derryl

Scary Drop in Velocity of Money: Is Deflation Knocking?

Great article as usual, Steve.

A lot of people don't seem to get that there are 2 different kinds of things subject to inflation/deflation. Consumer Price Inflation is a nonentity in our present troubles. Throughout the years of inflating asset bubbles the Fed and the world's central bankers, despite repeated warnings from BIS chief economist William White and his crew, kept their eyes firmly fixed on CPI and saw that it was flat. So the central bankers saw "clear sailing" when in fact massive bubbles were forming first in tech stocks then in real estate.

New money in the form of bank loans tends to inflate asset prices, not consumer prices. About 75% of the total money in existence was created by banks as mortgage loans. During Greenspan's 2000s we saw a tremendous increase in mortgage lending which inflated the housing bubble. All that money coming into the economy put money in people's pockets and exuberance in their hearts so they leveraged up their consumption even more. This created bubble demand for all kinds of consumables, and the stores that sell them, and the commercial real estate where the stores are located.

This debt-fueled real estate bubble is what is now deflating because too many of those borrowers cannot make their payments. Those houses and strip malls are the collateral for all the mortgages the banks made, and a bank's collateral is its "assets". The price of those assets has been rapidly deflating.

Remember, there are 2 sides to 'debt'. The borrower has debt. The person who the borrower bought a house or a car or whatever from has the money. The money did not disappear from the economy. Buyers have debt, sellers have money.

All the people who built and sold all that real estate and other bubble consumer goods have cash in the bank. Depositors' balances are the main category of a bank's "liabilities". When a bank's assets are worth less than its liabilities that bank is technically "insolvent", because if the bank had to immediately liquidate assets to pay out its depositors' balances the bank would not be able to raise enough money.

Bank's are required to hold a capital cushion to cover this difference. As the value of their collateral fell, regulators required banks to accumulate a greater cushion against potential insolvency.

FDIC deposit insurance prevents old fashioned 'runs' on banks where depositors who fear their bank is insolvent scramble to get their money out before the bank runs out of money. And just because a bank is technically insolvent does not mean it needs to be shut down and its assets sold to solvent banks. If a bank's mortgage customers are making their payments then it really doesn't matter if the house they're paying on is worth less than the mortgage, because the owner doesn't plan to default or sell the house in a depressed market so the bank will not realize the paper loss of the house's value.

My point is that the inflation all occurred in bubbling asset prices, not CPI, and the deflation is now occurring in those same assets. We should not even be looking at CPI in the present context because it just confuses our idea of what it is we are dealing with today. We are dealing with asset deflation and its consequences for the banking system.