For too long, money around the world had (and still is) been too cheap. There are all kinds of asset booms around the world, from Shanghai properties to US bonds. Stocks around the world are hitting record highs, with the consequent emergence of private equity booms and hedge fund crazes. Along with that, we have all kinds of grotesque imbalances?record consumer debt, negative savings rates and massive current account deficits in the US, Britain and Australia (with the corresponding massive current account surpluses in China and the oil-producing countries).Such good times can never end right? Many financial analysts predicted that 2007 will be another year of abundant returns in the Australian stock market as the sheer weight of more local superannuation ?investments? and Chinese and Middle-Eastern money heads towards the Aussie financial markets to find a home (see More Chinese and Middle Eastern money heading Down Under: recipe for inflation?). Maybe those analysts are right. But don?t you see the absurdities? Nowadays, it seems that the path to great wealth is to be good at shuffling money in the financial markets?speculation, trading, acquisition, borrowing and charging fees for gambling other people?s money. To lubricate all these wealth ?creation? activities, central banks around the world are running the money printing press at top speed in order to conjure up the necessary liquidity grease to be injected into the financial system.

But we smell danger.

It is a danger in which many in the finance industry failed to fully appreciate?deflation. Such complacency is beyond our belief. In the 1990s, Japan experienced it, with dire consequences for their economy. At least, the ordinary Japanese had their savings to fall back on. For many Americans, with their negative savings rate, what can they fall back on? Have they not learned from the mistakes of others in the past?

Before we delve further into the topic of deflation, let us clear some misconceptions about it. Inflation is popularly misunderstood as the general rising of prices. As a result, deflation is also commonly misunderstood as the general falling of prices. But such concepts of inflation and deflation are merely the effects of a root cause. We suggest you read our previous article, Cause of inflation: Shanghai bubble case study for the background understanding of the true nature of inflation and deflation. Henceforth, we will now define deflation as the contraction of liquidity (money and money substitutes) relative to the available goods and services in the economic system.

In our previous article, Liquidity?Global Markets Face `Severe Correction,? Faber Says, we asked the thought-provoking question: Are we now ripe for a contraction in liquidity? Given the colossal leverage in the global financial system, if there is going to be a severe and sustained contraction in the amount of liquidity, the effect will be a downward deflationary spiral in asset prices, which can lead to deflation in the real side of the economy.

Why is it so?

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ?decrease? in value that way too.

What is more worrying is that assets of such imputed values are used as collaterals for further borrowing, which becomes the borrower?s liability. The borrower?s liability then becomes the lender?s asset, which in turn is being used as collateral for the next round of borrowing. Conceptually, this is how the liquidity pyramid (mentioned in Liquidity?Global Markets Face `Severe Correction,? Faber Says) is made up of. As you can see by now, if the original assets? imputed values crash (which can happen easily), it will have a cascading effect on all the other assets? values further down the chain. If this chain-effect spirals out of control, it will result in the wiping out of vast financial wealth (this is how global liquidity contracts). The outcome is a gigantic deflation of epic proportion.

Since the majority of the world?s liquidity is made up of derivatives (which obviously derive its value from another financial asset) valued at hundreds of trillions of dollars, we shudder to think what will happen if that derivative bubble burst. There is a reason why Warren Buffet calls them ?financial weapons of mass destruction.?

What can the Federal Reserve do if this happens? Should it let the bubble burst in order for a resulting depression to clean up the colossal excess? Or should it print copious amount of money for the financial system to remain solvent, thus resulting in hyperinflation?