Over at the Mises Blog, Frankfurt-based business professor Thorsten Polleit explains the deflationary forces active in the banking system following the 2008 crisis:
In “fighting” the credit crisis, the US Federal Reserve increased US banks’ (excess) reserves drastically as from late summer 2008. As banks did not use these funds (in full) to produce additional credit and fiat-money balances, however, the credit and money multipliers really collapsed.
The collapse of the multipliers conveys an important message: commercial banks are no longer willing or in a position to produce additional credit and fiat money in a way they did in the precrisis period.
This finding can be explained by three factors. First, banks’ equity capital has become scarce due to losses (such as, for instance, write-offs and creditor defaults) incurred in the crisis.
Second, banks are no longer willing to keep high credit risks on their balance sheets. And third, banks’ stock valuations have become fairly depressed, making raising additional equity a costly undertaking for the owners of the banks (in terms of the dilution effect).
The bold part in effect represents Mike Shedlock’s argument for why we will see sustained deflation due to economic forces. He insists that the only way mass inflation or hyperinflation could occur is if the political forces in society decide to create it.
Interestingly, Polleit agrees:
The political incentive structure, combined with the antideflation economic mindset, really pave the way for implementing a policy of counteracting any shrinking of the fiat-money supply with all instruments available.
And the shrinking of the fiat-money supply can be prevented, by all means. For in a fiat-money regime the central bank can increase the money supply at any one time in any amount deemed politically desirable.
Even in the case in which the commercial banking sector keeps refraining from lending to the private sector and government, the central bank can increase the money supply through various measures.
Polleit says mass inflation can be produced by a central bank policy of quantitative easing (direct monetization of existing and newly issued government debt) and that in fact this is the policy choice already being observed with regards to the actions of the Federal Reserve and European Central Bank.
Deflation will be incredibly painful for the political and financial classes. But mass inflation is not necessarily a policy that will delight them either. On each side lies disaster and it’s hard to make the case that any particular disaster is more preferential than the other from the perspective of the political and financial interests. And surely, the absolute size of the problem and the precariousness of the perch currently enjoyed seems to dictate that an attempt at finding an “easy middle” ground will fail this time around.