The battle between credit contraction and government-sponsored inflation rages on. For several weeks, the forces of credit contraction have been winning.

There are fears that banks will never expand lending again, and that everyone with debt wants to pay it down as fast as possible.

I think these fears are excessive. They ignore the massive and limitless inflation schemes coming from the Treasury and the Fed.

Those fearing deflation assume that every American consumer is stereotypical: an overextended, credit card-addicted, house-flipping gambler. This is simply not the case. Many Americans don’t have a mortgage. And most Americans with mortgages are still making their payments.  They have, however, temporarily reigned in discretionary spending because of falling house and stock prices.

Those fearing deflation also assume that demand for debt is low and falling. But demand for debt doesn’t always come from businesses or households looking to invest more or spend more. Any business or household looking to refinance existing debt at lower rates — and there are many — is a source of demand for new debt. Banks borrowing at the Fed window at 1% or less will be looking to supply this new debt by make highly profitable loans to creditworthy borrowers.

Once borrowers refinance, they may not be as aggressive about spending or expanding business as they used to be. But at least they will have access to credit. In the Great Depression, they did not. So the economy fell into a negative feedback loop of asset sales, bank failures, and rising unemployment.

Treasury and the Fed will keep taking extreme measures to slow down the pace of credit contraction and housing prices — cutting off this deflationary feedback loop. This could include nationalizing Fannie Mae and Freddie Mac and using the Treasury’s low borrowing costs to refinance hundreds of billions in existing mortgage debt into new 40- or 50-year mortgages with reduced principal balances.

Sure, such an action would guarantee a decade or more of stagnation in housing prices, but it will also slow or flatten the rapid decline in prices. This is the essence of the Treasury and Fed actions: to stop the deleveraging from getting out of control — even at the cost of future economic stagnation. Like it or not, I think this is the most likely outcome from this crisis.

If this new debt is too much for savers and foreigners to absorb, I’m sure the Fed would set up an Enron-style conduit to buy up, or “monetize” new Fannie Mae paper.

Remember, Fed Chairman Bernanke believes that the Great Depression and the Japanese deflation grew steadily worse because the government and central banks weren’t radical and decisive enough in their pro-inflation policies.  So there’s every reason to expect radical new inflation policies in the coming months.

Best Regards,
Dan Amoss
November 17, 2008

Dan Amoss

Dan Amoss, CFA, joined Agora Financial from Investment Counselors of Maryland, investment adviser for one of the top small-cap value mutual funds over the past 15 years. As a buy-side analyst, Dan refined his value investing approach by meeting with corporate executives and sell-side analysts and writing proprietary research for the fund’s management team. Dan is the editor of Strategic Short Report.

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