First, let's address deflation and what happens during deflation. First, deflation eventually drives all prices down. This is because there is less money chasing goods, meaning that the price of goods must decrease as the value of money relative to goods goes up. Easily, one can see a few positive things about deflation. One, the decrease in prices has led to an increase in spending, quixotically. What has happened is that margins, and therefore profits, have decreased, as they must, which harms the rich. The average person remains unaffected by the travails of the stock market.
There's a misconception about the demand for jobs. It is assumed that jobs are created through industrial activity and that is the whole of it, when in reality, there is a demand for jobs as much as a supply. As a recession wears on, workers must accept lower pay due to a reduced supply of jobs, but the demand is still there for jobs, allowing, at a reduced cost, many activities that were formerly marginal. As the write-offs continue and money starts flowing again, the mal-deployed funds get deployed to accomplish more useful things for less money, reducing the cost to the entire system, which reduces prices, which leads to, quixotically, prosperity, because prices can and often do fall faster than wages in a recession.
Now, on to our second point, which is that this deflation cannot long endure. Part of the argument is that the government's attempts to inflate their way out of the deflation will not entirely fail. At some point, the Obama administration's infrastructure spending will start to provide a trickle of growth, and that will be all the inflation needs. If the fed does not act decisively to stop inflation at the very first sign, and the fed has never acted decisively to stop anything at the very first sign, then the current cash overhang will explode.
This deflation was caused by a massive overhang in imaginary money in the form of derivitives, most of which have simply gone away thanks to the collapse of the mortgage industry, where most of the toxic instruments lay. The mechanics have been hashed and rehashed, but suffice it to say that massive amounts of monetized assets have been removed from the system, which has reduced the cash pool significantly, leading to mild deflation. Why mild? Because the fed did everything in its power to stop the failure of these institutions, even to the point of assuming some of these toxic instruments. At the same time, the fed and the treasury department have been stuffing cash into the economy with both hands. So far, this cash has resulted in little change in the economy because the consumer lacks the ability to assume any more debt and bankers lack the will to risk greater amounts of money at this point on weak credit.
However, in about two years, most consumers will be in better shape, assuming the whole system does not implode, and most bankers will be looking at making better profits rather than merely surviving, so the credit situation will change. At the moment, there is plenty of cash in the system to enable lending. By that time, with continued efforts at essentially zero interbank rate, coupled with ongoing infusions of cash into the banking system, the banking system will be flush with reserves, leading to an ability to lend using fractional reserve banking. As the infrastructure Obama wishes to build will really start employing people right about then, given that engineers must design and contractors must bid and beaurocrats must approve, we can expect a spark of apparent recovery right about then.
Since the government-employed people will not necessarily be adding value to the system but will be given tokens just the same, they will bid up the prices against the rest of us producing the factors that they need. Since by that time a significant amount of the economy will be under control of the government, doing politically effective things rather than economically effective things, we can expect a continued decline in real production against an increase in demand through fiat money. Add in a generous dollop of lending and the dollar will simply collapse.
The seeds of this destruction are being sowed now. The continued inflation of the currency in an effort to save the banks is the foundation for the next bubble. The bankers currently running the system could not see the inevitable collapse that was obvious to any student of economics five years ago, so they will not now see the potential for runaway inflation. The end will be short and horrific.
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