There was a deflation in the money supply then. Remember Clinton bragging that the government was ‘running a surplus’?
I was working for a commodity company then, the price of everything was droppping....
http://www.aei.org/publications/pubID.9831/pub_detail.asp
What are the symptoms of this dangerously accelerating deflation? To answer this question, it pays to look simultaneously at the behavior of interest rates, exchange rates, and stock prices. Normally a strengthening currency and rising interest rates together constitute a sign of economic vigor since upward real returns can generate that observable combination of price movements. Simultaneously one would expect to see stock prices climbing as a reflection of higher expected real returns. Investors in such circumstances would be switching from bonds into stocks as expected earnings rose faster than interest rates. International capital then flows into the country with rising real returns to buy into the higher expected real growth; this process leads to the popular notion that a strong economy means a strong currency. The demand for cash is stable with higher incomes pushing it up while ascending real interest rates quash cash demand and induce substitution into bonds and equities. This situation prevailed in the United States from mid-1995 to mid-1998.
Japan’s Lack of Wisdom
The picture changes in a world of accelerating deflation, especially when the government, as Japan has unwisely done, proposes to fight the deflation with more spending and tax cuts. Keynes identified absolute liquidity preference (he never mentioned a liquidity trap) as a situation in which investors have an absolute preference for cash over bonds because interest rates are so low that they expect them to rise. The conviction that bond prices can only fall (or interest rates can only rise) produces a strong or absolute preference for cash. Stock prices too are expected to fall because accelerating deflation pushes down expected earnings as the attendant rising expected of real yields on bonds and cash draws funds away from stocks. In this environment a rising currency and rising interest rates are matched by a falling stock market. This combination has appeared intermittently in Japan over the past several months and signals an urgent need for reflation.
Japan’s manifestation of the most serious deflationary symptoms demands a closer look. Japan has made a disastrous policy error by promising to fight deflation with higher spending and lower taxes. Under this plan the weaker the economy gets (and it is getting weaker, as seen in recent reports such as the Bank of Japan’s December Tankan survey), the larger the expected supply of bonds becomes. The rise in the expected bond supply supports the Keynesian notion of absolute liquidity preference by reinforcing the idea that bond prices will fall (interest rates will increase) and so funds rush into cash and out of bonds, stocks, and foreign assets. Foreigners can participate in the switch out of bonds and into cash by buying yen, selling Japanese government bonds (JGBs), and selling stocks.
So do you think we are headed into deflation?
The dramatic destruction of what Buffet called Weapons of Mass Financial Destruction before our very eyes, with hundreds of Trillions of Dollars of Derivatives collapsing in value, has dramatically lowered the available liquidity, risking serious deflation. That's why the venerable Reserve Primary Fund (money market fund) 'broke the buck'. That's why the London Interbank Offered Rate (LIBOR) spiked so high last week. That's why every single remaining one of the Investment Banks on Wall Street has died (Lehman), been taken over for pennies on the dollar (Merrill and Bear) , or (Morgan and Goldman) have morphed into a bank holding companies seeking (Morgan) or getting (Goldman, from Buffett) massive cash infusions. That's why some companies would soon have had trouble meeting payroll. That's why GM, Ford and GE were crying out for help, warning (behind closed doors) of catastrophic collapse if help was not massive and immediate. That's why well respected Chinese experts were warning us of a financial tsunami. If AIG had gone down hard, that would have added substantial accelerant, risking turning this into a financial holocaust. AIG might have been (I'm not sure) the worlds biggest counter party to these Credit Default Swap derivatives
Whether we head down the inflation or deflation path is a onetime political decision.
With the passage of the (what was it ... $600 Billion ?) omnibus spending bill last week, and the likely passage of the $700 Billion dollar bailout this week, that political decision will have been made, in favor of inflation.
Once made, like a decision to go off to war, the decision is close to absolutely irrevocable.
I anticipate the Fed dropping the Funds rate from 2.0% to 1.5% within the week, as the final seal of approval on this decision.
Inflation it shall be. A few lucky, or wise, heads never doubted that it would be inflation. Most of us, sooner or later, doubted everything including our spouse, our dog and our names ;).
Not every company, country or citizen will see Benanke's Fiat Fleet of Financial Helicopters circling overhead, dropping pallets of dollars and Treasuries. I know I sure don't see any outside my window. As a Freeper, I'm perhaps at greater risk of seeing the CIA's black helicopters.
Some financial casualties, like Lehman and Bear Stearns already, will fall in the desert, their bones picked over by the likes of JPMorgan, Citigroup, Goldman or Bank of America, with the U.S.Treasury serving up a hefty dose of Pepto Bismol Treasuries to neutralize the more Toxic financial byproducts in the corpse.