Government vs. Deflation

The illustration serves as a metaphor for government spending in the face of deflation. Deflation is a reduction in the amount of outstanding credit. The Sentinel’s second Economic Law says “DEFLATION IS A LACK OF CONFIDENCE”. Government spending faces an unprecedented task holding up that rock of deflation that is about to crush it.


The Market has become extremely reliant on credit. The inaugural issue of The Sentinel publication demonstrated how most of what we consider money today is really credit. Credit requires repayment of the original loan plus interest. Additional credit creates interest due. Additionally, companies, individuals and governments often require new credit in order to satisfy old credit. Think of it like refinancing a home loan. When refinancing a home loan, a new loan pays off the old one.


Credit grows so fast that if plotted on a graph it looks like a hockey stick. The hockey stick pattern is exponential growth.

Can credit continue to grow in a hockey stick pattern? It looks like the curve is going straight up in the air. Mathematically speaking, the curve can continue to grow like a hockey stick. Unfortunately, human emotions do not always fit precise mathematical models. The brain’s rational pre-frontal cortex may tell a person this credit pattern is sustainable but their limbic or emotional brain starts the fear process which dimishes confidence. The mountain of debt created in the credit expansion must be paid. The realization of this condition is a catalyst for the deflationary process.


What starts deflation is the opposite of what started inflation – confidence. Confidence was high during the inflation and now is weakening. Let’s examine data indicating diminishing confidence. The Federal Reserve chart captures diminishing confidence. The chart is a plot of bank credit of commercial banks. After a sharp increase in the 3rd and 4th quarter of 2008, bank credit has shrunk noticeably. The reduction in bank credit is deflationary.

Considering stock market losses of $7 Trillion, collectively individuals have lost a staggering $15 Trillion (March 2009 data) in this and the real estate market. Stock market and real estate losses make individuals appear less wealthy on balance sheets. The paper wealth financing is no longer possible. Bankruptcy increases, foreclosures and other asset sales make for poorer credit risks. As such, lenders (banks) cannot approach credit creation as they did in the past. The banks’ earlier loans are now placing a great burden on their balance sheets.


Another aspect of credit deflation is the consideration by banks to rescind up to $2 Trillion in credit card lines – roughly half of the outstanding amount!


Need more signs of deflation? When a loan of credit money is paid, there is a reduction in the amount of outstanding credit. As more people and businesses repay loans, the credit in the economy contracts further. Complementary to this action is an increase in savings on the part of individuals. The savings rate, which had plummeted since the bear market low of 1982 and had gone negative in 2005-2006, has spiked upward in the last few months.


Presently there is $52 Trillion in outstanding US credit market debt. Consider that debt the foundation from which more deflation can occur. That foundation is several times larger than the rock in the earlier illustration.


The Government is attempting to fight deflation by creating $2+ Trillion in spending. At least $15 Trillion has already deflated in just the stock and real estate markets. Add to this amount the other deflationary forces at work. Can $2+ Trillion of spending overcome all of the deflation that has and will occur? Not a chance. Government is going all out with borrowing and spending to replace the borrowing the public is unwilling to do. After an administration of a credit appetite suppressant, the public will not return to the banquet table anytime soon.


While we may have more roads, bridges, public transportation, and shiny new federal buildings after the stimulus, it will NOT address the underlying cause of the deflation and will not cause people or businesses to start spending again.


Jim Mosquera is the author of The Sentinel financial newsletter www.TheSentinel.biz. Mr. Mosquera’s email address is jim@TheSentinel.biz