JWM, the inflation vs deflation argument is one we have over and over again, and will keep doing so. In my talk with Rich last week, he stuck to his guns on inflation and he had some good reasons for it.
I am still leaning towards deflation and have good reasons as well. Simply, “pushing on a string,” is not a realistic analogy. While its true that the FED cannot force banks to lend, which is the crux of the deflationary scenario, the FED has more tools that it has brought to bare. For one thing it could bypass the major banks and offer money at extremely low rates to EVERYONE. It could hand out Visa cards with 2000 dollar limits (which happened already to Katrina victims.)
Another interesting thing about the inflation vs deflation argument is where the money goes when its lent. If foreigners mostly invest in Tbills, then a sharp pullback in lending from them will hurt the govt directly and asset prices only indirectly. Whats the FED response to that? Drop rates like a rock and hope they can stimulate demand internally? Raise rates and hope to woo foreigners back? Thats based on the assumption that foreigners, meaning central banks, do mostly buy Tbills.
On the other hand MEW, seems to go more into consumption and financial assets like stocks. The cut-off of that is what makes me far more inclined to believe the deflation scenario. As you pointed out the confidence crisis or, “who’s hiding the sausage,” will chill lending. In this case the fed will have two choices, keep pretending or get congress to bail out the insolvent banks. I have no faith that they will be honest in the face of deflation.
At that point the FED would have to admit that we have a sh*tty asset crisis and let the markets work through them. I just don’t see that happening. So we come back to the original inflation deflation dilemma. Do you believe the FED has the ability to keep people borrowing? If so, you believe the inflation scenario, otherwise deflation should be your choice.
