Sunday, November 16, 2008

Understanding and Defeating Deflation

Oil falls below $56 a barrel today, but as we continue to rejoice over increasingly cheap gas, now is a good time to understand deflation. When the average person hears about deflation, the idea of generally falling prices, he tends to think of it as a good thing. After all, cheaper prices is a good thing, right? No, not really.

In fact, in our debt-saddled condition, deflation is just about the worst imaginable possibility. Public policy makers have not even begun to think about how to solve the deflationary cycle we are now in, as the recommendations from the G-20 group today indicated. Among other inadequate ideas, all related to an expansion of government power, the G-20 pledged to "take whatever steps are necessary" to stabilize the financial system, which means pumping more money out by the Federal Reserve and other central banks into the commercial banks, as well as stimulating consumer demand.

In other words, they plan to counter deflation with inflation. Wow, sheer genius, eh?

Deflation might seem good from a consumer's perspective, but it is a total disaster for business. The basic problem is that falling prices mean businesses are not able to make money, so they have to shut down. As they go out of business, their assets go up for sale on the cheap, further driving down prices and stressing the ability of existing business to make money, leading to further business closures, feeding the negative feedback loop.

Deflation is particularly devastating when combined with high debt load. The collateral for debt is an inflated asset price. Therefore when the asset price falls, the debt becomes impossible to pay back.

We see this in spades in our current deflationary housing market, which is the root cause of the financial crisis. Housing prices fall, getting people upside down on their mortgage, so people default on their mortgage. The house is foreclosed on, leading to a further drop in home prices, leading to more people going upside down on their mortage and defaulting, leading to more foreclosures in an ever widening cycle.

In short, deflation of housing prices is systematically wiping out the banking system. Asset prices are rapidly falling further and further away from the loan value built on top of them.

Banks are then forced to hoard money to cover their own asses, making sure their reserve levels are large enough to keep them from being shut down.

There is no amount of money that can bridge that widening gap between the high fixed loan values and the falling asset prices. We have entered a deflationary black hole. Money gets sucked into the banks to keep them alive, and never makes it into circulation.

The only solution is to eliminate the debt itself. Rather than attempt an infinite inflation to defeat the deflation, the best solution is a massive American credit default.

The banks, who created this whole mess, are the only ones who should suffer. But instead they are bringing down the real economy. Enough!

Cancel our debt now, hit the reset button on the financial system, and let our economy grow again.

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