Most Americans are conditioned to think that inflation goes along with deficit spending.
So, with record deficits for the last couple of years, where is inflation?
I am not an economist, but a very famous economist documented what happened during the Great Depression. His name was Milton Friedman, and the study was the Monetary History of the United States. This work contributed to Milton Friedman being awarded the Nobel Prize in Economics.
According to Milton Friedman, the monetary supply in the United States shrank dramatically during the Great Depression because of the collapse of the banking system. Banks create money through their lending practices. There were very tight lending practices during the Great Depression and fewer banks to lend money. Consequently, the United States suffered an unprecedented deflation. Since money is the “blood” of an economy, the lack of money smothered our economy.
What is happening during the current economic recession and recovery? We have again seen a collapse of many banks, although there is an orderly transition by acquisition that is supervised by the Federal Deposit Insurance Company. Home mortgages have particularly seen a collapse, with foreclosures and short sales, resulting in huge losses in the balances that were funded. The banking system has tightened up credit, making it difficult for businesses and homeowners to qualify for loans.
The decrease in the money supply relating to our tight banking system has more than made up for the deficit spending by our government.
That is why the Federal Reserve continues to support the money supply through low interest discount rates and buying Treasury notes and mortgages from Fannie Mae and Freddie Mac.
Like I said, I’m not an economist and don’t claim to understand all of the details, but that’s my brief explanation about how we can have big federal deficits without having high inflation. Of course, there is still the matter about how those deficits are going to be repaid …
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