Inflation? Deflation? Both?
The credit crunch affecting this country is superficial. Banks have hoardes of cash, but they can't lend because the other assets on their books (namely MBSs and CDSs) are being marked down to market during a time when there is currently no fluid market to provide accurate pricing feedback. With these assets being marked at dimes on the dollar, and the government requiring a certain amount of assets for every dollar that the bank lends, these banks must stop lending to keep their balance sheet ratios.
This is the first time that the U.S. enters a recession with these fair market valuation accounting rules. If GAAP accounting for investments was still at cost rather than this hard-to-define notion of fair value, there'd be at lease more ability for banks to lend out money. Whether that'd eventually lead to more doom and gloom is another debate, but it's hard to argue that credit (and therefore, money) would be more readily available if not for the GAAP rules. Ironically, the same accounting board that brought you these FMV rules are trying to move away from US GAAP towards international standards, where there is mostly cost-valuation accounting. Go figure.
Jumping to another topic for a minute... Right now, there is a fear that deflation is rearing its ugly head. Why is deflation so scary? Observe the housing market: prices have gone down, so your dollar buys more for its buck, which is basically the effect of deflation. But yet many people aren't buying, because they just can't wait to see how much lower it will go! This wait-and-see attitude sets up a decrease in buying, which decreases top lines for companies, which in turn lay off people to keep margins, which means less employment and thus less money in the people's hands to buy stuff, which leads to less buying, which decreases top lines for companies... etc. Hence a deflationary spiral... the last time we had one of those in the US was the great depression. Japan experienced it in the 90's and took about 10 years to dig itself out. But what are the signs that it's happening here? Well, as I pointed out, housing is spiraling. Commercial real estate is not far behind. On Monday, we showed the ability to lose more than a trillion dollars in day of trading. Credit markets are tightening even more with these FMV write downs. Baby boomers are entering retirement with less money in their 401Ks than they had thought and will likely have to control spending for the rest of their lives. You name it, and I bet you there's a sign of money tightness there.
But what happens when we recover down the road after the fed has "helped" us all by pumping money into our banks? All of the sudden, defaults are less of a concern. CDSs are valued higher again. Commercial real estate comes back. CMBSs are written up. All that compensation that the fed did to keep us from deflating to death has now flooded our economy with money. And these write ups are doing the same. Now the fed has to jump into action and make money less available again. Can it possibly act quick enough?
I fear we're building ourselves towards a tricky battle with inflation that we do not want.