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Can someone explain what exactly debt deflation is?
Submitted by TexaslovesRonPaul on Tue, 03/18/2008 - 23:14
I understand that the FED has created inflation by debasing our currency, and have watched prices rise and am expecting everything to get really expensive, possibly hyperinflation. But where does the deflation come in and what will it be like? Just trying to understand. Thanks. » |
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The Inflation/Deflation debate has been going on since the 70's.
There is NO One correct answer any more than to the question: Which came 1st the chicken or the egg?
I think we will experience BOTH, at the same time. In a way that will negatively impact the most people.
ie. We will have DEFLATION on assets that have had prices leveraged up via debt -the evil 4 letter word DEBT. Such as property, stocks, houses, new/used autos, boats, RV's etc.
We will experience INFLATION on items that are Not usually purchased via Long Term debt.
ie. Food, rent, energy (diesel/gas), healthcare, entertainment/tickets, clothing, consumer goods in general, etc.
DEBT DEFLATION IS NOW, in the aftermath of the Bear Sterns debt implosion, is what we are currently facing.
Michael 'Mish' Shedlock wrote a good article yesterday on Deflation & how it is currently affecting stocks, money, even gold in the short term. He also gave Michael kudos for his Great article,
"Michael Nystrom has an excellent post today called Welcome to the Future in which he discusses the debt margin call." See: http://globaleconomicanalysis.blogspot.com/2008/03/now-prese...
Deflation, NOT inflation for the next few months. Every ONE $1 of debt destroyed - takes out NINE $9 of credit with it! Thanks to fractional reserve banking in reverse. Leverage is a double edged sword. DEFLATION is real.
In yesterday's 3/18/08 Daily Reckoning newsletter Bill Bonnor summed up the DEFLATION/INFLATION argument pretty well I thought:
"...we present a lively exchange between the two schools of thought. But here at The Daily Reckoning , we never liked schools. We played hooky at every opportunity...and learned what we could by keeping our eyes open. In fact, now we see a different world than either the inflationists or the deflationists...a world both rising prices...and falling prices...where inflation and deflation alternately bicker and make up...like a married couple.
We have described this tension as a "war" between the two forces - one, unstoppable...the other, irresistible. But the two are as likely to be friends as enemies. They may squabble and even come to blows...but they still sit down to tea with each other at 4PM. They can't live with each other...and can't live without each other.
Yesterday, for example, we saw them both walking along, holding hands. Stocks rose in the United States. But so did gold. And when they visited the treasury market, bond prices rose sharply as yields fell.
And then they paid a visit to the commodities markets and took prices down a peg. The dollar, too, they brought down.
In the months ahead, who knows? The two could fall out completely. If that happened, there could be a meltdown in the few things that are going up - commodities, treasuries, oil and even gold. Or there could be a meltup in the things that are going down - stocks and property.
We don't know. As a financial analyst, this uncertainty worries us a bit. But as a moral philosopher, we take it for granted that there is more under heaven and earth than is contained in our philosophy. We'll let Mr. Market tell his tale...and happily listen." ...Amen!
The answers provided so far
The answers provided so far are excellent, but I think you are specifically interested in "debt deflation" as opposed to the deflation of an entire economic system, and this is because you are considering buying a house right? If things play out as I think they will, and we experience hyperinflation, then yes buying a house can become extremely easy - provided you have a stock of silver or gold. I explain it in a post I made awhile back here...
http://www.dailypaul.com/node/39677
All a matter of perspective
Inflation and deflation can each happen in a couple of ways. Imagine yourself on an island. The island's currency is clams. There are 10 clams on the island and that's it. Now, imagine that there are 5 equally "valuable" items and someone selling them. You would pay 2 clams for each item. Imagine now that the seller found 5 more items. There are now 10 equally valuable items and so you would pay 1 clam each. That's deflation by increasing supply. Likewise, inflation could occur by reducing supply. THe same price adjustments would also occur if you increased or decreased the supply of clams. Thus, there are many ways to look at inflation or deflation. We actually saw deflationary pressures with the importation of cheap goods from China. A bike made here costs $x, but one imported from China costs $x/2, therefore the value of your dollar just doubled in terms of its purchasing power. That's deflationary.
It is the opposite of.......
debt inflation. Just kidding.
Deflation occurs
when the central bank contracts the money supply. They do this by:
1) selling bonds into the market, thereby reducing the amount of (de)base(d) currency in they system. The member banks comply to the fractional reserve ratio. The fractional reserve is the amount that the banks can loan out, based on the amount of assets they have on deposit. So, if you have $10.00 in your savings account, the banks can lend out $100.00 against your $10.00, if the reserve ratio is 1:10.
2) increasing the interest rate. This is more apparent, but less relevant, than the more obscure, and harder to find, bond transactions.
There are several who argue that deflation is already occurring--that the central bank is selling long bonds into the market, thereby contracting the currency supply. One way to see if this is happening is by watching the price/interest rate of the long bonds.
The theory goes that if the interest yield on the long bonds goes up, and the price goes down, it means that the central bank is trading the long bonds for existent cash in the system for a high-interest yield in the future. Of course, by doing this, they are reducing the principal (cash) that could be used to pay off the debt.
The interest rates and prices of the long bonds are not set by the federal reserve; instead, they are priced by market activity. Those who argue this position also speculate that if the prices of the long bonds go up, and the interest rates on these bonds goes down, than the entire system is screwed, due to the fact that this is a signal that investors have lost faith in the scheme.
If this confuses you, don't worry. It took me a couple of months to figure it out. There is a good explanation of it in the "Money Masters" video found on google video. It's a 3.5 hour documentary on the history of central banking.
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"the only thing that keeps the banking system from failing is general ignorance about how the banking system works."
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thank you
it makes more sense now. I've been meaning to watch "money masters". We are thinking about buying a house (i know scary, right), and I'm afraid if deflation occurs, the debt will loom much larger. Is this correct? We are renting right now, but really feel we need to get our own place (out in the country compared to where we are, near friends) so we can start stocking up, preparing, etc for what might happen.
If you buy a house now
and the price goes down, then you will be paying a mortgage on an overpriced asset. You will also be faced with the challenge that there will be less actual money in the system to pay your mortgage with. This, combined with a probable property tax increase could put you in a real bind.
I'm in Houston right now, but I'm considering moving to Lincoln County NM, (where Billy the Kid used to hide out) when the prices come down enough. Something you may consider doing is renting in the rural area you wish to move to, and then buy up a distressed property when the time is right. This makes a lot of sense if you are in one of the larger Texas metropolitan areas.
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"the only thing that keeps the banking system from failing is general ignorance about how the banking system works."
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