The unbearable mightiness of deflation

[GliderGuider]

Another winner from Stoneleigh over at The Automatic Earth.

The unbearable mightiness of deflation

As we have consistently explained here at The Automatic Earth, inflation is an increase in the supply of money and credit relative to available goods and services, while deflation is the opposite. Deflation, moreover, is aggravated by a collapse in the velocity of money. Price movements are lagging indicators of monetary changes, but are also subject to a number of other drivers, such as scarcity and substitutability (or lack thereof).

For this reason, price movements alone have no explanatory or predictive value. For instance, we have lived through a highly inflationary credit expansion over the last couple of decades, but prices have not reacted consistently. Some have risen, as one would expect, but others have fallen, due, for instance, to the effects of global wage arbitrage. For prices to fall in nominal terms during inflationary times, they must be going through the floor in real terms.

Money is actually free when real interest rates are zero, or even negative, as they were in the years following the tech-wreck. Low nominal interest rates against a backdrop of a rapidly expanding credit pyramid was an invitation to take on unsustainable levels of debt if ever there was one, and both borrowers and lenders took full advantage of the opportunity. Borrowers thought only of their low monthly payments and lenders thought only of the fees they were earning by setting up loans and selling them to Wall Street in the form of securities. Lending standards hit a new low as credit-worthiness was forgotten.

Both parties are now living to regret their previous excesses, but the damage is done. Now that credit is contracting, that 'free money' has turned into unpayable debts and illiquid asset markets, which will eventually have to be marked-to-market. Now balance sheets must be rebuilt and neither borrower nor lender is willing to dig themselves into an even deeper hole. The velocity of money will inevitably fall dramatically as risk aversion rises, reserves are held again looming defaults and cash is hoarded. The scale of the bad debt in our global economy is gargantuan. The Fed cannot midwife credit creation under those circumstances, and things will get much worse before they get better.

Commentators are predicting an actual decrease in the effective money supply. If conventional analysts are not, then they need to broaden their understanding of what constitutes the money supply in practice. Saying that something cannot happen because the impact would be severe is a non-argument. Serious negative events do occur, and the circumstances leading to this one are obvious. We are headed for banking gridlock and a breakdown of monetary transactions, as we did in the 1930s, only this time it will be worse, as the excesses leading up to this crisis have been worse in every way than they were in the Roaring Twenties.

[zeemike]

1. That reminds me of a song I heard that goes:

"I'm leaving California for the dust bowl
Cause there is no where else to go."

For sure there is change a coming but is that what we need?
And argument could be made fore a yes.

[dixiegrrrrl]

2. I meant to thank you some time ago for link to Automatic Earth. I like the site.

:hi: