The Specter of Deflation

Published on BULL, by Michael Nystrom, December 28, 2006.

… From what we know of economic history, credit expansions lead to economic booms – this much is clear. What comes next is still up for debate. Austrian economist Ludwig von Mises tells us “The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The credit expansion boom is built on the sands of banknotes and deposits. It must collapse. There is no means of avoiding the final collapse of a boom brought about by credit expansion” (emphasis mine). Current Fed Chief Ben “Printing Press” Bernanke begs to differ. He earned his nickname in the now infamous 2002 speech, “Making Sure ‘It’ Doesn’t Happen Here” prior to his ascension to the Chairmanship. Though Bernanke never admits to it in his speech, the unspeakable “it” is more than just deflation, but the very “final collapse” that that Mises warns of …

… And thus begins the deflationary spiral. Credit is destroyed, jobs are lost, payments are missed, bankruptcies declared …

Um, Earth to Bernanke – We have a problem. If you want to preempt deflation, here is your chance!

In the latter half of his 2002 speech, Bernanke launches into numerous ways the Fed could stimulate an economy suffering from deflation. Compared to stories about alchemists and printing presses, this part of his speech is relatively boring, and you can practically hear him mumbling through the text. It all boils down to one thing anyway: lowering interest rates. This, Bernanke says, would solve deflation.

But would it?


There is an old saying that you can lead a horse to water, but you cannot make him drink. The human corollary is that you can offer a man a loan, but you cannot make him borrow. In spite of what Bernanke says, the Fed does not “print” money. It must loan it into existence, but this requires willing borrowers. Consumer spending powers 70% of the US economy. So how do lower interest rates translate directly into money in the pockets of US consumers? That’s what newly homeless consumers will need, in order to keep “powering” the economy. Of course credit card rates will go down, but will that be incentive enough to continue spending?

As the foreclosures work their way through the economy, you may begin to hear stories about how people you know have lost their home. But when it turns out that your neighbor – or a close friend – gets laid off from his well paying, seemingly secure job and falls behind on his mortgage payments … Well, you might think twice about upgrading your 39″ LCD TV to the new 52″ plasma model – even if you can get it for 0% interest (for the first six months). More likely you’ll start thinking about building up a cash nest egg of your own. But saving – which for most Americans means paying down debt – is deflationary. Maybe you could sell some stock, while price are still high. (Also deflationary) Downsize your McMansion? Good luck, and also deflationary.

But let’s get back to Bernanke’s story about the alchemist. Don’t we all know that alchemists don’t exist, and that alchemy is a discredited pseudo-science? Would Bernanke’s story have had the same impact if he were talking about the Tooth Fairy, or the Easter bunny? But for the sake of argument, let’s humor him about the alchemist: What if the alchemist really couldn’t make gold from thin air, but he just said he could. Then what would happen to the price of gold? It would still probably drop on his initial announcement, but as people realized he was bluffing, the price would return to normal. The alchemist’s effect on the price of gold would have just been temporary. But certainly the alchemist’s inability to make gold would have nothing to do with his desire to do so. The alchemist wants to be able to make gold – it’s just that he can’t. It’s impossible. This brings us back to what Mises warned us of: There is no means of avoiding the final collapse of a boom brought about by credit expansion. Like spinning gold from thin air, it’s impossible.

Which one of these men are you more inclined to believe? (full long text).

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