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.