Fundamentally, inflation must be suppressed: Greenspan wants homeowners helped - BBC
Back in the days when Kings ran the Western World, inflation, or, as it was then, in my view, more accurately termed, clipping coins, was a solution to the problem of over-indebtedness- depreciate the value of the currency sufficiently that debt service becomes easier. The other solution, (leaving aside, as Mr. Greenspan et. al. have done, the notion of avoiding the imbalances altogether) was to liquidate- deflate the amount of debt. Of the two, the Kings learned that inflation tended to be less disruptive to the current power structure as the losses were distributed widely.
The anti-Monarchical early Americans took a dim view of the Kingly prerogative to depreciate the currency on his whim and, with a few temporary exceptions, maintained a stable currency with the US$ fixed at 1/20th of an ounce of Gold. Liquidation was the preferred solution under this view.
Liquidation remained the preferred solution until the Great Depression struck. Power, as it is wont to do, became concentrated and inflation was once again seen as a solution. Under Franklin D. Roosevelt the price of Gold was raised from $20 to $35 in an effort to ease debt service burdens.
During the intervening decades, the US Financial System was reformed into an unrestrained inflation machine. First the citizens of the US lost their ability to demand specie (Gold) from the banks and thus force a liquidation or deflation and then foreign governments too lost their ability to demand specie.
Thus the imbalances which grew during the 60s and early 70s, in part a result of Vietnam War debts, were, in a sense, resolved through $ depreciation. Efforts to maintain a fixed link between the US$ and Gold during that period would have engendered liquidation. Let me repeat that to stress the point, efforts to maintain a fixed link between the US$ and Gold during periods of US financial imbalance engenders liquidation, i.e. deflation.
And, it seems, this maxim still holds true.
Consider the chart below.
As you can see, "stress" in interbank lending markets (measured here as the spread between LIBOR and OIS) peaked earlier this year in late August/early September and declined into early November only to turn up again, setting new highs, in early December.
Coincidentally, the US$ price of Gold, which had traded under $700 for most of 2007, rose significantly from September to early November- the period during which interbank lending stress eased. Interbank lending stress rose once again during the most recent period when the price of Gold did not advance.
It seems to me one could argue (and I am) that a depreciating currency, in this case, the US$, as was the case back when Kings clipped coins, is a solution to the stress caused by financial imbalance, and vice versa, that any strengthening of the US$ increases stress and raises the possibility of liquidation or deflation.
It's good to know some things never change.
Alas, some thing do change- notably, the views of those who run the show. These days, in many instances, faith in the "cure" is stronger than faith in avoiding ill health, as Greenspan's embrace of the virtues of mitigating the effects of a burst bubble, rather than pricking it early on, demonstrates. But, I believe this faith is misplaced. There is no "cure" if one defines "cure" as a return to previous conditions before imbalances had become unmanageable. There are only solutions like inflation or deflation.
Thus I find Greenspan's recent calls for inflation to be suppressed, and for the state to coincidentally forestall the liquidation of mortgage debt most confusing. To truly suppress inflation, one should avoid the imbalances that beg such a solution. Now that the imbalances are there, and given the near universal distaste for a deflationary liquidation, suppressing inflation is akin to trying to stop a process already in progress- kind of like prescribing diarrhea medication to the constipated.
If the powers that be really want to relieve the stress in interbank lending markets (and the indigestion metaphor seems quite apt here), they might consider letting the US$ fall further. Judging by the graphs above, this does seem to help.