The deflationists argue that credit is contracting, the monetary base is under assault and that the amount of debt will lead to a deflationary scenario. The problem is that the deflationist camp overlooks the fact that while private credit and debt have contracted the public side has expanded at a breath taking pace, offsetting the private economy. The figures on Government debt and credit expansion only reflect that which is reported openly, we do not know what is off balance sheet nor FED operations that are shielded from public disclosure.
The stated position of the influential FED Board members is deflation is upon us, which to me translates to inflationary responses. It appears as if the FED and congress stand ready to inflate again, which will keep the merry go round going longer. I believe this to be true as the government is using the media’s nonstop droning about deflation as cover to embark upon Quantitative Easing Part 2, also known as QE2 in financial circles. It has been my experience that if you listen to the media or the FED and invest 180 degrees from what they speak about you will do very well. Not to get off track but for example listening to the recent rhetoric about the sub-prime mortage mess initially one would have believed it was nothing and was contained based upon the pronouncements of FED Chair Bernanke along with those in Congress., and dear reader I am sure you are aware of how that played out.
From a deflationist’s perspective debt can be destroyed faster than money can be printed. First, that may have been true during the period of Von Havenstein in Weimar Germany of the 1920’s, but in this electronic age, zeros can be added to accounts at the speed of light. The central banks are no longer limited to creating physical paper as in inflations of the past. If you don’t think that things can electronically grow faster than debt deflation then look at a live example of the derivatives market, whose notional value appears to multiply exponentially faster than the underlying debt.
The deflation of sovereign debt on a worldwide basis destroys the debt itself and the underlying monetary value to the people or entity that loaned the money, in other words that money goes to “money heaven”. If this were to begin to occur especially on a worldwide basis what do you suppose the confidence in the underlying currencies would be? Moreover, if this were to happen to the US being the reserve currency who would bail us out? To use a metaphor, imagine if you will a large pile of logs has been set up for a bonfire the next day. The logs just sitting there represent debt and they are quite stable and inert. A couple hours before the bonfire an accelerant is dumped all over the logs and everything is still stable. Once a spark is now introduced the accelerant ignites and presto you have a raging fire. The accelerant is inflation and it will consume all the debt in its path. In this case the accelerant acts similar to a capacitor in electronics quietly standing by holding a charge for use later. Just as in the eye of the hurricane the deflationists extrapolate that just because money velocity is currently low or declining that it will continue on that path. As in inflations throughout history, money velocity was stagnant until the catalyst was introduced. I would argue that the sovereign debt crisis would be just such a catalyst, the US States in particular, some of which are in worse shape than Greece and have vastly larger economies.
If there were a Sovereign debt crisis in the US, it would affect the entire world’s debt markets. The US Congress and or the FED would no doubt respond to this situation. The chances are high that the FED would begin to monetize the debt, print money as well as use other tools in their tool box. As this crisis unfolds people begin to lose faith in their respective currencies and begin to spend them rather than hold them because prices are rising, just the opposite of what is being argued right now in the media. In a time such as described the automatic world response is to dump everything and run to the US Dollar and US Treasuries, the people of the world let alone the US would not opt for this option since this would be the epicenter of the situation. The US Dollar is the reserve currency of the world and that has afforded the US many advantages in business and monetary policy. In a scenario outlined being the reserve currency may provide little or no shelter from being dumped in a time of crisis. Today there are economies that use the dollar as their defacto currency and there are large pools of dollars floating around the world in petrodollars, Eurodollars, and other funds waiting just like a capacitor ready to deliver a charge of dollars.
If confidence in the currency is reduced and not necessarily completely lost we would still head in to a world of rising inflation as people use currency for trade, but looked for other means to save, such as: land, gold, whiskey or whatever retains value. This would also mean that interest rates would have to rise and growth would slow. There are many that argue that you can’t have slow growth, high unemployment and inflation, to which I would say look at the 1970’s. Unlike the 70’s I believe we are currently in a period of Biflation where we have simultaneous inflation and deflation, but inflation is going to win out in the end. Last time we had the world running around screaming deflation from the roof tops was in 2008 and yes we had a dip but it did not last as our system has an inflationary bias along with a FED and Government deathly afraid of deflation. This time will be no different.