Are we heading for a deflationary type of recession?

December 25th, 2007

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If you have been with us for quite a long while, you will know that we believe we may be heading towards an inflationary type of recession (i.e. ‘stagflation’ e.g. Zimbabwe’s current hyper-inflation)- see Supplying never-ending drugs till stagflation. But there are some contrarians who believe that we are heading towards deflation (e.g. Great Depression).

Today, we will explain their position, though that does not necessarily mean we are justifying such a view.

Remember, back in 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?, we said

Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let?s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%).

In this example, the original $100 is known as the “base money.” In the Austrian School of economic thought, “base money” is called the “standard money.” The $900 worth of money, according to the Austrian School terminology, is known as the “fiduciary money.” In common terms, that is called “credit” (which is “debt” from the viewpoint of the counter-party).

What happens, for whatever reason, there are bad debts? In that case, the value of credit has to be written off, resulting in the cascading contraction of fiduciary money in the economy (see How money & credit can shrink for more details) i.e. deflation.

Now, recall that in What makes monetary policy ?loose? or ?tight??, we said that,

… the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink.

To put it simply, under the current arrangement of global banking and finance, central banks cannot control the supply of money and credit directly. They supply or withdraw whatever amount of base money given its current state of demand by setting the target price of money (interest rates). Then through the banking system, credit is dispersed and created throughout the economy.

In times of recessionary deflation, when bad debts are abounding and there is great economic pessimism, the demand for credit (fiduciary money) will collapse. In such a time, borrowers will be unable to borrow money and lenders will be unable or unwilling to lend. Consequently, the banking system’s demand for base money (standard money) can potentially collapse as well. As a result, the quantity of base money can follow in the contraction (or at the very least, unable to expand). Whether base money will expand or contract is immaterial for today’s discussion. What is material is that central bankers cannot control (but can influence) the quantity of fiduciary money (credit) in the economy. This is especially true for today, where there is proliferation of non-bank financial institutions and financial ‘innovations’ that lies outside the mandate and control of central banks.

Thus, this is the root reason for contrarians who argue that the deflation of money (primarily fiduciary money) is unstoppable (because central bankers are in no position to stop the implosion of bad debts). Since it is outside the mandate of central banks to print money and force it down the throat of the economy, central banks cannot create inflation in such a situation. Japan, which experienced 16 years of extremely stubborn deflation since the early 1990s, is an object lesson for the deflation argument.

So, what are the arguments for inflationary scenario? Keep in tune!