gary north presents a lucid explanation of why we are heading for inflation, not deflation:

WHEN WILL BANKS START LENDING?

There is no answer from economic theory. Their willingness to lend will depend on these factors:

1. Their balance sheets
2. Their fear of private borrowers' defaulting
3. Their fear of T-bonds (rising rates, falling prices)
4. Their fear of running out of income to pay depositors
5. The rate of interest on excess reserves (FedFunds rate)
6. Their fear of nationalization

At this point, I offer my central response to the deflationists.

The Federal Reserve System can force the hands of commercial bankers at any time by charging interest on excess reserves for "safekeeping." The fact that the FED has not done this indicates that it accepts the present situation: a collapsing M1 money multiplier. It accepts the string.

Let me put it even more sharply: "The string is central to Federal Reserve policy today. It is not the FED's nemesis. It is the FED's ally."

The present economy is the result of Federal Reserve policy. Bernanke tried to pop Greenspan's bubbles, but without creating a major recession. That policy failed, as I predicted it would from late 2006 until late 2008.

The FED decided to lower the federal funds rate. This is what it has always done in the past. I predicted it would.

It also decided to swap Treasury debt for the banks' toxic assets. I did not predict this. This is Bernanke's uniquely innovative policy. But this policy has not led to a revival of bank lending. The FED is pushing on a string.

This does not mean that the FED's expansion of the monetary base is impotent. On the contrary, it means that the FED can buy Treasury debt, hold down Treasury interest rates, and enable the Federal government to buy equity in American businesses. The government can lend, as it lent TARP funds, at 5% per annum. The government can remain the spender of last resort. It can become the investor of last resort. This has already begun.

The FED knows it is pushing on a string. It loves that string. Why? Because that limp string – no commercial bank lending – delays the advent of price inflation. This has enabled the FED to achieve the following by doubling the monetary base (the FED's balance sheet):

1. Bail out the big banks (asset swaps)
2. Keep the banking system from imploding
3. Bail out the Federal government
4. Bail out Fannie Mae and Freddie Mac
5. Keep real estate from collapsing
6. Slow price inflation to close to zero
7. Keep T-bill rates under 0.5%

At what cost? Unemployed workers. That is a small price to pay if you are a high-salary central banker with a fully funded pension.

The FED's policies have not failed. They have succeeded beyond Bernanke's wildest expectations. Greenspan's bubbles are all popped. Price inflation is gone. There is no price deflation, either. For the first time since 1955, the FED has attained its mandate from Congress: price stability.

Greenspan's FED never attained the power over the economy that Bernanke's FED now possesses. The FED has been given almost complete regulatory control over the financial system. Congress buckled. Bernanke has been given a free ride. The Federal government now owns General Motors. Keynesianism is having its greatest revival in 30 years.

So far, the FED has won. Yet deflationists argue that the economy is in a deflationary spiral that the FED cannot prevent. They do not know what they are talking about. They never have.

CONCLUSION

The Federal Reserve can re-ignite monetary inflation at any time by charging banks a fee to keep excess reserves with the FED.

Anyone who predicts an inevitable price deflation does not understand that the present scenario is the product of legitimately terrified bankers and the Federal Reserve's Board of Governors. At any time, the FED can get all of the banks' money lent. But the FED knows that this will double the money supply within weeks. This will create mass price inflation.

This is the central fact in the inflation vs. deflation debate. Until the deflationists answer it with a unified voice, they will remain, as their predecessors remained, people with neither a theoretical nor a practical case for their position.

So, the FED waits. Meanwhile, the Federal government's share of the economy rises relentlessly because of the deficits. This is not going to change in the next few years.

We are seeing Keynesianism's last stand. When it fails, the FED will force the banks to lend. Then we will see mass inflation.

Mass deflation? Forget about it.

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