Can someone paint a similarly concrete scenario that illustrates a plausible deflation situation?
A million hedge funds holding a quadrillion dollars in bad derivatives all begin defaulting.
And this is going on as we speak. *Everything* is dropping in prices across the board as over-leveraged hedgies have to unwind positions to make margin calls. This is vacuuming dollars out of the world market much faster than they are being replaced by printing. And is deflationary, of course.
If you lend me $5 and I reach into a Monopoly game set, pull out one of the game 5 bills, give it to you and say “We’re square now”, you would feel like I ripped you off.
Not if I lent you $5 in Monopoly money in the first place. And I hate to break it to you, but fiat currencies *are* Monopoly money.
A better example would be if the Fed lent me $5, I lend it to you and you eat it. This is also deflationary as the total pool of $5 bills is reduced.
If I’m a bank and enough people are eating the $5 dollar bills I lend them then I might just sit on what $5 bills I have left. This is also deflationary, but of a different sort than dollar destruction. You eating the money deflates M; me stopping lending deflates V.
The simple fix for this is for the Fed to replace at least enough of the $5 bills to get me lending again. Hopefully not to any more money-eaters, of course!
All the problems you are referring to as apocalyptic are in reality simply a fundamental results of domestic over-consumption across the board. Fighting a war in Iraq with borrowed money is an example of this. Having $500k in mortgage debt with $50k a year income is another. This is where our trade imbalance comes from.
The solution in both cases is put an end to over-consumption. This will be a bitter pill to swallow for many, but for those of us that have always lived within our means we will enjoy cheaper products and services as a result.
