Monday, Jan. 23, 2009 | I wanted to thank Rich Toscano for writing about deflation (Part I is here. Part II is here.). It’s an important issue and I hope people will read his commentary and try to form their own opinions.

While there are many, many causes of the financial crisis, the general financial illiteracy in this country is surely one of them. The United States is the largest economy in the world, but few of its citizens understand it. Most don’t even try.

To that end, I’m writing to present the counter-argument in support of deflation and I do so in the hopes that more readers will join the discussion.

First, I take deflation to mean a general decline in prices. We don’t have to look far to see tangible evidence of falling prices. Housing prices, as Toscano has well documented, have plummeted. Gas prices are down considerably. And local stores are advertising all sorts of deals to induce consumers to spend, spend, spend.

Those are major sectors of the economy that are experiencing huge contractions. Best Buy put it best by saying it is witnessing “seismic changes in consumer behavior.”

After an orgy of consumer spending, Americans now are becoming a nation of savers. That’s bad news for our economy because 70 percent of the U.S. gross domestic product derives from consumer spending.

There’s no doubt that there’s a general decline in prices. When demand drops, suppliers lower prices. The question is whether this is a short- term decline or a long-term, extremely destructive decline such as the Great Depression or the Japanese bust of the 1990s. I believe it will last here in the US as long as we continue to prop up our failed banking system, which may be a long time indeed.

The bond market, which is extremely sensitive to inflation, is a good place to look for just such a forecast of inflation rates. One such forecast is known as the TIPS spread, which is the difference between 10-year Treasury notes and 10-year Treasury Inflation Protected Securities (TIPS). There’s not much of a difference between the two. Why? Despite the massive infusion of government dollars into the financial system, the bond market is forecasting little to no inflation over the next 10 years.

Why is this? Because the bond market puts far less faith in the government’s power to print money than Toscano does. In Part II of his deflation essay, Toscano notes that “The Fed is now printing money in order to lend directly into the mortgage market.” Well, not exactly.

The Fed is buying mortgage-backed securities from to lower mortgage rates and increase liquidity, but banks must still provide the mortgages.

These aren’t measures designed to “get around” the banking system. The Fed buys and sells securities through its open market operations in New York, which our new Treasury Secretary Tim Geithner used to run.

These trades are made through 19 (as of September) banks and bond dealers known as primary dealers, who then lend to other banks in the system. It still has to work through the banking system, not around it.

Nor does the Fed print money. The Treasury does. What the Federal Reserve does when it buys securities is credit a bank’s reserves.

Banks are required to maintain money in reserve, usually around 10 percent, to protect deposits. This is where the Fed has been putting its money, in the reserves of banks. And that, I think, is where the money has remained (unless it got paid out in dividends or ridiculous bonuses). Banks have stopped lending because many are no longer solvent. They are merely trying to hang on while they weather the storm.

Japan is often cited in debates about inflation because the country experienced a prolonged bout of deflation from which it has not fully recovered. Toscano says that the government of Japan could have ended deflation by dumping large amounts of cash on its citizens, but it wasn’t politically feasible.

I don’t think it was economically feasible, either. Dropping cash on the street corner would bypass inflation and move us directly to dangerous and destabilizing hyperinflation (think Germany post WW I). As Toscano notes, Japan is a nation of savers which helped them survive the crisis. We’ve only recently started saving.

As for the hypothetical example of Alice, Toscano is right. Alice technically hasn’t lost money. However, a financial institution or a corporation that owned the shares of XYZ company that Alice did is required to write down the value of its investment and take a loss.

Granted these aren’t cash losses, but they still affect the share price (market value) of a company. For banks, it’s even worse. The problem many banks are having now is that they had to write down so much of their assets that they are technically insolvent.

It’s true that much has changed since the Great Depression. But one thing hasn’t changed, and it’s something these charts don’t measure: the amount of leverage in our financial system. Our financial system became hopelessly addicted to easy credit and over the past few years, and our banks took on way, way too much risk.

As Irving Fisher wrote in his 1932 essay Debt-Deflation Theory of Great Depressions: “Easy money is the great cause of over-borrowing.

When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts.”

Ultimately, this is the strongest case for deflation. By saving banks from failure, we may delay their inevitable collapse, but we reward failure and scare away investors and fresh capital, the oxygen of our financial system.

Anyone fortunate enough to be sitting on cash now isn’t likely to put it in a U.S. bank or buy U.S. bonds. As a result, the destruction of our financial superstructure will continue no matter how much the Federal Reserve inflates its balance sheet.

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