Could a deflationary environment create an economic depression similar to the 1930s?
BANKING CRISIS = LIQUIDITY CRISIS = DEMAND FOR MONEY
Events this past week are indicative of what could be a more formidable problem for the Fed, investors, and the economy. Before we talk about that, lets first emphasize the key point made in my article SVB, MMT, TNT.
What happened at Silicon Valley Bank, Signature Bank, and now, Credit Suisse and First Republic banks, are not individual issues. All of them are the obvious signs of banking system fragility due to the practice of fractional-reserve banking. Therefore...
What has been termed a banking crisis is actually a liquidity crisis; and the loss of liquidity translates to a DEMAND for money.
DEMAND FOR MONEY
Most people are familiar with references to the supply of money: "increases in the money supply lead to inflation", "a continually expanding supply of money leads to higher prices for goods and services", etc.
Regardless of what happens on the supply side, though, a lack of demand for money can also produce inflation. In some cases, the lack of demand for money, by itself, can cause inflation.
The demand for money is the desire to hold it or keep it close for short-term needs.
There are growing indications that the demand for money is now increasing. The drop in bond and stock prices resulting from higher interest rates, plus actual or expected job losses, lower corporate profits, less capital expansion, slowdowns in real estate and retail activity are all contributing factors.
The combination results in an increasing desire/demand to hold money in cash and demand-type accounts or pay down some debt. The focus is away from spending (other than necessities) and investing.
When the demand for money is great enough, it can cause deflation.
WHAT IS DEFLATION?
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 not a bad thing; however, when deflation is severe enough, it can result in economic depression.
CAUSES OF DEFLATION
There are three specific things currently happening which can result in greater demand for money and lead to deflation. They are 1) asset price collapse, 2) credit defaults, and 3) bank failures; all three of which result in the destruction of money.
Less money available and tighter credit conditions exacerbate the demand for money. The more severe the demand for money, the more likely that deflation (falling prices for goods and services) will occur.
And, as we said earlier, a severe deflation would likely be accompanied by economic depression.
WHAT ABOUT THE FED?
The Fed will keep the charade going for as long as possible or as long as they think it is necessary. Regardless of their intentions, they will be just as helpless as any of the rest of us.
A hugely strong demand for money would dwarf any efforts by the Fed to prevent or reverse the deflation. This almost happened in 2008, which is why the economy was so slow in responding to the supply deluge of Fed money and credit.
If we experience deflation and depression, a new layer of government regulations and more restrictions of economic freedom will jeopardize any possibility of recovery. It will be worse than anything we can imagine. (also see: Orderly Markets vs. Chaos and A Depression For The 21st Century)
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!
Kelsey Williams