North County Jim pointed out that reducing credit supply by banks, as a result of new FDIC guidelines and their own negative foreclosure losses, would be deflation. Is that counter acted by the Fed printing money? Can someone explain again how they print money? They buy Treasury bonds and reduce bank reserve requirements? Sorry, I know Rich explained it once, but I can’t find it now.
Are we facing inflation (higher prices) or deflation (contracting money supply)?
Wikipedia has a pretty good entry on deflation, with links to concepts such as liquidity traps and the like.
A case for deflation can be made by the incredibly inflationary monetary actions of the past 5-6 years:
1) Cut interest rates to near 0.
2) Eliminate lending standards
3) When 1) and 2) inevitably lead to asset bubbles, encourage asset owners to borrow against the bubbled value of the asset, thereby expanding the bubble even further.
Despite those actions, there was limited inflation. One could argue that is indicative of a deflationary bias to the economy. Alternatively, one could suggest that the inflation occured in products not included in most inflation metrics. Perhaps the truth lies somewhere in between.
Now interest rates are much higher (even if historically low,) and lending standards appear to be growing tougher. Asset prices are no longer inflating, so (3) is removed as an input to the economy. These are all at least disinflationary stimuli, but potentially deflationary as well.
Perhaps someone with a stronger economics background can help me on this one: if credit is considered an immediate input to the economy, is debt service considered an immediate drain on the economy? Is the bill for 3, perhaps exacerbated by the “toxic loans” and rising interest rates, coming due? How do bankruptcies and defaults fit into the equation?
Classically, deflation occurs when aggregate demand falls sharply. If more and more debtors spend more and more income servicing debt, and if the appreciation credit spigot is turned off, will aggregate demand not fall for all but necessities?
On another note, if more liquid commodities have bubbled up over the past few years, would there not be a strong temptation to take profits on those commodities, thereby crashing those prices as well?
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