If we define inflation as a growth in the total supply of money and credit relative to goods and services, we see that inflation has two components: money and credit. The critical part of this formula is that, in a fractional reserve banking system, the amount of credit in the system, generally, is in vast excess to the money that has been created. Therefore, a contraction in credit can rapidly overwhelm the ability of the Federal Reserve to combat deflation through money creation.
Many fear that the current binge of money creation will end in hyperinflation. Others contend that the amount of money being created is too small, relative to the massive contraction in credit, to deflect the deflation bomb triggered by the subprime fuse. We can refer to this as the 'pushing on a string theory'. Still others propose that a relatively short deflationary trough will be followed by a hyperinflationary catastrophe on par with Zimbabwe or the Weimar Republic: disinflation. Here we will discuss a fourth possibility. Let's call it hyperdeflation.
Let us suppose that, at the height of a credit bubble, the relationship between money and credit changes. Let's think of it as 'reversing polarity'. During the cycle of credit expansion, money creation leads to more lending through credit. The aggregate of money/credit may grow logarithmically as credit is created in great excess to the actual dollars in circulation. Once the credit expansion cycle exhausts itself by extending credit to all worthy and unworthy borrowers who are willing to assume the risk of credit, the growth of the credit side of the equation in our inflation formula stops. In reality, the credit variable in our formula begins to contract as borrowers who assumed too much debt must sell assets to reduce their debt burden. The cycle of deflation begins.
The current operating theory--and it is only a theory--of the Federal Reserve is that deflation can always be rectified through money creation, which in turn reignites the lending/credit cycle. Those familiar with the writings of Bernanke know that it is his assertion that deflation is unneccesary and that the 'tools' available to the Federal Reserve are sufficient to banish for all time the spectre of deflationary depression. A utopian fantasy, perhaps. Well, likely.
Now let's revisit the supposition that the relationship between money and credit changes when the cycle of credit expansion goes into reverse. That is, counterintuitively, an increase in the money supply actually causes a decrease in the supply of credit. In a cycle of credit contraction and deflation, the pool of worthy borrowers has largely been exhausted. Banks, whose earnings depend on credit, must be very judicious about lending. It takes hard work and very astute accountants and analysts to make money by lending in such difficult times. But what if banks could swell their balance sheets without bothering with the risks of lending? What if they could recapitalize through risk free money supplied by the Federal Reserve? Here we reach the crux of the biscuit, a hypothesis that may be worth considering for those risking capital by betting on macroeconomic trends. It states that the current Federal Reserve policy is not inflationary and not 'just pushing on a string' but is, in fact, hyperdeflationary because it is destroying the system of credit when it would otherwise be rejuvenating itself by creating a stronger foundation from a smaller capital base. This theory states that the current Federal Reserve monetary policy, contrary to its intent, is accelerating and exacerbating the current deflationary trend and will ultimately result, if pursued to its logical conclusion, in hyperdeflation through complete destruction of the checks and balances that govern the system of credit.
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