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Deflation or Inflation or Both?

January 29, 2003

For a long time I have been tormented by a complicated question. I believe I finally have the answer. Especially after reading so much on the Café and other sites. There are two forces at work in the money system that determine whether there will be inflation or deflation. They are new money being created and old money being destroyed. If new money is created faster than old money is destroyed we have inflation and vice versa to get deflation. Although prices can fall due to cheap imports from foreign countries, this price drop is not due to deflation.

Now, in order to understand this article you must understand how the current money is created. Have you ever wondered just how is a new Dollar created other than a printing press? The answer is that new Dollars are created when a borrower pledges to pay back a financial institution "lender" when the borrower takes out a loan. The borrower makes a note, at interest, and gives it to the lender who in turn makes Notes, not at interest, which we call "Dollars" a.k.a. Federal Reserve Notes (FRNs) and gives them to the borrower. This is the process for creating New Money. When the "loan" is paid back, the loan principal, formerly New Money and now Old Money, is destroyed and the Note, made by the borrower, is destroyed by the borrower. Think of it this way; you give an I.O.U. to another player (Joe) in a poker game. Later, Joe is losing and he gives you an I.O.U. for the same amount as you gave him earlier. When the game is over, you trade I.O.U.s to pay each other and then you and Joe tear up the I.O.U. each of you "issued". This is how the "system" works except that in the real game, one side, the Banker, gets to charge interest on his issued Notes (FRNs). Now, in our money system there is a constant battle between those who pay off their debts and those who get into debt. The job of the banking system is, from an aggregate point of view, to keep people borrowing more than they pay off. This keeps the money supply growing and prevents deflation. Now, in the next paragraph I will explain the issue and the conclusion that just dawned on me.

If the money is created by a loan and then is not paid back, the money is still in circulation. The debt is "bad" and written off by the "lender". This "loss" is reflected in the reduction of the lender's capital base. If the outstanding "loans" are orders of magnitude greater than the capital of the banks and more people default than the banks have capital to fund the losses, the banks will go bust. However this only destroys the amount of money the lenders can fund out of their capital base. The lenders will go to the bankruptcy court and get protection from their vendors and their liability for the defaulted/defaulting loans. The capital base of the bank will be lost because they were destroyed trying to fund the defaulted loans. Some of these defaulted loans will be purchased by speculators for pennies on the Dollar. However, no money will be destroyed due to this process. The lender half of the transaction will just cease to exist and the borrower half will have been spent and still be floating around in the economy as Notes without any debt to back them up. Perhaps this is what one writer meant when he said something to the effect that debt backs the money, if the debt is no good then the money is no good. What do you think? I wonder if I have missed something?

Anyway, if there were trillions and trillions of "Notes" out there that have no backing then the Notes are nothing but paper, period! I believe this will cause prices to skyrocket as people rush to dump the things. I know that there are other factors in all of this such as foreigners dumping Dollars for other currencies. However, what would you think about your own country's currency as the mighty Dollar goes crashing down? Would you think your currency would not meet the same fate? What would you do?

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