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Author: jiml8 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 10556  
Subject: Re: The threat of deflation Date: 9/20/2002 12:19 AM
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I don't think that low rates will always stop deflation either, any more than high rates will cause it. You only have to look at Japan's recent troubles to get a good example of that.

We shouldn't overstate that case. Japan got into trouble with the mid 80s US real estate meltdown, brought about by the changing tax laws. In the US, Congress stepped up to the plate, formed and funded the RTC, bailed out or merged the failed S&L industry, and cleaned up the mess. In Japan, the central banks tried to ignore the problem and refused to mark their losses to market. Well, those losses will out and that was the beginning of the Japanese recession/depression/deflation. That situation was a classic case of how the US met the crisis in an appropriate way, while Japan met it inappropriately.

I think the chances of deflation here are quite high if the public ever starts thinking that bad times are around the corner. In some ways, it's already here, and signs of it are all around.

I, too, think the risk is imminent. Right now, it seems to me that we need to tighten mortgage credit and raise mortgage rates, and we need to be prepared to stabilize the real estate marketplace - which appears to be in imminent danger. We probably can ride through this thing if real estate can be kept from plummeting. Even if it declines substantially at a modest rate, that will be far far better than if it falls off a cliff, as it very well might.

As to a resurgence of high inflation, I think that they would have to actually give it away (drop it from helicopters or send checks in the mail like the Federal Govt. has been doing lately). Low rates are no good unless there is loan demand out there, and loan demand goes away during deflation, except for the need to fund debt service.

Deflation inevitably destroys cash flow, and in that environment the best investment is cash. If it gets started, there won't be any credit. Banks will try to call loans in order to collect the money while the debtor still has the cash flow to pay. This pattern will accelerate the deflation.

Keep in mind that our economy functions based on the flow of money, not the existence of money. The movement of money from place to place is the lifeblood of our economy. In a deflationary environment, it is advantageous for every entity to hoard money, not circulate it. This will dry things up very quickly.

Given where the discount rate is right now, the Fed is nearly at a limit stop. It has no where left to go with rates. The only alternative course of action is to print money to try to halt the deflation. This will succeed, eventually, as it must. But then the economy will rebound at which point hyper-inflation is a genuine risk.

Given the choice, hyper inflation is a better choice than deflation. At least a hyperinflationary environment stimulates consumption, which is what is required to halt a deflationary spiral.
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