How To Grow A Rabbit Hole

And the attraction of zero-bound Alice.

The fight to stabilize the financial system (through liquidity injections by the Federal Reserve, Treasury efforts to recapitalize the banks, and increased FDIC deposit guarantees to prevent bank runs) has had some unintended consequences. In a financial panic, the surge in the demand for money can result in a spending collapse. The rush for cash is on. In a rush for cash, consumers hoard money as best they can and stop spending. This, of course, has a negative effect on businesses. Businesses attempt to hoard cash too, by cutting expenses. Employees are the single biggest expense, so jobs are cut. An unemployed consumer cuts expenses to a bare minimum. This negative loop feeds on itself.

So, one of the symptoms of a surge in the demand for money (shown as a cutback in spending) is price deflation.

Fortunately, Ben Bernanke understands this. In October, in his speeches to both the Economic Club of New York and the House Budget Committee, he articulated the two keys goals of central bankers and policy makers in this crisis; 1. Regain control over the supply of money, and 2. Avoid deflation.

With regards to the supply of money, Bernanke's task is to overcome a circumstance in which the deleveraging banking system is pushing down the money multiplier at an even faster rate than the Fed is boosting the monetary base. The banks are a black hole. Thank you very much to the $500 trillion derivatives market...

With regards to deflation, it is already beginning to happen. Spending is collapsing. People that need credit cannot get it. People that do not need credit are pulling back in their consumption in order to boost their money balance. In this environment, virtually all asset prices have collapsed. Equities, commodities, real estate, art... all down.

In an attempt to stave off deflation the Federal Reserve has reduced its Fed Funds Rate from 5.25% in August 2007 to 1% now. With the Fed expected to cut another 50 basis points in December and unemployment on the rise, the danger of a zero bound liquidity trap are significantly hightened. If the deflationary spiral picks up speed, central banks will be forced to move from focusing on monetary policy to fiscal policy. We're already seeing that to some degree. The first and soon to be second stimulus packages are helicopter drops. The problem is, the first stimulus was spent. For the most part, the second will be saved.