How "It" Can Happen Here

The Cast of Characters

Mr. Consumer
Mr. Producer
Mr. Investor
Mr. Banker
Mr. Central Banker

The Props

$10 in cash
10 pounds of widgets

Act I

The curtains open. Mr. Consumer buys 10 pounds of widgets from Mr. Producer for $10. Mr. Producer gives the $10 to Mr. Investor. Mr. Investor deposits $10 in Mr. Banker's bank. Mr. Central Banker smiles. The curtains close.

Act II

The curtains open. Mr. Producer goes to Mr. Banker. He says, "Look at those widget prices. $1 a pound! If you loan me $20 then I can produce 20 more pounds and we can both be happy." Mr. Banker looks at the numbers and likes what he sees. Loan approved! Thanks to fractional reserve banking, Mr. Banker loans $20 out even though he only has $10 in deposits. Mr. Producer produces 20 pounds of widgets. Mr. Central Banker smiles. The curtains close.

Act III

The curtains open. Mr. Consumer goes to Mr. Banker. He says, "I'd like to buy 10 pounds of widgets, but I don't have any money. If you loan me $10 then I can buy 10 pounds of widgets and pay you back later." Mr. Banker looks at the numbers and likes what he sees. Loan approved. Thanks to fractional reserve banking, Mr. Banker loans another $10 out even though he only has $10 in deposits. That's $30 in loans to $10 in deposits. Mr. Central banker smiles. The curtains close.

Act IV

The curtains open. Mr. Consumer pays Mr. Producer $10 for 10 pounds of widgets. Mr. Producer deposits $10 in Mr. Banker's bank. Mr. Central Banker smiles. The curtains close.

Act V

The curtains open. Mr. Banker calls Mr. Consumer. Mr. Banker says, "You haven't paid me the $10 you owe me." Mr. Consumer says, "I have no money. I could give you 10 pounds of widgets though." Mr. Banker hangs up and calls Mr. Producer. Mr. Banker says, "You still owe me $10. Have you got it?" Mr. Producer says, "Um, well, there's a bit of a problem. Mr. Consumer only bought 10 pounds of widgets. I could give you the extra 10 pounds of widgets I still have though." Mr. Banker panics. He thinks to himself, "What the @#$% am I going to do with 20 pounds of widgets? I need the @#$%ing $20 back!!" He calls Mr. Central Banker. Mr. Central Banker frowns as he prints $20 in new money and bails out Mr. Banker. Crisis averted. The curtains close.

Epilogue

The curtains open. There is now $30 sitting in cold hard cash sitting on the table. There are 30 pounds of widgets sitting on the table. There's a sign above it that says, "Even with the bailout causing $20 of freshly printed money to suddenly exist, widgets are still worth $1 per pound. Deflation averted. Hyperinflation averted." Mr. Central Banker smiles. The curtains close.

You will note that the printing of the $20 did not create inflation in this example. That $20 was already thought to exist. The initial creation of the credit is what propped up widget prices. Otherwise, 30 pounds of widgets with just $10 of actual money in circulation would imply widgets should be 67% cheaper.

So how can deflation happen in our world? There's a key sentence back there that needs more thought.

"Mr. Central Banker frowns as he prints $20 in new money and bails out Mr. Banker."

What if our Mr. Central Banker doesn't actually print all $20? Or what if he instead simply loans money to the Mr. Bankers? Or what if he tells Mr. Bankers to pretend the losses never actually happened? Or what if it is all of the above?

$20 billion hole in FDIC Insurance Fund

Reggie Middleton is an investor and analyst who owns BoomBustBlog.com. He was one of the earliest to warn of the impending downfall of Lehman Brothers and Bear Stearns. Middleton told me, “If the FDIC had more money and manpower, it would be closing a lot more banks.” Middleton also said, “Many of America’s 8,000 banks are insolvent or close to it because of mark to market accounting.” Because of accounting rule changes, banks are allowed to value toxic assets for whatever they think they are worth, not what they actually are worth. Some call this “mark to fantasy accounting.” Middleton warns, “There is more risk now (in the banking system) than during the Lehman crisis because the pool of banks is smaller.”