The Razor’s Edge – Inflation vs. Deflation

Deficit spending has been touted as a potential driver of inflation, because only with devalued (inflated) currency can we hope to erode the real value of our mounting levels of government debt. Continuing to print U.S. dollars, it is claimed, can only lead to too many dollars in the system, and hence a devalued dollar. We should be so lucky.

A few years ago, in Sept. 2007, in a post entitled “Inflation vs. Deflation,” I cited a recent (at the time) quote from Paul Kasriel, an economist with The Northern Trust Co. in Chicago. He explained the danger of deflation quite well, describing what happened in Japan:

“Japan experienced a deflation in recent years because the bursting of its asset-price bubble in the early 1990s created huge losses in its banking system. The Japanese banks had financed the asset-price bubble. When it burst, the debtors could not keep current on their loans to the banks and therefore were forced to turn back the collateral to the banks. The market value of the collateral, of course, was less than the amount of the loans outstanding, thereby inflicting huge losses of capital to the Japanese banks. With the decline in bank capital, the Japanese banks could not extend new credit to the private sector even though the Bank of Japan was offering credit to the banks at very low nominal rates of interest.”

Another way to put this is as follows: Liquidity is a function of two factors, […] Read More