The ongoing financial and economic crisis has not only stoked fears that it will end in inflation — as central banks will print up ever-greater amounts of money — but it has also given rise to a diametrically opposed concern: namely, that ofdeflation.
For instance, in December 2011 Christine Lagarde, head of the International Monetary Fund (IMF), warned that the world might risk sliding into a 1930s-style slump, such as the Great Depression.
This episode was characterized by worldwide defaulting banks, a shrinking of the money supply (or, deflation), which in turn led to falling prices across the board, sharply falling production and drastically rising unemployment.
In today's fiat-money regime — which contrasts with the gold-exchange-standard that was in place in many countries at that time — the possibility of deflation appears fairly small indeed.[1]
This becomes obvious if one takes a look at the workings of today's fiat-money system, a system in which the money supply can actually be increased at any point in time in any amount deemed politically desirable.
Against this backdrop we find that the lower the minimum reserve ratio is, the more credit and fiat money the banking sector can produce with a given unit of central-bank money. And further, the lower the capital requirement and the risk weightings are, the higher will be the leverage banks can build up with a given amount of equity capital.
From early 1960 up to the end of 2007, US banks' credit and money multipliers (which denote the amount of credit and money banks can produce with $1 in central-bank money) increased drastically — thanks to a continual rise in central-bank money, ever-lower reserve requirements, and readily available bank-equity capital.
For instance, with a central-bank money supply of $1, banks produced around $211 of bank credit in August 2008. This compares with less than $20 seen in the early 1960s.
In "fighting" the credit crisis, the US Federal Reserve increased US banks' (excess) reserves drastically as from late summer 2008. As banks did not use these funds (in full) to produce additional credit and fiat-money balances, however, the credit and money multipliers really collapsed.
The collapse of the multipliers conveys an important message: commercial banks are no longer willing or in a position to produce additional credit and fiat money in a way they did in the precrisis period.
For instance, in the euro area, bank stock prices fell by around 76 percent from the beginning of 2007 to the beginning of 2012 — unmistakably signaling investors' lack of confidence in the viability of many banks' business models. In the United States, bank stock price declines amounted to slightly more than 50 percent.
The chances for a full-fledged deflation (that is a decline in the money stock) are fairly small in a fiat-money system, however, first and foremost because deflation runs counter to vital interests of government and its close associates.
What is more, mainstream economists, who undeniably exert an important influence on public opinion, keep saying that deflation, because of its allegedly devastating economic and political costs, has to be avoided by all means.
And the shrinking of the fiat-money supply can be prevented, by all means. For in a fiat-money regime the central bank can increase the money supply at any one time in any amount deemed politically desirable.
The fiat-money supply can presumably be increased most conveniently through a policy of monetizing outstanding as well as newly issued government debt — as there will be strong public support for keeping governments liquid.
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