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Jim,
We are clearly experiencing deflation, as bad debt and derivatives unwind. At the same time there appears to be massive inflation by the Fed, or else where did the three Trillion for Iraq come from?

The only “X factor” now is the money multiplier. Reserve requirements are now [effectively] zero. A good video (Flash required). But now eliminate the reserve component, [and its] Zimbabwe dollars ahoy.

Here is some scary stuff, directly from the Fed.

And here is an explanation similar to what I had wanted to write about the “Its the Economy Stupid” with Clinton and Greenspan – David in Israel

Dear Jim:
Your piece “Are Simultaneous Inflation and Deflation Possible?” was a great posting on the economic/financial storm brewing. As the “perfect storm” is just getting rolling, this is a good time for those who have not read much Austrian economics to get an understanding of what is likely to hit and why. I feel sorry for folks who have not been given the opportunity to get up to speed on Austrian economics – they are flying blind into the storm (and will get hurt, badly).

1. Robert Ringer has a simplified and easy to read introduction as to what money really is and how it got so corrupted – a great place to start,

2. A super one page distillation of the current problems.

3. After being a paid subscriber to to Gary North for many years, reading him is mandatory, in my opinion. He was very wrong on Y2K, but since then has called the top of the stock market mania (to the month!), begged subscribers to buy gold at $300, and gave years of advance warning of the housing bubble.
Get a fee subscription his Reality Check newsletter. I hope that will convince you to sign on for the full web site subscription. OBTW, I have no $ interest here – just a paid subscriber with a meager hope that if a critical mass of folks get exposed to more moral and economic sense it might help to turn this country around after the crash.
Gary North is a long term bull on gold and also wise enough to look at contrary information. For example, “Helicopter Ben” Bernanke has actually kept a lid on M1 monetary inflation, (even as he lowers interest rates). So just possibly, we’ll see a tight money recession and lower gold prices in the short run, before the (almost) inevitable long term inflation.3. For a real comprehensive education, see the Mises Institute. Here is a sample reading list. Regards, – OSOM

I often have friends and clients ask me how I can talk about inflation and deflation in the same breath. They’ve asked: “But I thought that inflation and deflation were contradictory. How do you think that we could experience both inflation and deflation at the same time?”

Let me explain, starting with a bit of background: The fractional reserve banking system, based on usury, creates money. Here is a simplified example: Each time you deposit a $1,000 at your local bank, the bank then lends nearly all of that money out to someone else, charging interest. The bank holds just a small reserve (“the fraction”) to cover the their likely daily withdrawal demands. Now, say that $950 of your deposited money is borrowed by a business, to purchase raw materials. The seller of those materials will deposit the payment check into his own bank. But then that bank can again lend nearly all of it out. The process goes on and on. Thus, the banking system has a multiplier effect: With the present-day 10% cash reserve requirement in the US, each $1,000 that you deposit eventually becomes more than $7,000. These additional dollars are electronic dollars that are created out of thin air. This puts a lot of new money into circulation, so it is essentially inflationary. Everyone is happy, as long as they all can keep paying their interest. (But by its very nature, the interest-driven banking system creates winners and losers. The losers cannot pay the interest, and go bankrupt. This explains why so many businesses fail each year.) The bankers are the happiest of all, since they make money from everyone on virtually every transaction, in the form of interest and fees. They earn a tremendous amount of money on the float.

The multiplier effect is an almost magical process, and everything hums along nicely in good times. But then comes recession. You get laid off from work. Instead of depositing money every week, you start to withdraw money. Your bank must cover those withdrawals. Things get interesting: when deposits decline, the multiplier effect also works in reverse. The reverse multiplier effect is deflationary. By withdrawing $1,000 from your bank, you are effectively removing $7,000 from circulation. The foregoing example is oversimplified, but is a useful illustration.

Now let’s look at home mortgages. These have always been a cash cow for banks, because of both an un-backed currency and fractional reserve banking, we live in a chronically inflationary environment. Therefore, on average, price of houses go up more than they go down. And mortgages are “safe” because most people are consistent about making their monthly payments. They might miss a car payment or merely pay the minimum on their monthly credit card statement, but they will miss a house payment only in extremis. Nobody wants to lose the house where they live.

Today, in 2008, we are living in exceptional times. The price of suburban houses, fueled by artificially low interest rates for more than a decade, inflated for so long that they created a speculative mania. At the peak of the mania in 2005 and 2006, people bought houses that they couldn’t really afford with no intention of ever living in them. They saw how fast the market was rising, so they bought houses purely on speculation, to either rent them out, or to quickly re-sell them (“flip” them), for a tidy profit. They often knowingly signed up for adjustable rate mortgages (ARMs) with relatively low “teaser” introductory rates, scheduled to be reset to much higher rates–with monthly payments that then would be higher than the buyer could afford to pay. The buyers did so, with the expectation that they would sell their “spec” house before the interest rate reset. But then interest rates went up for a while, and stopped the market bubble from expanding. This pause pushed more houses onto the market. Seeing the turn in the market, the more astute speculators immediately put their spec and rental houses on the market. Almost overnight, there were 6 or 7 houses available for each buyer. As the inventory grew, inevitably prices fell. (As I often say, the law of supply and demand is inescapable.) More and more speculators, unable to sell their houses, fell behind on their payments. Banks started to foreclose. Those foreclosed properties have now started to hit the market, further flooding the supply of unsold houses. This has started a downward spiral of house prices, as the market naturally seeks equilibrium. Since macro market swings tend to be prolonged and over-exaggerated, I wouldn’t be surprised to see the prices of residential real estate decline 30 to 40% nationwide, and as much as 70% in the erstwhile “hot” coastal market areas that were grossly over-inflated. As the market nears bottom, there will be some genuine bargains available in three or four years. A similar process, I believe, will soon occur in the commercial real estate market, as the economy slows.

Starting last summer, the turn in the US residential housing market had a profound effect on the global credit market. The millions of subprime mortgages had been repackaged in lots of creative ways, and the indirect investors in these debt instruments naturally began to wonder what was backing them up. These investors were willing to turn a blind eye when prices were rising, but when the market started to turn, they got nervous. Some of them started pulling their money out of hedge funds that had visible exposure to subprime debt. Two hedge funds managed by Bear Stearns were some of the first to suffer. In more recent months, the subprime contagion has spread, as more and more investors have realized that they have no way of knowing what tangible assets represent surety for their loans. Again, the repeated aggregation and “repackaging” of these mortgage-backed securities created opacity, right when investors sought transparency. Then, to make matters work, it was revealed that the big credit rating firms such as Fitch, Moody’s, and Standard & Poors were in collusion with the mortgage bankers. In what amounted to kickbacks and bribery, the credit rating firms had agreed to artificially inflate the credit ratings of hedge funds and banks with residential mortgage-backed securities (RMBS) exposure. This destroyed the reputation of all banks and hedge trading houses — even those with sterling credit and that had no exposure to subprime or midprime mortgages. Once the rating scandal developed, even “AAA” rated investments became suspect. The end result was that the global credit market essentially shut down. Unable to assess their risk, investors stopped investing, and in turn, bankers stopped lending. This squeeze (remember the reverse multiplier effect that I mentioned?) limited cash to meet the banks withdrawal demands. Rather than declare bankruptcy, some of the hedge funds “temporarily” suspended investor redemptions. Meanwhile, they scrambled to have their parent companies and Uncle Sugar bail them out. This explains the multi-billion dollar “write-downs’ that you’ve seen mentioned in the newspapers.

So now we are in an environment where global credit has shut down to a trickle. The current credit contraction, in terms of its effect on the economy, is actually more severe than that of the 1930s. (The economy is now far more dependent on credit than it was in the past.) There is no liquidity, so there is no chance at all for “business as usual” to continue. But yet we still see the talking heads on CNBC pitching the latest “hot” stocks. Are they blind? Are they spending their weekends picking psychedelic mushrooms? In my estimation the stock market is presently primed for a collapse of epic proportions.

Overall, given the credit squeeze, we are in a situation that is similar to the early 1930s–which was a distinctly deflationary period. Rather than letting the credit collapse cause a worldwide depression, the central banks (including the Federal Reserve banking cartel in the US) are floating huge un-backed loans through creative mechanisms–such as the discount window–to any bank that asks for cash. Hundreds and hundreds of billions of dollars. But this is not enough to stem the tide of deflation. The pendulum has already started to swing in that direction, and it is gaining momentum. At this point, it is almost impossible to stop. All that Bernanke and Company can hope to do is soften the blow. Mark my words: There will be recession and massive economic dislocation. The recession may be deep and long enough to qualify as a bona fide depression.

Do you remember Jim Cramer’s public meltdown back in August of Aught Seven, when he was screaming “Open the discount window!” His tirade was a foreshadowing of the severity of the current crisis. He could see what was coming, and he briefly let the world know what he felt in the depth of his heart. (He has since then become less vociferous.) It is also noteworthy that at roughly the same time, Cramer also let slip his prediction for “upside down” home investors–the folks that I call contrapreneurs–when he recommended that they “just walk away.” In much the same way that I predicted back in early 2007, Jim Cramer saw the advent of what is now euphemistically called “Jingle Mail”.

Another key point that I’d like to emphasize is the difference between the availability of credit and the willingness to lend or invest. Helicopter Ben could keep lowering interest rates all the way to zero, but still not make the housing market turn around. As a point of reference, the Japanese lowered rates to zero in 2001, in an attempt to end their chronic recession that started in 1992. It didn’t work very well. In fact, they didn’t feel ready to raise rates back above zero for five years–until their economic indicators crawled back up into the black, in 2006. But this respite was apparently brief, since Japan once again appears to be sliding into recession. Their recession, by the way, got its start in 1991 when the over-inflated price of Tokyo real estate collapsed. It took 14 years for prices to start to recover. Gee, based on their experience, I guess that we can look forward to many fun-filled years ahead, here in the States.

Is the foregoing making things clear, or just muddying the waters? You might still be asking: “How I can talk about inflation and deflation in the same breath?” Here it is in a nutshell. Assets such as real estate can be deflating at the same time that commodity and consumer prices are inflating. Why? Because Mr. Bernanke and his cronies have an unlimited supply of paper and ink. The banks are now begging their pals in Washington for huge bailouts and “economic stimulus” though artificial incentives such as tax rebates–on the scale of what could amount to trillions of dollars. As I’ve mentioned before, bailouts and cash infusions that large cannot be financed solely by taxes and bonds. The government will be forced to monetize the additional debt. As I mentioned in a recent article, monetization is highly inflationary. It is not just gradual leverage like the fractional reserve banking multiplier effect I described. Rather, it is an almost instantaneous dump truck load (or as Chairman Ben would call it, a helicopter load) of cash, rapidly hitting the economy. This monetization will not go un-noticed. It will push up consumer and commodity prices and simultaneously push down the value of the US Dollar in international exchange.

So what comes next? In my estimation it will be a continuing downward spiral for house prices, declining commercial real estate prices, more hedge fund collapses, some enormous derivatives melt downs (that will likely spawn municipal bond failures), and bank runs. As the economy slows, the flow of funds going into banks will dry up–both as individual depositors get laid off, and as foreign investors decide to find safer places to put their money. A silent run has already been going on for months, at the institutional level. Meanwhile, the FDIC has identified a growing number of “problem” bank and they are quickly adding staff to be prepared for big bank runs. (Hmmmm…What do they know that we don’t know?) But the Generally Dumb Public (GDP) remains clueless. I predict that the private depositor bank runs will start shortly. I believe these runs will be started both by domestically-chartered banks and S&Ls, as well as by international banks that have branches in the US. They will put limitations on withdrawals and balance transfers, starting with home equity lines of credit. These withdrawal restrictions will make depositors nervous. Bank runs are 99% psychological. All that it will take is just one rumor stated on a talk radio show in just one major US city, and the avalanche will begin. It could begin very innocently, for example: “Bank of X says that I can’t draw any more money from my home equity line. But I know that my house is still worth $500,000, and I only paid $420,000 for it. So if its not my house that is causing it, then there must be some other trouble at the bank. I’m going to tell my friends to get their money out of Bank of X, right away.” The avalanche, once started, will be huge. It will take down virtually all the banks and S&Ls, regardless of their subprime and midprime exposure. Yes, the FDIC will make good on their long-standing promises, but that will take months to resolve. In the meantime, people will be short of cash. Even worse, this shortage of cash may mean that many people won’t be making their house payments. Which means even more delinquencies and foreclosures.

Be ready for bank runs. Even the mainstream media is catching on to the threat. Be ready for far-reaching “temporary” executive orders that limit withdrawals. Be ready for the bank run jitters to spill over into other effects that could escalate into veritable mass hysteria: stock market collapses, commodities spikes, and public outcry for “moratoriums”, “debt relief”, “suspensions”, “debt restructuring”, “stimulus packages”, “buy backs”, “grace periods”, “liquidity injections”, “collective stock purchases”, “public investing”, “bank holidays”, “open market operations”, “wage and price controls”, and huge “pump priming” public works programs. Brace yourself for an assortment of government edicts and massive market intervention hidden behind a huge smokescreen of Orwellian Newspeak and double talk. By the way, also be ready for restrictions on international currency movements–but only for us little guys with greenbacks–not for the financiers’ multimillion dollar wire transfers.

Depending on the outcome of the next presidential election, government reaction could range from merely “large”, to downright gargantuan. (The latter may go down in history as “Obama’s trillion dollar bailouts.”)

What is really needed is the abolition of fractional reserve banking and un-backed fiat currencies. A monetary and banking system based on usury is the root of the problem. Debt-based money and currency inflation (a hidden from of taxation) are both parasitic at the core. We need honest (specie-backed) currency, and traditional warehouse banking. In the long run, honest money will prevail. The recent run-up of crude oil above $100 a barrel, spot gold above $955 per ounce, and spot silver above $19.25 per ounce–all time highs–are indicative that the market recognizes the real value of the US Dollar. Incidentally, I also think that the folks at WIR Bank in Basel, Switzerland have had the right idea for 70 years, through the use of private credit clearing circles.