Money supply doesn't shrink, in the first instance, due to default. It remains the same. However, the inclination by the bank to continue lending at current levels is tempered by default - because its owners are losing net worth. Because normal debt repayment decreases the money supply - if there is no uptick in lending to replace this lost money - the effect of default can be deemed deflationary. What you have to remember about "money supply" is that it is a measure of monetary liabilities of the banking system - and only certain liabilities. Not all of a bank's liabilities will be monetary. The write-off is of an asset. This asset not classed as money by any M measurement. The money supply measurement doesn't change. The UK does measure assets through the "M4 Lending" statistic. However, this is not classed a money supply measurement - but a "counterpart" to the "M4" measurement - which is a measurement of monetary liabilities.
While I appreciate the simple, instructive example, injin, the big picture is, I'm sure you'll admit, more complex. Numerous sources of credit expansion have been used over the past years - fractional reserve banking with increasing lowering reserve requirements, disregard for credit-worthiness, securitisation, derivatives, the shadow banking system, corrupt ratings agencies, fraud etc. When the whole lot crashes there will be a very disorderly deflationary implosion. Liquidity is confidence... fear is a far more powerful driver of human behaviour than greed. When fear takes hold, confidence drops, liquitdity will disappear and there will be far too little money left to run the global economy.
Yes, we have had a debt deflation. But the debt deflation does not equal a monetary deflation - monetary being everything that people consider to be money: Cash, central bank credit and bank credit. These are the things that are always measured at par with cash - have the most liquidity - and are hence "monetary". Securitized debt assets are not measured at par and do not share the same liquidity. They are not monetary. As I said above - money is the most liquid instrument and measured at par with itself. If it is not liquid nor measured at par - then it is not money and never was. We are in this bind because monetary liabilities are fixed - but the income producing debt assets (and associated private debt liabilities) have vanished. If the monetary liabilities also deflated - we would not be in this problem. Why do you think liquidity will disappear? The aggregate level of liquidity is decided solely by the Central Bank. Individuals banks may suffer problems due to a lack of income producing assets - but while the CB is willing to stand as buyer/borrower of last resort and the Treasury as investor of last resort - how is this a problem? The debasement of the currency in this way is ultimately inflationary if as we see banks are forced to export this monetary inflation abroad in search of yield. It's inflationary to the target economy and inflationary due to the FX movement. This would appear to agree with what we are seeing with countries outside the US currently suffering inflation. Much the same way Japan exported the effects of its monetary inflation. It seems to me we are suffering from price deflation in things bought using debt - and secondary industries which feed off that credit - and price inflation on everyday essentials that are not. We will see worldwide monetary deflation when banks start going bust. Central banks will keep supporting their banking systems while the international value of their stock of currency, and political environment allows. The headwinds of a lack of lending one currency area and CB actions to counter that - will result in forewinds in another currency area. While it may feel like a deflationary depression to some people given the skewed distribution of money and incomes - I don't think in actuality it will be given the current course.
Interesting explanation of what's going on, but although it makes sense I still have many niggling questions. Fair point about the difference between debt deflation and monetary deflation. You're right, it has largely been the former up to now. But nonetheless, just because central banks print billions to combat domestic issues, what happens to the trillions in excess claims on hard assets that underlie them? The extinguishing of the debt is deflation even if not strictly monetary. If you only accept this debt has a secondary affect on monetary situation, it must still be significant as it ruins the confidence on which the system relies. My point about liquidity is simply that if people are uncertain they horde cash... from banks and corporations right down to individuals. Interbank lending in Europe has collapsed and the banks are keeping their money with the ECB. Corporations are sitting on piles of cash. Without trust the global economy will not work and no one central bank can pulls levers to control things globally and force spending and lending. At another, more local level, during the 2008 crisis billions were withdrawn from Aussie bank accounts in cash, never to be returned. That is just one tiny example. If credit lines seize up and cash/cash equivalents are horded due to a lack of confidence, what role can the central banks play? If people refuse to take on new debt and pay debt down due to uncertain future expectations, what can the central banks do? Simply print trillions and debase their currency? I'm not so sure tenable. Just because they print who's to say lending will resume. So you've said what it won't be (deflationary depression), so I am eager to hear how you see the inflation playing out, injin. In my mind it is a huge bubble which has first to deflate before the inflation can take place.
