Won't we get inflation BEFORE deflation?

(Reposted from EWI message boards, www.elliottwave.com )

Question: It seems that the U.S. Federal Reserve is committed to a course of ever-increasing liquidity and credit expansion. Even with a rising Fed Funds Rate, the Fed has found other ways to pump money into the economy. Given this behavior, is it not equally - or even more likely - that we will experience an inflationary depression as opposed to a deflationary depression?

Answer: Here's an answer Bob Prechter gave in his November 2005 Elliott Wave Theorist:

"The consensus appears to be that the long term expansion in the credit supply will continue or even intensify under the Fed chairmanship of Ben Bernanke. One reason many people share this belief is their recollection of Bernanke’s November 2002 speech, “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” in which he likens the Fed’s printing press option to dropping money from helicopters. There are reasons to believe, however, that the outcome will not be as the majority expects.

"One reason that Bernanke is likely to preside over a deflation in credit is that everyone believes the opposite. Investors have poured money into commodities, precious metals, stocks and property in the belief that if anything is certain, it is death, taxes and inflation. When the majority of investors thinks one way, it is likely to be wrong. This is basic market analysis.

"A more complex answer begins with the understanding that analysts constantly confuse credit creation with money creation. In fact, just today an essay became available on the Internet that includes a presumptuous edit of a statement by the dean of Austrian economics, Ludwig von Mises. In Human Action (p.572), Mises said, “There is no means of avoiding the final collapse of a boom brought about by credit expansion.” This statement is true and undoubtedly reads as intended. Yet the author of the article felt compelled to explain von Mises, with the following insertions: “There is no means of avoiding the final collapse of a boom brought about by [bank] credit [and therefore money] expansion.” First, a credit boom does not have to be financed by banks. As Jim Grant recently chronicled, railroad companies financed one of America’s greatest land booms, which, as Mises predicted, went bust. Second, credit is not money. Economists speak of “the money supply” as if they were referring to money, but they are not; for the most part, they are referring to credit. The actual supply of dollar-denominated money, legally defined in today’s world, is Federal Reserve Notes (FRNs), i.e. greenback cash. That money provides a basis for issuing credit. Credit may seem like money because once extended, it becomes deposited as if it were cash, and the depositor’s account is credited with that amount of money. But observe: the account is only credited with that amount of money; the actual money upon which that credit is based is not in the account. Every bank account is an I.O.U. for cash, not cash itself. Needless to say, the $64.3 billion in cash in U.S. bank vaults and at the Fed is insufficient backing for the 38 trillion dollars worth of dollar-denominated credit outstanding, not to mention at least twice that amount in the implied promises of derivatives. The ratio is about 1 to 600. This ratio has grown exponentially under the easy-credit policies of the Fed and the banking system.

"When credit expands beyond an economy’s ability to pay the interest and principal, the trend toward expansion reverses, and the amount of outstanding credit contracts as debtors pay off their loans or default. The resulting drop in the credit supply is deflation. While it seems sensible to say that all the Fed need do is to create more money, i.e. FRNs, to 'combat deflation' it is sensible only in a world in which a vacuum replaces the actual forces that any such policy would encounter. If investors worldwide were to become informed, or even suspicious, that the Fed would follow the ’copter course, it would divest itself of dollar-denominated debt assets, causing a collapse in the value of dollar-denominated bonds, notes and bills. This collapse would be deflation. It would be a collapse in the dollar value of the outstanding credit supply.

"Contrary to popular belief, neither the government nor the Fed would wish such a thing to happen. The U.S. government does not want its bonds to attain (official) junk status, because its borrowing power is one of the only two powers over money that it has, the first being taxation. The Fed would commit suicide by hyper-inflating, because Federal government bonds are the reserves of the Fed. That’s why it is called 'the Federal Reserve System.' U.S. bonds are the source of its power. As long as the process of credit expansion is done slowly, as it has been since 1933, people can adjust their thinking to accommodate the expansion without panicking. But by flooding the market with FRNs, the Fed would cause a panic among bond-holders, and their selling would depress the value of the Fed’s own reserves. The ivory-tower theory of unlimited cash creation to combat a credit implosion would meet cold, harsh reality, and reality would win; deflation would win. Von Mises was exactly right: 'There is no means of avoiding the final collapse of a boom brought about by credit expansion.' Observe that he said 'no means.' He did not say, 'No means other than helicopters.'”