Banks Are Causing Deflation

Last year I have predicted that 1% stimulus package enacted by Bush will do nothing for the economy. That prediction has unfortunately proven to be true. Economy now is in a much worse shape. Last quarter GDP contracted at annual rate of 4%. Unemployment has risen sharply. Even in California where I live, home to most vibrant investment, start up and high-tech community, the unemployment is now at 9%.

I have also argued that banking standards had to be lowered not tightened and that interest rate be reduced or caped. In September 2008, I have written that banks should be only bailed out if the interest rates were capped. Opposite has happened. Banks received funding but has not resumed any lending. Mortgage rates stayed the same despite fed rate reduced to virtually zero. Banks are saying that they are helping home owners to work out mortgages but in fact they are sending work out packages that are more onerous than existing mortgage. Many of the home owners are upside down on their mortgage, which means the can't sell, move or refinance. As a result housing crisis is accelerating, more foreclosures, more wealth destroyed and more people are suffering.

Fear of inflation has been replaced with fear of deflation. How is possible you would think with so much of government's injection of money? I suspect that the reason is that the banks are "sitting" on it. By not lending, banks are effectively reducing money supply thus causing deflation.


One way that monetary expansion can occur is to get around the banks - such as direct funding of specific projects, which is the aim of Obama's stimulus package.


So, will the Obama's package which is about 10% of GDP work? In such a deep crisis, I am afraid it may not be enough. In addition to government spending, credit must be made to flow again.

Obama's administration, has authorization to use second have of TARP money. They need to put restrictions on the use of those funds to be directed towards reducing lending rates and reducing lending standards (now even people with excellent FICO scores are refused credit).

The banks that do not sign up to this plan should be allowed to fail.