What is creating deflation

I just listened to Mish Shedlock and another guy debate inflation/deflation on Jim Pulovas website. Mish and I have a lot of the same ideas about deflation, but I do believe there is more to the story than either of us knows. As I listened to this moron, who probably has more degrees and been overpaid more dollars than Bernanke could print, I realized there is a world of ignorance. Asset inflation is inflation and asset deflation is deflation. Both are end game results of inflation.

As most people that come to this site understand, I am in the minority, a deflationist. As I have pondered this idea, my sense of how it gets started and what happens grows. Deflation is always preceeded by a massive inflation of debt. There really can't be any printing of money as anything but debt or the value of money collapses in a short period of time. Thus the supply of debt itself is a prime determinant of money. But, it is also only the new supply of debt that can actually inflate, as the rest of the debt is actually a deflationary phenomenon. This is a hard idea to grasp, but technically the money that has already been created is followed by the urgency of the debtor to get it back to pay it back and not to spend it again. Along with this urgency is the interest due everyone, which is money in excess of what was created in the credit system. Thus someone is generally in default and someone isn't going to get paid. As long as the system continues to inflate at a reasonable rate and debt can be liquidated on a broad scale, it continues.

Something happens in the long credit cycle that few understand, especially those educated guys like Mish debated who say it has never happened before. that something has happened over and over again throughout history. John Law used paper money to inflate. The Bank of England used paper money to inflate with its value based on gold backing, but not based on gold 100%. Banking has never been based on having money to pay depositors, which is the missing link in most people's arguments today about inflation. I hope to describe the credit crisis and how this need to deliver liquid funds between banks themselves is the primary funding problem.


Well, by default the US dollar became the world reserve currency. In some fashion it is paper gold. Plus it is something that is created by banks alone, as it is bank paper and not government paper. The Fed is a bank as well, meaning it needs to possess good assets in place of its paper, which is what the dollar is, Federal reserve bank paper.

Lost on the side of inflation is the absolute need to liquidate in this game. Not only are assets outside of banks needing to be liquidated, but those inside banks as well. I doubt many are understanding that the Fed is merely liquidating assets or loans that have already been made so banks can have some liquidity between each other. In any case, the Fed is buying what amounts to real property in the sense that whomever sold it to them no longer has it.

The point is that what is being liquidated is needed to pay debt, not to reload and spend more. Thus the government borrows money and issues debt and the money is put into accounts and the bonds bought with the funds from the Fed, who in turn buys them back from the banks so they can cover the checks coming in from other banks. Banks don't lend this money because they owe it and they realize it won't be that easy to get back in this climate.

The real reason we deflate is the boom and inflation of the recent past. Not only were prices pushed up with inflation, so was capacity. The capacity remains, but those that were the big spenders are left with deflated credit lines and sizable debts. In many countries, there were housing bubbles which drove demand. Now these bubbles are deflating with little to stop the deflation, as with most capacity, the capacity of housing has been significantly overbuilt. Housing is not only a sizable source of employment in most times, but also has provided a sizable amount of credit to the system in the form of collateral. As the problem is currently compounding itself, there will be a net shrinkage of everything relating to housing, most importantly the capital position of those that have financed it.

In the end, the most important determinant of deflation is the fact that so many things were looked at as money, whether it be the balance of ones brokerage account, the bonds that are no longer solvent owned by many or the equity in ones house. Also, the widespread supply of credit allowed those with collateral to feel as if they possessed money whether they had need for the cash at the time or not.

What vew understand is that the Fed rarely ever puts money in the system it doesn't need. I believe it is trying to expand lending, which is the only determinant of what is referred to as the velocity of money. I don't buy the idea that money just slows down, but instead lending slows down. Most lending is done to immediately go out and buy something, which means that money immediately changes hands. Lending creates pressure on the system. Buying instruments that represent lending that has already taken place does little or nothing. Banks don't have money in the sense they could pay off their depositors, so what is being put out amounts to zero.

All said, we are in a system of insolvency and insolvent systems are no longer creditworthy. An insolvent borrower could more readily borrow money than an insolvent lender can make a loan. The entire system is insolvent and the asset values that backed it are falling. The just pretend method that the current authorities have adopted is not going to make an insolvent outfit solvent. It might allow them to fudge their earnings or losses, but it won't make dead men walk, which is what the real desire is. Zombie banks won't make many real loans. Without money available directly for what the private sector individuals desire, deflation will be the norm.

When does it all collapse

The United States has gone to pot. Most people my age don't realize the US has gone to pot. Recently I was at a school reunion, being my 35th year out of high school. One of the guys I played golf with was a local business man. Another was a guy that is a wheeler dealer who made a lot of money out of real estate in Florida. The wheeler dealer agreed with me, though he was a liberal. His brother is more down my line and spoke to me about this mess that is brewing in the US. The business guy, who is buying more stores in a currently growing area of the Metroplex refused to believe the government wasn't going to fix this stuff.

There are only 2 type people that believe we are going to get out of this mess by spending and lending more money, morons and those that haven't studied it. Most of the experts we hear on television and are pushed forward by the Nobel Prize in economics committee propose that we spend even more, which means they are either paid liars or miseducated. Being the central bankers of the world have dictated economic education for the past 100 years, it isn't surprising that many could be miseducated in finance, economics and money in general.

Worst yet is that economics in general is nothing more than an extention of politics. The constitution of the United States set the political tone, but the Constitution no longer prevails. I have seen copies where the preamble of the Constitution had a word changed from ensure domestic to insure. One mean to help bring about and the other means to sell insurance. That is what socialism is and the economics of the day are structured to bring about the end of the original intent of the document with its guarantees of private property and limits on government in favor of a rule of necessity and constant war and bankruptcy.

Thus it is the political persuasion of intelligencia that dictates the mainstream and not fact. Because I tended toward the conservative side of politics, I happen to be able to see what has occurred that has precipitated this crisis. This leaning along with a degree in finance which led me to a sound conclusion that assets were massively overvalued clued me into the idea that something was amiss.

Austrian economics is a free market economics. The counter economics of Keynes and the Chicago school are government and banking manipulation economics and when problems like this arise, they blame the free market and the lack of regulation. This is a failure of the capacity to see that it wasn't the market, but the presense of government and quasi government organizations like the Federal Reserve, state chartered fractional reserve banking and international banking organizations that actually provided the platform for this disaster. Thus, the solution is to give over more power to these organizations that pushed the world to the brink of collapse to push us closer to the edge. The fix is the problem.

Hopefully the American population has had enough and the stomach to go through the long term solution. But, we have a problem in that the culprits of the creation of this mess are those that hold the power in US government, along with the bulk of the media. Instead of free markets, most banks of size are socialist organizations, the Federal Reserve being an idea of Marx and J.P. Morgan. Though Morgan was a capitalist, his idea of the Federal Reserve was straight from Marx. Also, Morgan was engaged in fractional reserve banking, which was the source of the problems faced in 1907 and in the 1890's.

Fatal mistakes were made by the Federal Reserve and government sponsored enterprises like Fannie Mae, Sallie Mae and Freddie Mac. The result was a John Law type fiasco that destroyed Ameican production in favor of American credit and set the country up in a debt bubble that has no solution other than painful deflation. But, being those that have bankrupted the system and themselves in the process hold titles of nobility and the governmental power itself hostage, there is no solution presented other than to bail them out. Being there isn't enough money in the world to reflate a debt bubble, more debt to create more money is going to lead to economic and financial collapse of those entities that attempt such solution.

Currently I am watching the Japan solution applied to the United States. For several years I heard these Wall Street types point fingers at Japan knowing they were going to not have any other solution than what Japan was using. The US banks are just as entrenched in the political power structure as the Japanese banks and Federal Reserve money created off US government debt does nothing more than bankrupt the country while sliding down the black hole of compound deflation. The system is bankrupt from the top down.

Being the system is bankrupt from the top down, the unwinding is going to eventually occur from the top down. This means the government itself is going to suffer a debt crisis. I don't know when this is coming, but I do believe that the US treasury market is going to be the next step down the road of collapse and to save itself, the government is going to have to abandon the saving of the too big to fail system. With this, the entire world will fall into a depression of epic proportions.

It is hard to envision saving this mess without at least a semi socialist solution. What I would propose is a plan to reorganize the debt system while putting together a plan to feed and house the population on a temporary basis. The Fed should be abolished and fractional reserve banking outlawed and replaced with a dual system. If the government has a position in the economy, it might be to serve as the holder of the bank deposits, while all lending at interest is done out of a pure capital at risk with no fractional reserve leverage allowed. The fact is that there isn't any such thing as supportable compound interest money, which is what fractional reserve banking eventually leads to and there isn't a such thing as a government guarantee of deposits.