Odd isn’t it, but it’s the truth. For much of 2007 inflation was a concern across the country. The FED kept slashing rates and saying that inflaion wasn’t a problem, causing many to worry.  For those unfamiliar, a basic tenet of Macroeconomic Theory holds that when the FOMC pursues expansionary monetary policy (a la cutting the FED FUNDS rate), aggregate demand shifts and the result is a boost in output and higher prices (a la inflation). This is the most common tactic used to battle a recessionary environment.

Yet in an economy where inflation already seems to surround us, cutting too much becomes a scary issue. So why does the FED continue to slash rates instead of waiting to see if things will get better? The answer, which I very recently came across, is that the current environment faces a much more serious issue, one that has not been around for 70 years…Deflation. Deflation is a much more reckless enigma for an economy. It can cause slow growth for many years and truly hamper the working class and corporations. Indeed deflation is so scary that Mr. Bernanke is resolved to continuously pump liquidity into the system to promise it won’t occur. Here’s the details:

During the 1920’s and ealry 1930’s, our economy was firing on all cylinders and prosperity was high. Indeed the ‘roaring 20’s’ was one of the best periods of economic growth and prosperity our nation has known. This prosperity lead banks to lend out more and more capital in the form of consumer and commercial loans, backed by little (if any) collateral. Towards the end of the 1930’s, as growth began to slow, many of these loans began to go into default. Banks weren’t able to collect adequate collateral on these loans, and they suffered huge losses. When a bank issues a loan that is not repaid, that money is wiped from the economy. Moreover, the loan itself is considered capital to the bank and more loans are made from that capital. These loans too, get wiped from the system which is the ultimate cause of deflation.

Ben Bernanke is the foremost student of the Great Depression, and fully understands the similarities between todays situation and that of the 1930’s. His works illustrate that he believes the FED did not do it’s part to sufficiently add liquidity to the banking system in the 1930’s, which lead to the severe depression. Thus, today, he is slashing rates and using various methods to pump liquidity into the system. Your initial response might be that we are not seeing the same ‘bank runs’ that we saw in the 1930’s, but a NY Times article today points out the opposite. Indeed there are many bank runs occuring as we speak in the corporate sector. Things are bad, they’re not getting better just yet, but there truly is no man better for the job than Ben Bernanke. Let’s hope for some inflation.

Here’s a list of my sources:

http://www.friesian.com/money.htm (Deflation)

Another way that deflation can occur is because of banking. A bank receives money on deposit, holds part of it as a cash reserve, and loans out the rest. In effect this increases the supply of money since both the loaned cash and the credited deposit at the bank function as money. The result could be inflationary, but the system tends to be self-balancing because bank loans, especially commercial loans which are used to create or expand businesses, multiply transactions. A loan is also a kind of deposit, as a bank credits itself with the money it has loaned. A bad loan, to an unsuccessful person or business, cannot be paid off and so at some point must be written off as a loss by the bank. Thus the bank’s “deposit” is simply lost, and the money supply thereby decreases by that amount.

http://www.nytimes.com/2008/03/10/opinion/10krugman.html?ref=opinion (de facto bank runs)

Popularity: 31% [?]

See Also:

• GMACBank
• The Best Gas Rewards Credit Cards
• What are people buying in this market?
• 401k rollovers and rollbacks
• For all you ‘Eternal Optimists’ out there…