First of all, I did address the impact of fractional reserve banking in the article. That is a means by which money can be created (though not the only one) and it is inhibited when bank lending decreases for any reason, be it unwillingness to lend or borrow or asset value declines. But this inhibits future money growth; it does not effect the stock of existing money. And because money created by fractional reserve loans shows up in the monetary aggregates, the results of fractional reserve transactions are easily measured by looking at how much money there is.
There is a lot of focus on the ability of the banking system to create new money under these conditions, and I think that is a valid concern… however, there are other vectors for money creation, notably “QE” (the Fed printing money and directly injecting it into the economy). The Fed has already done this and if there is a threat of deflation, they will do it again. Their actions and words and analytical biases have made this very clear.
JP, the point is not to suggest that our economy functions like the island economy, it’s to simplify things so that you can see the differing impact of money, credit, and asset values on an economy.
Re. CAR’s point about using assets to trade. I just think you are looking at one side of the coin. In your example, someone could trade financial asset for a treehouse, but the other guy is trading a treehouse for a financial asset. When the value of the asset went down in terms of treehouses, and you said wealth was lost. But the value of treehouses went up in asset terms — so wealth was gained for treehouse holders and lost for asset holders. It is a wash.
So I stick with my assertion a change in asset values doesn’t change the amount of purchasing power in the economy in currency terms — it just moves it around between holders of assets and holders of non-assets.
DWCAP explained the distinction better than I did, that money isn’t the same as values. The relative values between two things changing does not impact the supply of money, nor does it DIRECTLY change the value of money (though there could be indirect effects via changed spending patterns, etc). It just changes how much money each person could get.
Finally, yes, the government can print as much as they want… whether they can prop up asset values is another question because one never knows where the money will go. That’s their goal, or one of them, but I think at some point it will stop working. But the newly printed money will go somewhere and cause some prices to rise — they can flood the economy with money but they can’t predict or control where it will slosh around to.
