Another deflation scare as excuse to print more money.

Inflation or deflation?

The debate has been going on by hard money enthusiasts for years, but especially since the Nasdaq dot-com bubble burst almost 10 years ago now.

It is an important question for wealth preservation because in a deflation you want to hold primarily cash or high grade bonds as their purchasing power is increasing relative to items you buy and in an inflation you want to hold real tangible items such as gold as they are increasing in value relative to the depreciating currency.

First a few definitions: Inflation is an expansion of money and credit, the result of which is typically higher prices. Deflation is a decrease in money and credit, the result of which is typically lower prices.

Both sides of the debate make a good case. The deflationists contend that because what is important are the supply of both money and credit, and there is roughly 10 times as much credit as there is money in the U.S. that the defaulting debt will easily overwhelm any money creating efforts by the Federal Reserve. (See last weeks post here for a discussion of the fractional reserve banking system that allows all this credit creation) The presumption is that The Fed will be handcuffed in the amount of new base money they can create.

The inflationists contend that the Federal Reserve has the ability to create as much money as they wish with the click of a button and no amount of debt defaults can ever be a problem for them as they can create an infinite amount of money if need be.

When the Fed creates money, also known as monetization or quantitative easing, they exchange newly created dollars for assets, typically US bonds. It is the necessity of having to exchange the new money for assets that is key. There are already trillions of dollars of bonds in existence. The current owners of all those bonds may sell them en masse if they believe the Federal Reserve is determined to inflate at any cost. This would create a situation which could quickly lead to total and utter destruction of the currency through an uncontrollable hyperinflation as everything dollar denominated gets sold. It is this unacceptable situation which would lead to the demise of not only the dollar, but also the Fed itself that the deflationists contend will handcuff their money creation.

The Federal Reserve realizes this predicament so it creates a situation where it can monetize bonds without the negative repercussions. To do this it needs a deflation scare. After the dot com bubble burst and again after the housing bubble burst, the spinmeisters set out to work. The Fed can create new money during times where people are fearful of deflation as it is precisely this fear that prevents the snowballing hyperinflationary scenario described above.

There is another alternative to a deflation scare that will also allow massive quantitative easing, at least the first or second time around. That is a crashing stock market. Bonds typically rally sharply during stock crashes so the risk of a bond rout are slim

It is a fine line indeed that the Federal Reserve must walk. Create too much money in the absence of a deflation scare or crashing stock market and risk hyperinflation. Do nothing and we actually have deflation as the bad debts are written off. This scenario is unacceptable to the Fed because all their banker friends who took unwise risks will be taken down as well.

We had a meltdown in 2008 that required not only Fed schenanigans but also a few trillion dollars of money borrowed by the US Government to give to the powerful Wall Street banks. Not only was that borrowed money given aka "injected" into the banks, the Treasury bonds sold to finance this operation were then essentially swapped off the Fed's balance sheet for those same bank's toxic losing assets.

Where do we stand now? The Fed has bought time. Their balance sheet and the monetary base have exploded. They are paying banks interest on deposits, so as not to have the fractional reserve lending aspect of our money system create hyperinflation. They know there will be more money creation ahead and cannot afford to let that snowball into credit creation as well. So for now they pay banks interest not to lend.

Another deflation scare is upon us now. The Fed has used the opportunity and the rallying bond market to announce QE2, a second round of quantitative easing.

What is next? At some point the bond market will not accept all this money creation and the Fed will have to decide if it wants to fight the tide of bond sellers and continue to monetize or stop in a last ditch effort to ensure their own survival. It is a no win situation for them. We await their next move. In the meantime gold is not fooled. it is near its all time high and looks poised to move higher with each move on the Fed's chessboard.

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