Don’t be fooled by the inflation-talk head-fakes in the economic commentariat these days. Inflationary pressures are a function of “money” supply and its velocity, both of which are functions of lending.

Dealing with debt, whether by default or repayment, reduces the money supply, and when lending declines the velocity of money falls. Both of which are deflationary. Frenetic Fed “printing” of money is really just an attempt to counter-balance those deflationary forces.

Inflation is quite unlikely to be a significant factor until banks begin lending freely and people begin borrowing enthusiastically. This article suggests rather cogently that the trend is running in the opposite direction.

Your best individual response to deflationary pressure is, ironically, to get out of debt** as fast as you can. Which, of course, reinforces the cycle, and I suspect that’s what we’re seeing in the numbers.

**The reason is that deflation punishes debtors. Not only is the “real” rate of interest quite high—“real” interest is the nominal interest rate minus the inflation rate, and when there’s deflation that number is negative, which means you must add it to nominal interest—but you’re having to repay the loan with money worth more and more, which what you borrowed it for is worth less and less. Ouch.

Check out the graph:

http://www.businessinsider.com/chart-of-the-day-commercial-and-industrial-loans-at-all-commercial-banks-2010-2

That big spike in ‘08 BTW was driven mainly by businesses running their lines of credit up to the max, in what turned out to be well-justified fear banks would cut back any unused portions of those lines.

Companies with only $50 K on a million dollar LoC found those lines cut back to ... $50 K.

These things continue until all the bad debt is washed away. ALL of it. My guess is 2013 or so, if government doesn’t mess things up more than they already have in the past year.

A comment from the link given by #2 which reinforces #1:

Except for one little problem: banks still won’t lend even if the Fed raises.  Because of deflating real asset values. You don’t lend $100,000 on collateral that will be worth $90,000 in a year and $80,000 in three. That’s when you get jingle mail and a capital loss. In a deflationary environment banks hoard cash as “dry powder”. They lose interest in “interest”. And as we saw during the crisis, they buy Treasuries even with negative yields because they’d rather pay the government for safe return of capital than lend it out in a risky environment.

My parish has been out recently applying for loans from local state banks.  Our loan should have been a cream puff—we have 60% to put down.  It’s tough to borrow money at all.

On the personal front, though, we paid off our mortgage last summer.  I thought it might not be so smart if inflation was coming, but now it looks like a good financial call.  (And it was anyhow, with retirement looming.)

Ditto to #6.  Bart, thank you for taking the time to educate us.  I have learned a lot from you.

Bart, I have a question.  What is your opinion of the Princeton Economic Confidence Model?  Is there anything to it, or is it all…er…fanciful thinking?