http://www.zerohedge.com/article/guest-post-sound-one-hand-clapping-what-deflationists-may-be-missing

Submitted by Chris Martenson of ChrisMartenson.com and creator of The Crash Course

The Sound of One Hand Clapping - What Deflationists May be Missing

My central thesis to this crisis, developed a few years before it even hit, is that the economic troubles are the symptoms while the money system itself is the cause.

My views on this are expressed in the opening of an article I initially penned in 2006, but updated in 2008:

Within the next twenty years, the most profound changes in all of economic history will sweep the globe. The economic chaos and turbulence we are now experiencing are merely the opening salvos in what will prove to be a long, disruptive period of adjustment. Our choices now are to either evolve a new economic model that is compatible with limited physical resources, or to risk a catastrophic failure of our monetary system, and with it the basis for civilization as we know it today.

In order to understand why, we must start at the beginning. While it was operating well, our monetary system was a great system, one that fostered incredible technological innovation and advances in standards of living, two characteristics that I fervently wish to continue. But every system has its pros and its cons, and our monetary system has a doozy of a flaw.

It is this: Our monetary system must continually expand, forever.

The article above provides the big picture backdrop that drives my long-term vision and thinking. I raise it now so that you'll understand that I principally view the economic world through a monetary lens.

The hot topic of the day is "Inflation or Deflation?" and the camps are firmly divided into the inflationistas and deflationistas. When asked which camp I am in, I reply "Yes." Some would say that puts me in the confusionista camp, but I actually have an explanation for why are living in a world of 'both.'

From a technical perspective we are absolutely in one of the most powerfully deflationary periods in history, yet besides housing prices and a few over-produced consumer goods, we find that stocks, bonds and commodities are all well bid at the moment.

While we can ascribe some of this to the artificial wall of liquidity (come to think of it, is there any other kind?) being thrown into the financial market(s) by the Fed, it leaves hanging the question of why that money is not being completely swallowed into the bottomless black hole that the deflationist camp says lies at the heart of our current financial system.

And they are right; there is a black hole at the center. If we treat the credit doubling (from $26 to $52 trillion) that occurred between 2000 and 2008 as a normal bubble that will follow the same pattern of decline as numerous historical bubbles, then we might reasonably predict that some $26 trillion of debt will somehow "go away" over the next 6 years. This is indeed a massive black hole.

Yet everything just keeps perking along. What gives?

The answer, I believe, requires us to ask a Zen-like question along the lines of "what is the sound of one hand clapping?" That question is, "If nobody recognizes a defaulted debt on their balance sheet, does it exist?"

Suppose, for the sake of argument that a world exists where banks are allowed by their regulators to pretend their default losses simply do not exist. And, even more outlandishly, some of these banks are allowed to sell heavily damaged loans to their central bank at nearly their full original price.

What does "deflation" mean in such a world? Not much, as it turns out. At least from a monetary perspective, because money is not being destroyed at nearly the rate that would be expected or predicted by the size and rate of the defaults.

This is the world in which we currently live. Trillions in probable and provable losses quietly exist out of sight on the balance sheets of the Federal Reserve and other financial institutions. If they ever come out of hiding and onto the books, I think the deflationists will be proven correct in spades.

But let me ask this; what prevents the authorities from simply storing them out of sight in perpetuity? Or at least long enough to allow the wave of liquidity to work its inevitable magic? So far, much to my great surprise, they've managed to do exactly that with hardly a squeak from the mainstream press (although the blogsphere is on the job, as usual). I am now wondering if they cannot keep this up indefinitely.

So from a purely monetary perspective, money can only be "destroyed" if banks and other financial institutions have to recognize the losses and take a hit to capital. If the loss is not recognized, no money is destroyed. At least it is not recognized as gone.

Perversely, when a bank sells a ruined loan 'asset' to the Federal Reserve, it is a double shot of money to the system - the money initially created upon the issuance of the original loan which is still out there in circulation, and a second bolus when the Fed creates money out of thin air to buy the failing 'asset' from the bank. One blob of money into the system when the loan is made, another when it is bought by the Fed. One loan, two blobs of money. Many have failed to recognize this feature of the Fed's asset purchase programs.

So from this perspective we could even argue that by employing the 'pretend and extend' strategy coupled to an aggressive Fed purchase policy, it is possible that more money is being created than destroyed right now. Which means that from a strictly monetary perspective I am not yet sold on the idea that money is being destroyed at the rates sometimes implied by the deflationary arguments.

Also, the data is not really in support of that notion either:

Of course, this money needs willing lenders and borrowers which brings us back to the matter of price deflation.

Out in the real world where consumers and producers exist, the bursting credit bubble has severely cut off consumer's access to and desire for new credit and producers have dialed back excessive capacity and cut their prices in order to attract business and survive.

About this process there can be no doubt, but here I would argue that falling prices are currently as much a matter of supply and demand as they are a monetary issue. In other words, the price deflation we are currently seeing is not a pure monetary phenomenon.

Which means I think we are in a bizarre hybrid world, where deflation should be the order of the day but it currently is not because its impacts are being held in abeyance by the simple expedient of pretending the losses do not exist.

My current outlook calls for productive capacity to continue to fall out in the real world even as the Fed conjures more money into existence in the make-believe world of 'high finance' (what are they smoking over there?).

Is this not a recipe for eventual inflation? More money but fewer goods and services? History says 'yes.'

All that said, I would not disagree with the notion that there's another year or three of grinding along as stock and bond prices are concerned, possibly down but maybe not, before the monetary/goods imbalance comes charging out of the chute ready to throw off the unwary and trample them in a blistering round of inflation.

But it could be sooner than that. Or later. The point here is that we really don't know and because our monetary system operates on faith, it means that we have to be prepared for the fact that a shift could happen at any time. Nobody can predict when a school of fish will suddenly turn to the left. Who knows what final trigger will cause a critical minority to suddenly determine that they'd rather hold things than paper?

For now, while I understand, and appreciate the deflationist argument, the only thing that would convert me fully to that camp would be a sudden return to rigorous application of honest accounting. If you derisively snorted at that last sentence, then we share the same assessment of the likelihood of that happening any time soon.

In order to answer the main question of this article we regretfully have to turn to Dadaism* to develop an appropriately absurd non-sequitur:

"What is the sound of one hand clapping? Insanely high stock and bond prices."