible that it could just counteract the credit that’s not given out by banks?
You made a good explanation above about their “correction” of the system, not giving back to people to steady the money supply.. but is it possible that their plan could “work” and in the end have neither deflation or inflation?
No I am not sure but that seems to be what top ecomomists are saying. Also the Fed (and UK government) are saying the same thing, just saying that inflation won’t be as high as some of the more impartial economists are saying.
What I said above was simply explaing the reasons behind what is being said in more simple language. The mainstream media never explains the reasons for this, or dumbs them down to one liners (the credit crunch is the cause). Of course that means nothing and without understanding the reasons behind what is happening it leaves us clueless.
To actually find out if the borrowing (printing of money - an inflationary force) will actually offset deflation you’d have to do the complex math behind it. That’s beyond me so I’m left to trust what people more experienced then myself are saying.
The theory is of course that it will offset deflation, and I guess it is doing that to some extent, preventing deflation from being as bad as it could be (through massive slashes in interest rates and massive borrowing). It will at least work in the short term and that can be enough to win over politicians. The bankers will also be happy with this as it helps them handle their toxic assets.
But in the long term it does not solve the problem which was a bubble being created as it tries to keep that bubble afloat by borrowing (printing) money, but done for too long it just devalues the currency through inflation, so eventually inflation takes over.
Now it seems kind of stupid they would do this, but remember their interests (the politians and bankers) are not neccesarily in the interests of the people. During a recession and depression everybody does not suddenly get poor. The wealth is simply transferred.
Also there is the fact that if the government borrows (prints) loads of money to prevent deflation then its debts get huge (we’ve aleady seen this). To reduce the effective value of their debts hyper-inflation might be a good thing for them. I don’t know how true that is but it seems like a good theory.
Also bear in mind that as the government debt gets bigger, the less money from taxes goes to government spending since it is repaying loans and interest. This shortage of cash for the government cause a need for them to borrow more to keep the country running also gets bigger - its a downward spiral.
Sheepmoney’s explanation looks pretty solid. I think the reason the Fed’s policay can’t work concerns something entirely different though.
The Fed concern themselve entirely with the money supply and with the money supply equation. They believe they can control the rate of inflation by controlling the money supply. Presently they are replacing the dollars that are evaporating as debts go bad in order to try to maintain the quantity of money in they system that is available for you and I to spend, so as to avoid any fall in aggregate demand. To that extent, they are pushing new reserves into the system and, as long as the quantity of reserves they push into the system does not seriously exceed the quantity that are evaporating (due to bad debts) inflation can be kept at present levels.
When the bad debt stops dissapearing, the Fed could theoretically then sell a bunch of their treasuries to counter the measures that they’ve taken during this (supposed) deflationary period and so they could, in theory, avoid a hyperinflation out the other end of this as the result of all the new reserves that they’ve been pumping in of late.
One minor objection to that theory might be that there is a lag on the Fed’s activities. Typically prices in the market only react 18 to 24 months after they do anything and in all liklihood by the time they know that they need to contract the money supply again it will be too late… and inflation will take off well before they get around to controlling it again.
In my opinion, the more serious problem that the Fed faces though is the effects of inflation. When they inflate the currency they are conducting a form of wealth distribution from savers to borrowers. Savers are forced to lend their money out at rates that they would not accept in a free market and borrowers get to borrow at rates below what they would ordinarily have to pay savers to borrow… This allows bankers to earn more money (since they get to be the middle men in the transaction) and allows money to be borowed for uses that quite simply are not profitable (government expenditure, businesses, and houses etc.). These unprofitable sectors of the economy are being subsidized and need the subsidies to continue if they are to continue to exist.
Were that the full extent of the problem you might say, OK cool, so inflation is kind of like a tax. If the tax/inflation rate stays the same and the proportion of the economy that relies on those taxes stays the same then this system is sustainable right? It’s no worse than any other tax? But that isn’t the full extent of the problem because interest rates are also a price - they are the price at which savers lend their savings to borrowers. Inevitably, if you cap the price of anything below market rates, there is insufficient incentive for producers to participate in the market and the goods that are available are put to uses which are not profitable (and to which they would not be put if the price of these goods were a true and accurate representation of their scarcity). So, not enough supply and over demand… which leads to - you guessed it - shortages. In the case of interest rates, the goods concerned are real savings and when the shortage hits, no amount of government intervention can magic the underlying good into existence. They cannot “legislate” real savings into existence and further attempts at price controls will only aggrevate the problem (leading to more severe shortages).
As such, at one stage or another the goose must be cooked and it must be realized that there are insufficient real savings to support both the profitable and the non profitable industries. At that stage, the government can do one of two things. They can:
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Try to sustain the unprofitable industries through increased inflation and wealth redistribution.
-
Bite the bullet and let the market readjust. Abstaining from inflation and proping up ailing industries.
If they should choose course number one then the unprofitable industries will be sustained at the expense of the profitable ones. Productivity will go down as will the quantity of goods and services available and the general standard of living. This may be reflected in higher prices (without higher wages accompanying them) or it may be reflected in further shortages of certain goods or both (Zimbabwe style).
If the true nature of the problem is realized, if government abstain from proping up ailing industries and the central bank abstains from doing the same (whether by inflationary policies or simply by way of policies that “maintain liquidity and the integrity of the financial system”) the funding that was keeping the unprofitable industries alive now no longer present these will naturally “go out of business”. There will be a painful readjustment period as resources (including labor) get reallocated from the unprofitable to the profitable industries. The speed at which this process can occur will depend on all sorts of things like the rigitiy of employment legislation and the degree of specialization in the economy’s workforce (and thus the timeframes required for people to retrain). But at the very least with option number 2 the economy is headed in the right direction again.
So although the Fed may think it is able to provide the “liquidity required to get the markets functioning correctly again” I don’t believe the fundamental problem is one of liquidity. That might temporarily avoid a drop in the aggregate demand of consumers but if there are good reasons for the aggregate demand of consumers to drop which are not merely monetary in nature then they have a problem… They’re going to get shortages that no amount of money can fix - i.e. shortages of real goods.
There is a temptation for people to think of money as something abstract that has no relation to the real economy, but this is a mistake. When people save money they are implicitly producing something (maybe accounting services) and not choosing to consume anything. They create savings of real goods (in this case accounting services) which are required and which are what really gets borrowed by people taking out loans. Without a solid supply of those real savings, no amount of monetary or fiscal policy can magic those things into existence to paper over the problem.
Deflation = less available dollars per available goods. It is good if you are not one of the unemployed nor in the stock market, because prices come back to realistic levels.
Right now there is fear, and people are hoarding their dollars (less available).
Meanwhile the Fed is flooding the system with dollars. Fear will give way one day and you can combine the new dollars with those released from hoarding, and here comes inflation.
The Fed never gets it right. Central planning can never compete with the free market control of interest rates and a stable money supply. Central planning causes busts to happen to all at the same time, where in free market control, such is spaced randomly and not noticed.
I don’t quite understand that. I thought that selling treasuries was simply where they sell bonds to the Fed, and the Fed creates money, and the government pays it back at interest. And that is what they are doing now with the bailouts right?
I’m a bit confused so if you could dumb it down and explain it a bit more I’d appreciate it
It’s probably easier if I just point you to another post in this thread…
That post talks about reserves more than anything, not about the actual money supply.
Essentially our current medium of exchange is based on debt. The Fed buys debt from the market (in the form of treasuries) to pump extra reserves in and can sell debt (it’s stocks of treasuries) back to the market to take reserves out. Very little of the money in existence is physically printed (coins and paper) so the Fed has the ability to contract the money supply as well as to expand it… so their actions now do not guarantee hyperinflation further down the line, providing they act to reign in the reserves before these get used as the basis for a massive hyperinflationary credit expansion by the commercial banks.
If you’re not sure what I mean when I talk about the distinction between the reserves that the Fed issues and the actual money that you and I use (credit issued by commercial banks) then I’d advise you track down a bit of information on Fractional Reserve Banking. Wikipedia has an OK summary of how the fractional reserve banking process works… and Rothbard wrote some pretty good stuff explaining the net effect that this system has (ultimately a form of wealth redistribution from savers to borrowers via the middle men - bankers - who take their big cut on the way). If you’re interested in that I’d recommend The Case Against the Fed here on Mises.org.
The Fed has also been in many reverse repo transactions, which drains the money supply. Upon quick inspection, it appears a reverse repo will inflate the money supply, but its an agreement from the Fed in the near future to sell its securities.
http://app.ny.frb.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE
the original article reverses cause and effect. the article says that deflation causes consumer spending to slow. in reality consumer spending slowing down causes deflation (well, one of the causes).
I see this happening constantly in mainline economics. depressing.