Building on what Drwasho wrote back in June, I have to say, I’m really not sure. There’s a good reason to believe both could happen but as always timing is the hardest part to predict.

The case for deflation is a strong one – commercial bank credit is in freefall as banks look to let their commercial loans run down and don’t seem to be replacing them with new investments. This has to have a strong deflationary effect on the economy and it’s unlikely any amount of prime-pumping on behalf of the Fed can counteract it. In fact, a lot of the new money is simply sitting in excess reserves, likely going into treasuries or simply collecting interest from the Fed (a new ‘tool’ in the Fed’s arsenal – paying interest on excess reserves) rather than funding new loans.

The deflationary theory is hardly new; it’s exactly what happened during the great depression. Rothbard, in America’s Great Depression, highlighted a few key reasons as to why deflation occurred despite the low interest rate, cheap money inflationary policy pursued by the government of the day. They are:

1)     Lower interest rates further discouraged the banks from making loans or investments. Just when risk was increasing, the incentive to bear risk—the prospective interest-return—was being lowered by governmental manipulation.

2)     The enormous increase in bank failures. With over 1,000 banks failing every year, bankers knew in their hearts that no bank (outside of the nonexistent ideal 100 percent bank) could ever withstand a determined run.

3)     Foreigners lost confidence in the dollar, partly as a result of the program, and drew out gold;

4)     American citizens lost confidence in the banks and changed their deposits into Federal Reserve notes;

5)     Bankers refused to endanger themselves any further, and either used the increased resources to repay debt to the Federal Reserve or allowed them to pile up in the vaults.

Today a lot of the conditions that prevented the politically ‘desired’ inflation from occurring back in the 1930s don’t exist. For one, we have a fiat money regime rather than a gold standard making it harder for foreigners to convert their US dollars to gold or other assets without losing value. Another big difference is that government’s around the world enacted a policy of deposit insurance, thereby preventing mass bank failures (creating ‘zombie banks’ instead) through bank runs. But aside from those two differences, the other points still hold true.

It’s important to remember that Bernanke is well schooled in the great depression. His problem is not that he doesn’t understand why inflation didn’t occur; it’s that he still believes inflation is the correct solution and is therefore looking to prevent the above from causing deflation this time around. He’s going to go all-out in an attempt to reinflate the bubble rather than let the necessary deflation and restructuring work its magic.

So can he do it?

This is what I’m not sure about. It’s going to be very difficult to get people to leverage up this time around. What we do know is that Bernanke will stop at nothing in his attempts to reinflate the bubble, an effort which may amount to nothing more than blowing air into a broken balloon. Excess reserves have increased astronomically, as they did in the great depression, but the question is whether they will make it into the money supply or not. At this stage every attempt has been fleeting with banks quite happy to buy up treasuries or simply take the small, but safe, return that the Fed pays them.

Will the new powers the Fed is after allow Bernanke to charge a negative interest rate on excess reserves, forcing banks to buy existing securities or create new loans, thereby increasing the true money supply? Will the growth in the public sector, public works, ‘stimulus’ and so on create enough spending to drive inflation faster than the private sector is deflating? These are all very curious questions and unfortunately, at this stage, no one knows. We’re stuck in limbo and all I can say is that the next several months are going to be very, very interesting.

Concerning Australia, this time around we have China. While in the great depression we were one of the hardest hit due to our export dependence and protectionist policies pursued by our major trading partners, this time we have a centrally-planned major trading partner in China instructing their factories to keep production up and, therefore, demanding our commodities. The export-focused, mercantilist policies of the Chinese government, while depriving their own citizens of deserved wealth, are in effect a subsidy for the Australian economy. By artificially keeping their currency low and subsidising their export industries they’re not only increasing demand for our raw materials but are supplying us with goods that are cheaper than they would be if China was a more free market orientated country. Yes, this is a bad thing for the Chinese people, but it’s good for Australians.

This leads me to believe that it won’t be as bad here as it will be in Europe and the US, despite our government rolling out the third largest stimulus package behind only the US and Korea (on a per-capita basis). The biggest threat to Australia is the growing size of the public sector, of increased regulation and the massive debt that we, and future generations, have been laden with for no good reason.

It seems, as with the US, Australian banks are finding it difficult to (likely voluntarily) create new loans to replace the ones that are running down. I’m more concerned, at this stage, about inflation in Australia than in the US. The RBA has been a bit reckless with their monetary policy – for example, they just increased the currency stock by $4 billion – an increase of almost 10% on the existing supply. This is money that won’t be sitting idle; it’s being spent and will have an impact on prices, perhaps not immediately due to the winding down of credit, but it will in the future. What happens when the banks start expanding credit and the RBA’s cash injection is already flowing?  This, together with the irresponsible spending by the government will have to force interest rates to rise if we’re to have any chance of avoiding price inflation.

When the government’s stimulus proves to be ineffectual at providing long-term jobs we’re probably going to be faced with rising inflation, rising interest rates and rising unemployment. But with an election looming, we probably won’t hear anything about that until Rudd is sworn in for a second, and probably final, term. The Keynesian solution adopted by this government requires endless doses of government spending, deficits and new money which will only lead to a growth in the welfare state, inflation and wealth destruction. The real solution is simple: get the government out of the way and let the necessary coordination between prices, costs and wages take effect.