"It's the 'Deflation', stupid"

Sometime it's interesting to revisit certain speech or article as they make more sense in today context. The one below is from Ben Bernanke, Chairman of the Federal Reserve made in 2002.

It's about Deflation and its consequences. I have put an unusually big extract from the speech as it is really worth to read.

Although I would like to highlight few points and correlate them with todays actions and situation.

"even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation"

"massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year"

Some action taken:

->Now interest rate in the US have been falling very sharply, they went from 5% to 2.25% within 6 months.

->At the same time, deflation is bitting hard : house price are on free fall. According to Case-Shiller Survey , Home price index in the U.S. fell by 10,7% in January..a Record since the last depression in 1930.

Let remind us that chairman Ben Bernanke spent much of his career studying the Great Depression and realized that it was the failure to respond to the collapse of financial institutions in the 1930s - and the panicking of banks - that turned a market crash into a general economic disaster. You could read his book if you want to know more see link .

So the last episode was about Bear Stern... or rescuing a major financial institution, what would have happened if they didn't? have a look with the following analysis :

"We may never know for sure whether the Federal Reserve's rescue of Bear Stearns
averted a seizure of the $516 trillion derivatives system, the ultimate
Chernobyl for global finance.

Bear Stearns had total positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP - at least in "notional" terms "

"If the Fed had not stepped in, we would have had pandemonium," said James Melcher, president of the New York hedge fund Balestra Capital.

We are at an inflection point where the global economy could go both directions, for the best or the worse... Let's hope that the guy at the wheel knows what he is doing ...

Another important poin is if we are heading toward deflation, on a global scale then debt is a burden and cashholder are kings.

No wonder you see some institutions or investors buying 2 year US Bond yielding 1.75%...people are parking their money in the safest possible place: government bond... at least for a period of 2 years...

Looks like more and more are thinking that chairman Ben Bernanke will not succeed in rescuing the financial system. Europe will come to the rescue most probably at the end of the year after the U.K. Spain housing market join the deflationnary party...

Here is the article regarding the ravaging effect of deflation, by chairman Ben Bernanke :

"Deflation is defined as a general decline in prices, with emphasis on the word "general."

"... some have expressed concern that we may soon face a new problem--the danger of deflation, or falling prices."

"So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons."

"The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow... . A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape."

"The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers..."

"Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy."

"To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn. "

"Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value."

"Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year."