Macro Economists - blind people touching elephant #2

Inflation VS Deflation - The role of Debt plays

We all know what debt is when someone borrows money from someone else. But what kind of role does it play when we talk about inflation or deflation? Let's take an example:
Let's say an average American makes $3,000 a month after taxes. How much can he spend, from 0 to $3,000? No he can spend from zero to $5,000 if he can say borrow $2,000, or even more if he can borrow more. Therefore, the total purchase power for this American is the amount of money he has earned minus his expenses, then plus the credit he can borrow.

Now, let's think about the 1930’s. During that period of time:
1. Consumer debt exploded
2. Government was on gold standard system, so it had no freedom to print money to borrow, they could only borrow every cent from average Americans.

In that scenario, when the economy was expanding by more and more borrowing, we have a great time before the market crash in 1929. It is simple to see that if everyone is borrowing, everyone can spend a lot more than he has earned, and it makes every business happy because things, including houses, get sold very fast. But one day when your income can't even pay your interest, you need to start cutting your spending or sell your inflated asset. But there may be no greater fool left to buy it. That is the day of reckoning. However, with gold standard system, government has limited ability to battle against this situation, since the government cannot borrow unlimited amounts money because the total amount of money is limited by total amount of gold.

So, what about the fiat currency system that started since 1971? It is the system that US is running now, and our money is backed by national debt which is explained by Chris Martenson's website that I mentioned in first post. Now with fiat currency system government can borrow money from the people, or even easier, just from the Fed Reserve Bank. The way to do it is simply auction the national debt, then ask Fed to buy it back, in this case, you have government has unlimited borrowing power. What can government do when it has the power to print money? Keynesian economists says government can use this tool to fight deflation because if government print too much money; we will have inflation and therefore, avoid the deflation. Is it true? We will find out.

In 1973, we had an oil crisis. This was a SUPPLY side recession because our supply of oil was interrupted so companies started to lay people off because they did not have enough goods to sell, didn’t need to employ as many people. The government thought this recession would lead to deflation so it started to borrow money by printing. Guess what happened? STAGFLATION!! why? because when you have supply side recession, print more money will just make the supply even more expensive, and people still lose job while resource price and wages both go up at a crazy rate! Ok, so even neo-Keynesian admit expansionary fiscal and monetary policy is useless to battle adverse change in supply.

What about DEMAND side recession? Well, sometimes it works, like in 2003 we successfully ended the recession fairly quickly. Does it always work? And it seems to be working this time right? Why doesn't it seem to be working in Japan? Again, let's explore the graph of total the US Debt since 1920. We see that our debt is increasing at an exponential rate. We cannot have unlimited debt vs our GDP number, so I think the Keynesian's expansionary policy to borrow more will work until the day we hit a wall that we can not borrow anymore. I personally believe this wall is at where CONSUMER debt is maxed out. When does consumer debt max out? When majority of Americans cannot pay their credit card bills, when Americans housing price is falling so they can not borrow with home equity loans, and when American's can not borrow any more money to boost house price.

Interestingly our government has stepped up to the plate to borrow where the consumer no longer can. The government is now borrowing and using printed money to fill the void left by the missing consumer. Do you think this is going to work? My next post will be: Demand Side Recession, how does Keynesian stimulus work, and does Keynesian stimulus always work?