Are We Headed for Deflation?
Is the US economy headed for deflationary times?
As financial institutions keep writing off losses caused by the sub-prime credit crisis the time has come to ask if we are headed into a deflationary period. Deflation is caused by a decline in the amount of money in circulation. Declines in the money supply can occur when financial institutions take massive write-offs. Are we headed there right now in the United States economy?
The answer is that it depends. What is the Federal Reserve doing? The Federal Reserve was created back in 1913 to specifically prevent deflation, declines in the amount of money in circulation, from occurring. Is the Federal Reserve doing today what it was created to do?
The answer to that right now is no. While the Federal Reserve has injected some liquidity into the financial system the fact that more and more financial institutions keep taking more write-offs is sending a clear signal that the Federal Reserve has not done nearly enough.
As more and more write-offs occur the amount of money in circulation will begin to decline and deflation will occur unless the Federal Reserve steps in and does what it was created to do, provide liquidity to the financial system during times of crisis. Clearly the Federal Reserve has been quite lacking in terms of handling the ongoing financial crisis to date. It is not doing what it was created to do.
Anyone who says that it is not the Federal Reserve’s job to bail out those who make bad financial decisions has no clear idea of why the Federal Reserve was created. The Federal Reserve was created to provide liquidity to the financial system during times of crisis so the amount of money in circulation would not contract and economic growth could then continue to occur. Of course the Federal Reserve failed miserably in doing this during the Great Depression.
The Federal Reserve was not created to try and determine who should be bailed out and who should not be bailed out. If there is a liquidity problem in the financial system the Federal Reserve is supposed to take care of that problem. If the Federal Reserve does not take care of any liquidity problems in the economy not only is not doing what it was created to do but then the Federal Reserve will be allowing economic growth to contract and deflation to occur.
Essentially the Federal Reserve was created to prevent monetary contractions from occurring because those monetary contractions always lead to economic contractions, known as recessions today. The Federal Reserve was created to prevent recessions or declines in economic growth. Since there have been dozens of recessions, and one Great Depression, since the Federal Reserve was created one must conclude that the Federal Reserve has continually failed at serving the purpose it was created for. Whether or not it will fail once again this time is still an open question.
Will the Federal Reserve prevent liquidity declines from occurring in our economy?
The answer lies at the feet of the handful of people who make up the Federal Reserve Board. A handful of people who have far more power in this country to affect the economic outcome of everyone living here than any politician does. If the Federal Reserve does not prevent liquidity declines from occurring then we are headed for deflationary times and economic contraction.
I presume the author of this article would love to see interest rates be dropped to 1 percent again, never mind that it would practically destroy all savings accounts and savers and retirees will be harder pressed to pay the higher and higher energy and food costs. But for the sake of argument, let’s say I agree with him. Where exactly should we inject this instant “liquity”? Whom can we favor if not those directly responsible for today’s turmoil? Wasn’t it almost predictable when banks starting lending at adjustable rates and communities raised property taxes as a result of the artificial housing demand that eventually this mess would result? Someone please educate me here. It all seems like a simple economic principle that people just can’t grasp. Maybe we need some painful deflation to help understand that IOU’s just create artificial demand or “bubbles”. And someone will always be hurt by this. I believe this is better called the “days of reckoning” and not depression or deflation.
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