There are 4 things can cause deflation:

• 1. The supply of money goes down.
• 2. The supply of other goods goes up.
• 3. Demand for money goes up.
• 4. Demand for other goods goes down.

However the Fed concern themselves entirely with the money supply and with the money supply equation. By expanding and contracting the money supply, the Fed believe that they can control not only the rate of inflation (which they certainly can), but also aggregate demand for goods in the market place.

Just about all money in our current economy except paper and coins (the quantities of which are trivial) is essentially just a form of debt – credit issued by commercial banks on the basis of “reserves” (the reserves being the bit the Fed is responsible for). Once credit is issued by the commercial banks people purchase goods with that credit by writing cheques, use credit cards etc. Credit, therefore, is our current medium of exchange. Presently the realisation of massive quantities of bad debts in global markets is causing the evaporation of money that was based on those debts, which gives rise to the semi-plausible risk of deflation.

Since deflation is a dirty word for the Fed, they are attempting to replace any money that might evaporate in order to try to maintain the total quantity of money in they system that is available for you and I to spend… the theory being that in doing so they will be able to avoid a fall in aggregate demand. To that end, they are pushing new reserves into the system and, as long as the quantity of reserves they push into the system does not seriously exceed the quantity that is evaporating due to bad debts, inflation could be kept at present levels.

Presumably their hope is that once the bad debts have worked their way out of the system they will then be able to undo the “temporary”  measures that they have taken, by selling treasuries and withdrawing credit facilities from the market, thus reversing the massive increase in the total quantity of reserves in the system that has occurred over the past 6 months as the result of the various coordinated actions of the US treasury and the Federal Reserve. Thus they could, according to their theory, hopefully avoid any drop in the aggregate demand for goods as a result of monetary contraction (in the short term) and also avoid hyperinflation out the other end of this as the result of all the reserves that they’ve been pumping in of late.

One minor objection to the theory might be that there is a lag on the Fed’s activities. Typically prices in the market only react 18 to 24 months after they do anything and in all likelihood by the time they know that they need to contract the money supply again it will be too late… and inflation will take off well before they get around to controlling it again. Once banks have already loaned out money on the basis of the reserves they hold, it will be extremely difficult to get them to hand those reserves back over again without inducing yet another financial spasm… but for the time being I will ignore this pothole in the road that lies ahead for the Fed.

I believe the more serious problem that the Fed faces is the effects of past inflation just as much as future inflation. When they inflate the currency they are conducting a form of wealth distribution from savers to borrowers. Savers are forced to lend their money out at rates that they would not accept in a free market and borrowers get to borrow at rates below what they would ordinarily have to pay savers to for their savings… This allows bankers to earn more money (since they get to be the middle men in the transaction) and allows money to be borrowed for uses that quite simply are not profitable (government expenditure, businesses, and houses etc.). These unprofitable sectors of the economy effectively exist as the result of subsidies and need the subsidies to continue if they are to continue to exist.

But that isn’t the full extent of the problem because inflating the quantity of money in the economy has the effect of lowering nominal interest rates. However interest rates are a price – they are the price at which savers lend their savings to borrowers. Inevitably, if you cap the price of anything below market rates, there is insufficient incentive for producers to participate in the market and the goods that are available are put to uses which are not profitable (and to which they would not be put if the price of these goods were a true and accurate representation of their scarcity). So, not enough supply and over demand… which leads to – you guessed it – shortages. In the case of interest rates, the goods concerned are real savings and when the shortage hits, no amount of government intervention can magic the underlying good into existence. They cannot “legislate” real savings into existence and further attempts at price controls will only aggravate the problem (leading to more severe shortages).

As such, eventually it must be realized that there are insufficient real savings to support both the profitable and the non profitable industries. Once the shortage of real savings is realized, the government can do one of two things. They can:

• 1. Try to sustain the unprofitable industries through increased inflation and wealth redistribution.
• 2. Bite the bullet and let the market readjust, abstaining from inflation and propping up ailing industries.

If they should choose door number one then the unprofitable industries will be sustained at the expense of the profitable ones. Money is given to unprofitable industries that are then able to outbid the profitable industries for the scarce real savings available in the market place and thus profitable industries must go out of business. As a result, productivity will decrease as will the quantity of both goods and services available and ultimately the general standard of living. This may be result in prices rising more quickly than wages or in further shortages of both (Zimbabwe style).

If instead the government show some courage (highly unlikely I know, but just for argument’s sake) and abstain from propping up ailing industries and if the central bank abstains from doing the same then those unprofitable industries will naturally go out of business. There will be a painful readjustment period as resources (including labour) get reallocated into profitable sectors of the economy which will eventually result in monetary profits (representing surpluses of real goods and thus the sorely needed real savings that are missing from the economy at present). The speed at which this process can occur will depend on all sorts of things like the rigidity of employment legislation and the degree of specialization in the economy’s workforce (and thus the timeframes required for people to retrain). But at the very least by passing through door number 2 the economy is headed in the right direction again.

So although the Fed may think it is able to provide the “liquidity required to get the markets functioning correctly again” the fundamental problem is not one of liquidity. It is not the result of an “accounting error” or a lack of paper and coins that has brought the global financial markets to their knees. Additional liquidity might temporarily avoid a drop in the aggregate demand of consumers but if there are good reasons for the aggregate demand of consumers to drop which are not merely monetary in nature then nothing that the Fed can do will help.

Essentially what we have is governments and central banks around the world that refuse to face the music. They don’t want to let non-profitable companies in the economy go bust and so they subsidize these businesses (banks, mortgage lenders, insurance companies and car makers). The fact that they make monetary losses implies that they make real losses though. Loss making companies consume more resources than they produce. You give them nice shinny new clothes and they give you rags back. You give them more than you get back from them. Companies like GM and RBS are the equivalent of giant unemployed things – massive bureaucratic parasites. Not only are they are of no benefit to the economy – they are a liability to it, impoverishing everyone who is forced to participate in the economic system that they are a part of.

Nor does it matter that large loss making companies employ people. I could, personally, employ everyone in the US tomorrow. I could hire them to dig holes and fill them in again and then I could go to congress and say “I need a few trillion dollars to stay afloat – if you don’t give it to me all these people are going to be unemployed”. Congress would be entirely justified in answering, “So what? All you’re doing is getting them to dig holes and fill them in again and we have need for neither. We need food, housing, health care and education”.  That would be an entirely appropriate response. Employing people really isn’t important – finding ways to occupy people’s time is not difficult at all. What is difficult is to find ways to employ people such that their contribution has a positive impact on the economy as a whole – such that their efforts serve to improve both their own lives and the lives of other individuals. That is precisely why companies keep accounts – to gauge whether the sum total of their efforts is profitable… whether their output justifies the labour and capital that they have invested in order to produce that output. If they are not turning a profit then the logical course of action is to cease operations and allocate those resources to something else which is profitable.