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"by: Michael Panzner April 07, 2009 | about stocks: EWL
Michael Panzner
Michael Panzner

Many deflationistas believe that the wealth being destroyed by the bursting of the global credit bubble will swamp the money being created by fiscal and monetary authorities for the foreseeable future, thus eliminating the threat of inflation, at least in the near term.

But what they seem to be discounting is the effect that a contagious loss of confidence can have on the value of a fiat currency, which is, after all, dependent on the continued faith of those who accept it as a medium of exchange and a store of value.

If, for example, enough people start to believe that a government is embarking on road-to-ruin economic policies, hordes of those who hold the currency may suddenly start stampeding for the exits, altering the supply-and-demand equation and leading to a contraction in its purchasing power.

In "Inflation Prospects In An Emerging Market, Like The U.S.," Baseline Scenario's Simon Johnson highlights circumstances where changing demand stemming from altered perceptions might spawn a serious inflation problem.

There are two ways to think about inflation in today’s economy. The first, suggested by conventional macroeconomic frameworks for the US, is that, with rising unemployment and actual output sinking further below “potential” output, inflation will stay low - and we could actually experience the dangers of falling wages and prices (think what happens to mortgage defaults in that scenario). This is the view, for example, expressed by Fed Vice Chair Don Kohn last week, and the Obama Administration seems to be on exactly the same page - talking already about a further very large fiscal stimulus.

Some people in this camp do see a danger of inflation, down the road, as the economy recovers - and resumes its potential level (or growth rate). As a result, many of them stress that the Fed will need to start “withdrawing” its support for credit and raising interest rates as soon as the economy turns the corner. One informed insider’s reaction to our piece on Ben Bernanke in the Washington Post on Sunday was that we were too easy on Bernanke for failing to tighten monetary conditions as the economy began to recover after the last big easing earlier this decade (specifically, our correspondent argues that Bernanke provided the intellectual underpinnings for what Greenspan wanted to do.)"

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