Baranaby33 is not correct. Repaying debt is not deflationary in the classic sense. [/quote]
Yes and no. If the money borrowed to fund consumption comes from a pool of financial assets, then the borrowing is price inflationary. If the money borrowed to fund consumption comes from workers’ wages, then it is not price inflationary.
The fallacy comes from thinking of all money as one pool that is being used for consumption. If that were the case, price inflation would have been horrendous as total debt increased dramatically over the last decade.
When the government borrows money – issues treasuries – to fund a stimulus payment, it is inflationary to the extent that the stimulus payments are spent and used to fund consumption. If recipients of the payments use them to pay down debt or otherwise save and do not consume with the money, the stimulus payments are not inflationary. Of course, the reverse happens when the debt matures and is paid off. This ties to the great debate of the impact of mortgage equity withdrawal, which effectively acted as an ongoing stimulus payment over the last eight to ten years.
On the original topic: Deflation leads to a stronger currency, which decreases import prices and weakens the export sector. The former creates deflationary expectations, and the latter decreases the velocity of money. Both result in deflation. Whether this feedback loop, which also works for inflation and a weakening currency, starts with prices or the currency is a moot point, though currency changes might come first, driven by speculation or risk aversion.
In any event, it is hard for me to imagine Fed and Treasury not intervening to weaken the dollar to ward off deflation. Right now things look awfully deflationary. Watch for a lowered Fed Funds Rate or – not sure how this would work – U.S. open market operations to sell dollars and buy foreign currencies.
Problem is, if the Chinese, or any other net accumulators of dollar reserves, develop any bias away from the dollar, there would be a rapid devaluation. Fed and Treasury might not be able to intervene fast enough to stop the dollar from crashing.
