Saturday, October 18, 2008
Banks and other lenders have lost trillions of dollars recently (see this).
Credit contraction is deflationary. Indeed, one of the two basic definitions of deflation is "A contraction in the volume of money and credit relative to available goods."
If the amount of money in circulation and available credit drops, then prices will eventually drop also.
In addition, banks are hoarding cash like never before. When cash is hoarded, it decreases the "velocity of money" - that is how quickly money changes hands. This also tends to lead to deflation and eventual prices drops.
If the economy is an airplane flying through the air, then deflation could be thought of as a decrease in cabin pressure.
The current economic crisis - with trillions of dollars in losses (an evaporation of available money), trillions of dollars less available credit, and hoarding of cash - is like a big gash in the side of the plane. For more evidence of deflation, see this.
The government's actions of lowering interst rates, sending people rebate checks, and throwing trillions of dollars at Wall Street is like someone trying to stabilize the cabin pressure in an airplane with a gash in the side by blowing air into the cabin.
If that person had a nuclear-powered blower, he might be able to re-inflate the cabin pressure in most parts of the cabin.
Are the government's actions powerful enough to stabilize the pressure? Will the government prevent deflation and push us into inflation?
Many people are sure we're headed into deflation. Others are just as sure we're headed into inflation.
But an expert says that its hard to predict which way it will go during periods of rapid change. Specifically, Oxford Economics professor John N. Muellbauer, an expert on U.S. inflation, said on October 10th:
The world is on the cusp of an inflation “turning point”, so the standard models are likely to go badly wrong.
***Too Much Here, Not Enough There
Forecasting inflation is notoriously difficult. . . . the speed of price changes tends to increase with big shocks. Most forecasting models used by central banks therefore put a large weight on recent inflation. This tracks inflation quite well except at turning points because the models miss key underlying influences.
We are now on the cusp of the most significant tuning point for inflation in the last 20 years so that the many of the standard models are likely to go badly wrong.
Leading economist Dr. Marc Faber acknowledges that if the government takes enough action to fight inflation, it will cause some price increases. But, he points out that it is impossible for anyone - even the government - to predict which prices will increase.
For example, he notes that the government would like house and stock prices to increase, as that would help reinflate the economy (or at least give the middle class some sense of well-being in the short-run).
However, he said that it is possible that - instead - commodity or interest rate prices will increase, which will harm the consumer by causing higher food and energy prices and the cost of other essentials. As CNN writes: "Stock prices have plunged in recent weeks. So have oil prices. Most Americans probably see the former as terrible news and the latter as a ray of sunshine at a dark time." And as CNBC writes: "Home prices, much like stock prices, fundamentally affect people's sense of wealth".
When the government shoots its high-powered hose inside an airplane with a huge hole in its side, it will cause too much pressure in some parts of the cabin (unintentionally pushing some people out of the airplane) and not enough pressure in other parts.
We're in for a bumpy ride . . .