Still, there’s no denying the mounting bad news: China has peaked, Europe’s in trouble, and the American economy has hit a “rough patch” at the very least. The Dow is down seven straight days. The fear about inflation is being eclipsed once again (as we always warned) by fears about deflation. The long bond keeps climbing. The gap between the TIPS (inflation-adjusted) rate and nominal rate keeps narrowing. The Fed continues to pump reserves into the banking system (literally half of the money supply created in the U.S. over the last 234 years has been created in the last three years), but the velocity of money plummets because no one wants to lend… or borrow. Initially, everyone said, well, we’re just too uncertain about America’s immediate political, regulatory, and economic future to want to lend. Increasingly, potential lenders are beginning to wonder: If I just hoard my cash, will it be worth *more* a year from now than it is today? Central bankers fear nothing more than the psychology of deflationary expectations. They fear it even more than inflation. It is the one monster against which they have no weapons.
Some (most notably Krugman) say we need a vast expansion in fiscal stimulus. Keynes to the third power. It is certainly too late for that for Europe. (After all, they actually need to worry about a collapse in their exchange rate.) But it may even be too late for that for the United States. We’ve simply taken the “debt” cure too many times—its side effects now exceed its efficacy. Farrell excerpts a good quote from the Economist: “Borrowing has been the answer to all economic troubles in the past 25 years. Now debt itself has become the problem. A society built on consumption will have to pay more attention to saving. The idea that using borrowed money to buy assets” is over, “the debt-financed model has reached its limit. Most of the options for dealing with the debt overhang are unpalatable. … The battle between borrowers and creditors may be the defining struggle of the next generation.”