Deflation is usually precipitated by a recession, or the bursting of an economic bubble .
As demand for products falls ,deflation results in a steady erosion of prices.
As we have seen, the real estate bubble popped, resulting in a dramatic decrease in real estate values.
The sub prime lending mess, has accelerated the falling prices. There is now an avalanche of houses for sale or foreclosed , causing a glut on the real estate market.
The lack of down payment requirements of these dubious mortgages, has made it easier for people to walk away from their homes, once the values began to drop below the amount still owed on their mortgages.
In hindsight, some of these subprime recipients should not have taken on the responsibility of owning a home. Giving them these mortgages was a gamble, with the World economy unraveling based upon a bad bet.
The lenders and investors who packaged these shakey loans to leverage and maximize their profits, should be out of a job, and prosecuted for incompetence and fraud, but instead many of them have been bailed out, by us.
The classic response to a deflation has been for the Federal Reserve to lower interest rates, and gently expand the money supply. Lowering taxes and encouraging spending, is designed to restimulate business activity.
The problem we are faceing today is unfortunately more complicated.
The $trillions of dollars of subprime loans were packaged into new very risky investment vehicles, which were them marketed throughout the World financial community as higly leveraged “safe ” investment vehicles.
This worked, until the real estate bubble finally burst. As property values fell, the risky mortgages, began to unravel. The highly leveraged (as much as 30x’s) investment vehicles began to crash, exposing a very highly leveraged collateral asset on the books of most banks, Wall Street firms, Insurance companies, and even personal and Hedge fund portfolios..that were basically worthless.
Margin calls and capital requirements became a torrent of financial agony.
Credit and lending stopped! Abruptly!
No mortgages! No auto loans! Shrinking credit card limits! No business loans!
Worst of all, the entire banking system was locked down and dangerously close to disaster,World Wide!!!
Next: Deflationary Spiral. Are the Bailouts Working?