The bursting of a credit bubble is a deflationary event. In the case of the Great Depression is was massively deflationary. In order to understand how deflation happens, you need to understand how currency is created and how it can disappear.
When you or I take out a loan from a bank the bank does not actually loan us any of the currency that is on deposit at the bank. Instead, what it does is, the moment you sign that mortgage, loan document or credit card receipt the bank creates those dollars as an accounting, or book, entry. In other words, we create the currency and the bank or credit card company gets to charge us interest for the currency we just created. This brand new currency that we created then becomes part of the greater money, or more accurately, currency supply. Much of our currency is created in this way.
But when a house goes into foreclosure, a loan is defaulted on, or someone files bankruptcy the currency loaned against those assets disappears. So as credit is destroyed the currency supply contracts and deflation sets in.
This concept can be a little difficult to understand. During the Great Depression, and even more so today, money is a concept. Think about it for a moment. What is the U.S.Dollar based on today? What determines its value? It is no longer based on gold or silver or any other precious metal, or anything tangible for that matter. The U.S. Dollar is a “fiat” currency. Many suggest that fiat currencies – all the world’s currencies are fiat by the way– are based on nothing. The value of the dollar floats against other currencies. It’s value is determined by how the dollar trades against other fiat currencies in the $4 trillion Forex market.
This is what happened in 1930-1933. As a wave of foreclosures and bankruptcies swept the country, one third of the currency supply of the United States simply evaporated into thin air. Over the next three years, wages and prices fell by a corresponding one third.
At the time, because our currency – the dollar – was backed by and fully redeemable in gold, there were constraints on the response of the Federal Reserve to these deflationary events. The Federal Reserve did not have the option of flooding the economy with fresh, newly minted or printed (or more appropriately today, electronically created) currency as it does today.
This explains, at least in part, why the Federal Reserve is creating trillions of dollars of new currency and pumping it into the economy. They are desperately attempting, through the only policy action they know, to reinflate the currency supply, prop-up collapsing businesses and markets, and stave off deflation. Will their efforts be successful? That is the $64,000 question. Many support the approach, others believe it will result in inflation, or even hyperinflation. I believe they will ultimately fail and our economy will be plunged into deflation and depression.