Deflation is a monetary and psychological event. The Sentinel's second economic law says deflation is a lack of confidence. That is the psychological event. The monetary event is the contraction of credit and increases in personal savings. If the public were simply given money by the authorities in a deflationary environment, much of it would be hoarded or used to pay off existing debt. The net effect monetarily would not be the one desired by government or Fed authorities.
Debt will only go away by one of two methods: a) default (non-payment), b) payment. Government and Federal Reserve action has forestalled the failure of illiquid institutions. As we move further into the economic doldrums, more institutions will fail and the authorities will be unable to rescue them.
Our arrival at this economic point is a factor of our money /credit system and social changes. The Sentinel uses technical analysis and a model called The Saeculum to forecast social and economic trends. A Saeculum is a unit of time roughly equal to a human lifetime (approximately 80 years). Changes in social and economic trends are cyclical and our models assist in identifying these changes. The inaugural issue of The Sentinel newsletter (available for no charge under the "Free Material" link at the top of the page) outlines the evolution of our money/credit system and provides a simulation for deeper understanding.
The capital of many banks today is tied up in mortgages or mortgage securities. In days past, much bank capital took the form of safer, short and long-term government securities. With such risky capital and a greater propensity of bank failure the last two years, banks are no longer the safe haven they once were. But what about the Federal Deposit Insurance Corporation (FDIC)?
The FDIC is a woefully undercapitalized institution. We wrote about this topic in the January 2010 forecast issue. The FDIC maintains a Deposit Insurance Fund (DIF) that by statute must maintain a reserve ratio of 1.15%. On September 29, 2009, the FDIC adopted a plan to return to this ratio – within 8 years!
Presently, deflation is a far greater danger due to the reduction in the amount of outstanding credit. There are many more reasons to argue for a deflationary environment. A deflationary environment means something totally different for investors than they have witnessed in the past one or two generations. Being prepared for this economic environment is something few investment advisers recognize. Read The Sentinel for more details.