Inflation is the primary game plan of governments and central banks. Its effects have left their mark on societies throughout history. As the effects of inflation continue to dominate headlines, financial and economic activity is scrutinized and analyzed with the intent of planning, projecting, and predicting it.
Most people think they understand inflation – they don’t – but for now, let’s look the other way. There is a triple-decker bus coming straight at us.
Default can happen three different ways:
1) Credit default
2) Bank failures
3) Asset price collapse
Universal credit default happens when individuals, corporations, and countries can no longer sustain the debt they have assumed on a scale that overwhelms ordinary financial and market activity.
This happened in 2008 with education loans, mortgages, and auto loans. The price of all this non-performing debt sank into a deep hole, until the government and Federal Reserve embarked on a new experiment of making more and cheaper credit available and buying up the non-performing debt.
Bank failures happen when banks violate the reserve requirements set by the Federal Reserve and are unable to meet the ongoing demand for money from their customers.
Bank failures were a common occurrence during the early 1930s and are evidence of the ongoing risks associated with fractional-reserve banking. (see Fractional-Reserve Banking – Elephant In The Room)
An asset price collapse is more often than not associated with stock prices. The stock market collapse in 1929 is the most prominent example; and it was a factor on three occasions in this century (2000-02, 2007-09, 2020).
An asset price collapse, however, includes all assets denominated in dollars and includes stocks, bonds, commodities, and real estate. We are currently in the early stages of another asset price collapse.
Deflation is the opposite of inflation; it is a contraction in the supply of money and credit.
The effects of deflation result in fewer currency units (dollars) in circulation and an increase in purchasing power of the remaining units. In other words, your dollars will buy more – not less.
As the deflation takes hold, the prices of goods and services will decline, rather than increase. In and of itself, deflation is a good thing; however, when deflation is severe enough, the result would be a catastrophic economic depression.
Any single one, or combination, of the three types of default (credit default, bank failures, asset price collapse) can result in deflation. This happens because of the huge sums of money involved which are subsequently wiped out.
According to Investopedia, “A depression is a severe and prolonged downturn in economic activity.”
The stock market crash in 1929 did not cause the Great Depression. The Great Depression was the result of a flip-flop in Federal Reserve policy.
During the Roaring Twenties, the Fed pursued a generous approach to loans and interest rates. Because of concern about the rampant stock speculation fueled by their own generosity, the Fed became more restrictive and economic activity slowed. This slowdown in economic activity was underway before the stock market crash in October 1929.
It is quite possible that the Fed’s current efforts to raise interest rates could trigger a credit collapse, ushering in deflation and a New Great Depression. (see A Depression for the 21st Century)
MORE ABOUT DEFLATION, DEPRESSION
Deflation occurs when the system can no longer sustain itself on cheap and easy credit. The more aggressive the creation of the credit, the more horribly destructive are the effects of deflation when it occurs.
The effects of deflation are not nearly so subtle as those from the long years of inflation preceding it.
An implosion of the debt pyramid and destruction of credit would cause a settling of prices for everything (stocks, real estate, commodities, etc.) worldwide at anywhere from 50-90 percent less than current levels. It would translate to a very strong U.S. dollar and a much lower gold price.
The most severe effects would be felt in the credit markets and in any asset whose value is primarily determined and supported by the supply of credit available.
Conditions would be much worse than what we experienced in 2008-12. The biggest difference would be that the changes would result in another Greater Depression on a scale most of us can’t imagine. And the depression would likely last for years, maybe decades.
CAN’T THE FED STOP DEFLATION?
They will try, of course, just as they tried and failed in the 1930s. The Great Depression lasted much longer than necessary because the U.S. government and the Fed persisted in efforts to counter the natural effects of deflation.
The effects of a credit collapse and deflation now would overwhelm any efforts by the Fed to re-inflate and stimulate.
The Federal Reserve, in its current attempt to avoid a complete and total rejection of the U.S. dollar, is trying to raise interest rates. Recent strength in the U.S. dollar indicates a measure of success thus far.
Unfortunately, the Fed’s efforts might backfire and trigger another credit collapse. In fact, a collapse might already be underway.
We are all hooked on the drug of cheap credit. But cheap credit was not buoying economic activity to the extent hoped for. Now, higher interest rates are choking off more of the activity that would normally have been there.
The Federal Reserve does not act preemptively. They are restricted by necessity to a policy of containment and reaction regarding the negative, implosive effects of their own making.
The problem is that the bond market is telling us that a credit collapse, deflation, and economic depression are on the horizon. The Fed knows this and can’t do anything about about it.
The three Ds – default, deflation, depression – are upon us. If you are focusing on inflation, you need to look the other way.
(also see Effect Of Deflation On The Gold Price)
Kelsey Williams is the author of two books: INFLATION, WHAT IT IS, WHAT IT ISN’T, AND WHO’S RESPONSIBLE FOR IT and ALL HAIL THE FED!