:> A falling :> velocity of money as people hoard cash to await lower prices compounds :> this effect. Basically the whole system ratchets down in a reverse of :> the prior inflation and back towards stability.
: Mike,
: I've been following your postings on this for a few years now (I've even : read a book or two from your reading list). It's not clear to me though how : deflations work where there is a fiat currency
Japan has a fiat currency and so we have a current example.
: why would people hoard cash : when the central bankers are printing it by the bucketload?
You've got me there, but many are doing that in Japan. The banks are even accepting a near zero rate by holding Japanese government bonds. I guess the anser is that the cash gets more valuable simply due to the deflation. The authorities there are printing money, but with an effective credit revulsion underway, there's no easy way to force people to borrow it and get it into circulation. In the end, printing too much risks the currency itself as folks begin to move to hard money analogs such as gold and precious metals. There's little point in preenting deflation at the cost of a currency collapse and depression, as Argentina has discovered.
: Presumably this : is what Greenspan et al hope will break the cycle - it seems intuitive that : it it won't work, but I can't explain why it won't. Has there ever been a : deflation with fiat money?
My suspicion is that the ructions in the bond markets are an inkling of the reason that this won't work in the US. If you're in a lot of debt, you lose the power to set the interest rate on that debt. Greenspan needs to keep the printed money going in through property refinancing. That means that he needs property prices to keep rising to give people cash to take out when refinancing and he needs interest rates to keep going down to make it worthwhile for people to refinance. It's classic credit bubble dynamics.
Unfortunately, due to the US trade deficit, those cashouts are being spent on foreign goods and mean that the US needs foreign cash at the rate of nearly 2 billion Dollars per day. As it's been more than a billion Dollars per day for years, there's a lot of foreign holders of US liquid assets such as Treasuries. Those bondholders are the guys who really get to decide the long term interest rate to which US mortgages are tied and can therefore turn of the credit taps despite Greenspan's efforts. Greenspan needs to keep them onside, and since they've been promised deflation and made the bet on it, any threat to that means that they sell and the long rate goes up and shuts down the mortgage refinance pipe.
The shenanigans at Freddie Mac, and now investigations at Fannie Mae are also a case in point. The mortgage backed market is basically a multi-trillion Dollar leveraged play on the interest rate through derivatives. There's no way that Fannie and Freddie can possibly deleverage their holdings quickly without the markets ceasing to be liquid. Any accident with interest rates which left them on the wrong side would be a threat to the entire financial system that would make LTCM look like a sneeze. Greenspan can't afford for bondholders to get spooked and drive up the long rate too quickly and so he can't in the end just print whatever he wants.
The way I see the problem is that the authorities see deflation coming and deflation becomes defined as the problem. Deflation isn't the problem though, it's the solution, to the prior inflation and credit bubble. Left to run, it'd reestablish credit and price equilibrium at a level somewhere between the start of the credit bubble (let's say 1982 or 1992) and the start of the inlation (1948). It'd be uncomfortable for many at first but we'd sooner or later get deflationary growth and we'd soon adjust to falling prices. Obviously there are reasons governments don't want this. The tax escalator stops and they also have to pay back their own loans in more expensive money. It's better than a depression though.
The problem is the inflation that occurred and the credit bubble that it engendered. A lot of investment was malinvestment and that needs to be liquidated in order that resources can be efficiently reallocated to produce real wealth rather than the illusionary wealth that credit-driven speculation and binge borrowing produces. A lot of the debt undertaken in that binge-borrowing needs to be paid down or liquidated and that means that the money supply will have to contract for a while. Asset prices that have been driven up by the credit binge also need to fall again so that people can have discretionary spending without having to service huge debts in order to pay for basics such as housing. The cutting off of the credit spigot for housing will in an of itself cut the cost of housing so much as to produce a great deal of discretionary income which will again become available to feed demand.
The longer we put off cutting capacity, debt and asset prices, the more debt will be accumulated and the deeper, longer and moe painful the eventual and necessary transition will be. In trying to stimulate more asset price growth to stimulate more borrowing to stimulate more demand to meet the supply engendered of overcapacity built up through the bubble, we're simply inreasing leveraged debt based on a lower and lower interest rate which itself is the reason for so much malinvestment because it made projects seem economically feasible which wouldn't have been at normal rates.
In this, each ratchet down in interest rates is an admission of loss to the much needed deflationary forces and yet another double-or-quits bet with the same. The bill for the reckoning is going up and up. The game can't continue indefinitely because rates can't go below zero and something will probably break before they get there. Capacity will have to fall to meet demand and that fall will cut demand and so on. The stable level is below where we are now and it's going to hurt to get there but it's still the best thing to do. The idea that we can somehow keep going and simply borrow our way out of debt has been proven again and again by history to be one of the largest financial mistakes it's possible to make. The signs of strain: record private debt, record house prices; record levels of bankruptcies (in the US), record trade deficits, sluggish economies despite record low rates, record house prices, record levels of debt on houses, are all around us.
It's time to admit the party is over and the piper needs to be paid. Acting otherwise will be saving a recession at the cost of a later depression.
FoFP