The Fed is still talking about the risk of inflation...while the risk of deflation rises daily. Deflation happens when liquidity dries up. Suddenly, money disappears. Lenders don’t lend. Spenders don’t spend. The velocity of money declines as everyone holds on to what he’s got...fearful of losing it.
When this happens even the feds can’t do much about it. They have their printing presses...but they have no good way of getting the money into the hands of people who will move it around. The usual way is through the credit markets. The Federal Reserve pushes down short-term interest rates, for example, enabling lenders to offer money at lower rates.
But when a deflationary mentality takes hold of people, the last thing they want to do is to borrow money. They’re afraid that they might not be able to pay it back. Besides, in deflation, consumer prices fall. So the money they pay back will be more valuable than the money they borrowed. Their effective, or real, interest rate will be much higher than the nominal rate they are paying.
As prices fall, consumers become even more reluctant to spend. They begin to see that they’ll get a better deal if they wait. They turn Japanese.
That is the nightmare that haunted Ben Bernanke when he took over at the Fed. It is what prompted him to announce that “the Fed has a technology...called a printing press…” with which it can print up dollars at almost zero cost...and if need be, the Fed can drop dollars from helicopters in order to get the money into circulation.
Of course, this was a fanciful description of monetary policy. Let the Fed scatter dollar bills from helicopters and the US dollar would fall faster than the currency in Zimbabwe, where inflation is said to be running at 100,000% per year. Some things just have to run their course – like hyperinflation, for example. Once it begins it continues until the currency is completely destroyed. Deflation, too. Once begun, it is hard to stop...for the cure is often worse than the disease.
The Japanese economy was strong when prices began to fall in 1989. First stocks fell. Then property. Then consumer prices. All prices came down. And each falling price strengthened deflation’s grip on the Nippon economy. People hoarded money. You practically had to hold a gun to the consumer’s head to get him to spend. And business investment? Takeovers? Leveraged buyouts? All came to a stop.
But Japan could afford deflation. People had savings – lots of savings. And the economy always enjoyed a trade surplus. Nor was there any large subprime lending problem.
Can America afford a liquidity crunch...a credit contraction...a deflation? We don’t know...but if we were Ben Bernanke, we might want to make sure the printing presses and helicopters were in good running order.
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About the Author
Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
Comment by Deron Kawamoto on 8 August 2007:
I agree with your analysis that deflation is taking hold in the US. Hedge funds and CDOs are quasi-banks that increase the financial leverage in the economy. Each time one of them blows up and forces deleveraging, the broad money supply shrinks.
The problem that I have is that this reality seem wildly at odds with your affection for gold. If the dollar is deflating, the price of gold should fall. Are you assuming the Fed will print huge quantities of currency to try stimulating inflation? We see no evidence yet in the places it should show up - bank deposits or retail sales.
Comment by Kevin Morgenstern on 9 August 2007:
Dis-inflation of asset bubbles to a certain degree - followed by a strong surge in inflation...Possibly hyper-inflation...A genuine depression or long deflationary period would cause a break in the chain of payments...We have entirely to much debt...The Federal Government could not afford to pay back the Japanese and Chinese 9 trillion in debt in a deflationary economy. Tax revenue would plummet...They simply must create more dollars to pay down the debt. We are the Germans of the 30's - China is the US...We will both crash...we're both definitely screwed...There is no way around it...Unless, you are ultra wealthy, and can buy dual citizenship, or you already enjoy dual citizenship, and you've hid your money off-shore...It's not a matter of if, but when, this whole mess comes crashing down...
Comment by brouxhon george on 11 September 2007:
We live in uncertain time. Bad political management of the economy is the ssential culprit. Privatization, deregulation, globalization,lax monetary policies and political polarization of government agencies have largely favoured corporate welfare over people's welfare.Yet, it is common knowlege that consumer spending accounts for 70% of GDP.Consumers continue to spend but on credit. This is added debt but not increasing wealth.
Comment by William Place on 19 September 2007:
Well George you are correct! Rampant unbridled capitalism is just as dangerous as socialism. We Americans have been so focused on becoming rich that we have missed the fact that we have become STUPID! We have exported nearly all of the real pathway to wealth - manufacturing and mining - and fooled ourselves that a "service economy" is the road to riches, what IDIOTS. All forms of energy have doubled and tripled and quadrupled in price yet we continue to spend on credit like drunken sailors. Hopefully we will not drag the planet down with us into another depression. Come to think of it, we will probably be dead form the poisonous foods imported from China before the crash happens. Well, there is a bright spot in this mess after all.
Comment by Dom on 11 November 2007:
Ok,
please explain to me what happens to Australia when the US finally comes clean and says 'Ok when are now officially bankrupt'. When the oil is all finally being sold in Euro and the stock market collapses. What then for Australia?
Comment by Dave on 10 January 2008:
Should we head to the hills and plant mung beans and water chestnuts?Hoard flour and two minute noodles(also from China)Should we buy Gold or Gold mining stocks? Is gold the answer or the eradication of greed?? We have only just started, where are we going to be when the rest of the billions want what I have???
Comment by Dave on 10 January 2008:
Sorry, I'm just raving now. I have been avidly reading now for a few hours/days/months.
This is all very complicated to understand for the average Joe trying to make ends meet.
Complex economics taking place in the financial markets currently is understood by very few people.
Where are we going to end up? The average family surviving on one or two average wages with a couple of kids do not stand a chance in todays economics.
I am, and have been in the mining industry for over 20 years. I still have another 20 years to go if commodity prices hold up. My family and I are one of the lucky ones.
Most of the current mess we are in is because tens of millions of people want nothing more than something better, just a little bit better and the sharks circled and infected the poor fools with hope and promise.
Liability is not bundled in CDO'S. The real liability lies with the freaks selling faulse hope and promise to people who can least afford it.
Comment by bob novo on 18 February 2009:
Wow! It’s February, 2009 and I’ve been searching the internet for answers to our present financial dilemma. I find it truly amazing that these comments were posted as early as 2007. Where were our leaders? Where were our journalists and columnists in Barrons, The Financial Times and The Wall Street Journal? I always considered myself to be a somewhat educated investor, listening to recommendations of so called authorities and have paid a severe price for being a “good boy”. Recent news about or government’s looking the other way while investment scams are being perpetrated and misrepresentation of investments by so called rating companies is enough to made one depressed (no pun intended). As for me, having observed the folly of mankind from a distance all my life, how foolish and misguided we can be has finally hit home.
Comment by Pete on 18 February 2009:
Yeah bob this site has saved me a lot of pain. I've only been reading since Sept 2007.
The real irony is that a site with a contrarian view such as this one would only be able to have such a view IF the mainstream media and pollies thought otherwise. Perhaps it is more like a paradox. The more the masses start to realise the problems, the more that the outlook here is likely to change.
Mass psychology is a really interesting topic that can earn you a lot of money.