What about the US financial system? Inflation, Deflation or Stagflation?

No one will ever forget that the financial crisis began to take on frightening proportions that was creating a self-sustaining death spiral, when it became clear how much trouble the big banks and non-financial lenders were in. We witnessed the failure of Bear Stearns, the demise of the GSE's, Fannie and Freddie, and the rest... you know.

The banks are the source of credit that consumers and commercial borrowers need to be functioning in order for the US economy to recover. So far, the consumer is missing in action in the economy, placing all the pressure on both commercial and government balance sheets. Commercial balance sheets are doing everything possible to restore financial health, including cutting expenses by laying off workers and paying off debt. Most businesses do not have pricing power, so prices are holding the line. The lenders are lending too little to assist with economic recovery and expansion. The only entity stimulating our economy is the US Treasury, by printing new dollar bills.

Many of the 2010 outlooks I read are concerned about the timing of Fed tightening. Tightening is a way of describing an undefined process (policy) of getting the money out of circulation. How the Fed, will do it is unclear and there is not widespread confidence that they can do it without increasing inflation expectations that could also become self-sustaining and fulfilled. The result is a vote of no confidence so far, which is reflected in the dollar index. The widespread assumption is that tightening is going to happen and that the Fed will make mistakes in their implementation of it. The question is seldom will there be a need for tightening. What's up with that? I wonder about the wisdom in this assumption. Are people forgetting how we got here and what has happened to make things appear to be improved, the condition we desperately want to believe.

Inflation or Deflation, or both? Right now?

I have been puzzled for a long time over the question of "inflation or deflation" as the next economic condition to challenge our economy in the US. Before I get into this topic, the terms have to be defined. They do not have universally accepted definitions. Monetarist's (the Monetarist school of economics, i.e. Milton Friedman), Keynesian's (the followers of John Maynard Keynes economic theory) and Austrian's (the Austrian school of economics, i.e. Friedrich von Hayek) all use differing definitions. I have gravitated to appreciate the Austrian's definition which Michael Shedlock (Mish's Global Economic Trend Analysis) describes in his article http://globaleconomicanalysis.blogspot.com/2008/12/humpty-dumpty-on-inflation.html . It's several pages long and inquiring minds will find it interesting. From this article I take the definition for inflation as the increase in the money supply along with credit outstanding. Deflation is the opposite, a reduction of the money supply and the amount of credit outstanding. In the case of credit, using the market value of the credit securities is the most accurate measure. The alternative is when I, as owner of the security, am allowed to tell you what I think it is worth for establishing my net worth. (This situation is what is permitted in the case of the former investment banks, AIG and the too-big-to-fail organizations after the FASB changed the rule earlier this year. I digress.)