Tuesday, September 15, 2009

Debt-Deflation (Still About Friedman)

Time for another economic update, categorized as Politics since I did not expect to need an economics category.

It is bad when the items that are loan collateral lose value. This is called debt-deflation. For example, if a the value of a house decreases to less than the remaining mortgage debt the homeowner has incentive to walk away.

Recessions can become depressions when debt-deflation undermines banking. If the total of all loans shrinks too fast then the value of credit becomes uncertain. This is currently happening: debts are shrinking faster than the Federal and State governments are spending.

The only way out is medium-term inflation. The government will need to create new money aimed directly at paying off debts (instead of aimed at paychecks, infrastructure, and other "stimulus" efforts that feel better to voters). Then creditors will have feel more confident with fewer unstable debts and a "fresh slate".

Tangentially, this need for more inflation is why gold is still doing well, and why my family is not yet selling off our February investments that expect upcoming inflation.

Now, I wrote back in February that such things needed to happen, and noted in March when the Fed began such a program. However, M2 has been surprisingly flat since March. Why? My hypothesis is because the Federal government is also causing uncertainty about the value of hiring new employees. The companies that are ready to make new loans with sound collateral are wary of doing so. Having cash reserves is valued more.

Just as the recession was caused by an inevitable credit bubble being allowed to grow and fester too long through inept politics and bad math use, politics and bad math use are now extending the recession's duration.

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