(This is Part 7 of a continuing series. Go back to Part 6.)
At the present time the economy seems to be wobbling. Perhaps it will even improve short-term. But within a few years we could get the worst of both worlds, stagflation, where prices go up while economic activity moves to a recession or worse.
Alternatively, we could get a classic depression where both prices and economic activity decline. We could even get stagflation followed by a classic depression.
This is what's so tricky about gigantic credit bubbles. The massive increase in credit, which amounts to a massive increase in the money supply, tends to foster inflation. At the same time, the piercing of such a bubble, which can occur at any time, could precipitate a depression.
Once a massive credit bubble has been created, either inflation or deflation can occur (or one followed by the other), and both processes can become self-reinforcing.
A price inflation can occur either in the prices of assets (such as stocks, bonds or real estate) or in the prices of goods (food, gas, etc.). If the former, the rise in the assets enables more money to be borrowed, which then fuels a further rise in the assets in a self-feeding process.
If the latter: As consumers and businesses begin to realize that inflation of goods and commodities is indeed a factor that they have to contend with, they tend to buy things quicker. Thinking like this arises: "That thing I want to buy will only be more expensive down the road so I better get it now."
More rapid purchasing increases the velocity of money (how fast it circulates) and in effect creates more money, again bringing about a self-feeding process.
On the other hand, once the credit bubble is pierced by some proximate event, prices can accelerate downwards. As consumers and businesses become increasingly aware that prices are declining, they begin to put off purchases. "If I can buy something cheaper next month or next year, doesn't it make sense to wait until then?"
Again, a self-feeding process can begin where a decrease in prices feeds upon itself.
Meanwhile, companies and consumers become more reluctant to borrow money—because they'll be paying back the debt with units of money that, as prices fall, become more valuable. Meanwhile, too, banks become more reluctant to lend, since risk is becoming a bigger issue to the banks in the uncertain environment.
Thus, in a deflationary environment, even though the central bank may increase the monetary base, the overall money supply tends to decline. This decline happens because banks, consumers and businesses become more averse to debt—and let's remember, that's how new money enters the economy.
So once a gargantuan credit bubble has been constructed, if the bubble is pierced and a decline in prices begins the price decline can also become a self-reinforcing process.
This points up the incredible fragility that is created when a credit bubble has become gigantic (as the Great Global Credit Bubble is now). Prices on either the upside or the downside can become self-reinforcing. There can even be combinations such as stagflation, mentioned above, where prices are accelerating upwards even as economic activity is decelerating or declining.
Another common feature of both inflations and deflations is that central banks ultimately lose control of the process.
As an inflation moves towards hyperinflation the central bank usually creates more and more money to try to "get ahead of the process." The problem is, it no longer can.
As people sense that inflation is virulent and endemic, they purchase faster and faster, so that the velocity of money—and thus prices—keep increasing faster than the central bank can shovel new money into the economy. Paradoxically, this creates a "shortage of money" where real purchasing power goes down even as the ostensible money supply keeps increasing.
In a deflation from a large credit bubble, the central bank also eventually loses control as the downward movement accelerates. In a deflationary environment the central bank usually attempts, in effect, to create inflation by pushing interest rates below the level of deflation.
The problem is that interest rates cannot go below zero, so that the Fed and other central banks reach a floor beyond which they cannot go—and become essentially powerless to stop the continuing deflationary process. This dilemma is the infamous liquidity trap.
Thus once a credit bubble has reached an extreme, the economy becomes vulnerable to a runaway inflationary
or deflationary scenario. Or even both: one followed by the other. But in either case, 1) a "shortage of money" occurs; 2) the central bank loses control; 3) the process becomes self-feeding.
The other common factor is that the economy suffers a severe loss of real economic activity in either case. Paradoxically, both inflations and deflations eventually produce the same result: depression. And of course, the size of that depression is proportional to the size of the credit bubble that preceded it.
However, of the two, a deflation is much to be preferred to an inflation. A deflation from a large credit bubble drastically lowers economic activity as does an inflation as it picks up speed. But an inflation adds something else: the money supply is also destroyed. Since money is the very fabric of economic activity, this usually results in the financial elimination of the middle class.
But let's remember, down economic cycles are ultimately constructive processes because they correct the excesses, distortions, and mal-investments of the previous up-cycle, thus preparing the way for the next upward movement.
Even more importantly, down-cycles foster a huge wave of spiritual deepening. Students of Shakespeare's King Lear (often considered the greatest play ever written), know that two great movements occur in the play: As Lear's external circumstances go downhill, his spiritual depth and compassion lift to greater and greater heights.
This is the two-level process that humanity will soon be embarking upon. The thing that seems so unwanted and painful—the increasing and relentless downward cycle in economics, energy, the ecology, etc.—is the very thing that will foster a great spiritual uplifting in the human race, leading ultimately to our destiny and rebirth as the compassionate heart of the planet.
(This is the end of Part 7. Go to Part 8.)
—jim sloman, 5.14.03 for Sep 22
|
