Prechter's EWI site has posted their primary deflation analysis. Worth studying.
Prechter defines deflation as follows: "Just as inflation is an expansion in the supply of money and credit, deflation is a contraction in the supply of money and credit. Deflation is not falling prices. Falling prices are a consequence of deflation. It is dangerous to confuse the two ideas because prices can fall without deflation." PC prices are an obvious example of this.
Is deflation impossible because the Federal Reserve Bank can just print money? Prechter says no, since the Fed primarily 'prints' money by fostering the expansion of credit. Banks create money by lending. The volume of bank money dwarfs the volume that the Fed could sensibly create on its own. Hence the Fed has to weave its magic by trying to manage credit markets.
Currently credit markets for business ("Main Street") are not working well - another way of saying that it is hard to get venture capital, or go public, or get commercial loans at reasonable rates and terms. It is virtually impossible in certain segments, such as dot-coms, or new telecom companies. During the Great Depression, banks simply stopped lending, and the levers he Fed used to change behavior did not work. This was called the liquidity trap' since the Fed made credit available to banks but the banks did not make it available to borrowers. The psychology had to be broken before banks lent. Speeches about fear, big government deficits, government job programs, Fed pump priming, cheapening the currency, failed to do so then, just as they have failed for Japan more recently. It took WWII to break the psychology.
(A fascinating validation of Prechter's point of view can be seen in WWII movies. Some of the most commended early movies about WWII are actually about the Depression; watch From Here to Eternity or In Harm's Way. These movies start with people being bored, and when the war comes, it is welcomed, as a way to escape the psychology of the Depression. More recent WWII movies, such as Saving Private Ryan or Pearl Harbor, completely miss this context, as they were made during the social mood of the '90s.)
Three credit markets have been working in lieu of Main Street: Muni's, Mortgages and Margin, although the window on two of them appears to be closing. Given the sorry state of California, muni borrowing is approaching its limit. Given the recent jump in mortgage rates, after a final rush to borrow, the real estate boom is likely to end. That leaves the stock market. As Yelnick has reported, it appears the Fed has used any significant event (9/11, Iraq War, blackout) to pump credit into equity markets and keep the stock markets afloat without creating a dysfunctional reaction from naked credit pumping.
Greenspan's strategy is use credit in these ancillary markets to keep the economy afloat long enough for Main Street to return to normal. This means the Fed is primarily trying to manage social mood and psychology, not more mechanistic targets such as money supply growth.
Prechter's point is that the Fed is running out of arrows in its quiver to affect credit market psychology, and when there is no more it can do, the negative social mood may overwhelm all that it has tried to do, and send us into a deflationary spiral and subsequent depression. The marker for when the 'herd' recognizes this point of no return is a severe stock drop, or even crash. If it happens, it will be said after that the crash caused the subsequent depression, or 'discounted' it, when in fact, the crash only reflects a collective "Oh, $#!@" reaction as investors head for the exit, not knowing what may follow.
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