Be wise. Be brave. Be tricky. (slithytove) wrote,
Be wise. Be brave. Be tricky.

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I am not an economist.

For those of you who are -- and there are one or two of you out there -- I have a question.

My understanding of the current financial crisis is that, although it was triggered by sub-prime mortgage speculation (both on the part of borrowers and lenders) coming unglued, and made worse than it ever needed to be by the non-transparency and risk mis-classification of derivatives like CDOs, abetted by a false sense of security engendered by credit default swaps...

Despite that stuff, I say, my understanding is that the main underlying problem is banks, chiefly investment banks, but some others as well, using historically very high levels of leverage. Examples: Bear, Lehman, and those three Icelandic banks. These high levels of leverage are now being unwound.

We seem to be entering a period of financial contraction, 'deflation'. Evidence of this is the collapse of commodities. Even if industrial commodities (corn, oil, etc.) go down in response to the decrease in economic activity, gold at least should go up in bad times, because it's a stable store of wealth. Instead, it's barely held steady, and gold funds have plummeted.

So, after all of that, my question is this: Is this deflation the result the banks' leverage being unwound? Did they create an inflationary economic climate by creating money (via leverage), essentially private entities doing what the central banks are supposed to do? That what these highly leveraged banks were doing was, in essence, executing an inflationary monetary policy (without consciously intending to do so)? Now that this money/leverage has disappeared, and been taken out of the system, what we have left is deflation?

I keep hearing that because of the Fed's actions, pouring hundreds of billions into the economy (and lesser actions by the Euro central banks), we are likely to have horrendous, 1970s-type inflation in a few years. But if the above thesis is correct, this won't happen. The Fed is acting correctly, in Keynesian theory, and just filling a hole that the collapse of bank leverage (and home mortgage leverage) has created, hopefully resulting in a stable money supply, and neither serious inflation nor deflation. If they *didn't* do this, we would have another Great Depression. (In the real Great Depression, the Fed didn't do this, and that's why it happened.)

Economists: does this sound right to you?
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