The next burden: inflation

It is now clear that every government in the west is going to try their best to ensure that no savers lose any of their deposits. The Federal Reserve is lending directly to companies, and here in the UK, the government is going to start buying shares in UK banks. There is no escaping the severity of the crisis. Monetary authorities around the world are now focused on trying to ensure that we avoid the fate of the United States in the Great Depression of the 1930s, when output fell by over 30%. Instead, their hope is that the recession to come is more like the early 1970s, when western economies shrank by 5% to 10%. Painful but not catastrophic.

What we cannot escape is the fact that the amount of money in the banking sector far outweighs the value of the assets that it was lent against. This is how it works. You want to buy a house, and you need to borrow £100,000. You go to a bank and they create the loan, and at the same time deposit £100,000 in your bank account. This money did not exist before: it is new money. You buy your house, and at the other end of the chain, the sellers deposit the £100,000 back into the banking system. The amount of money in circulation has risen by £100,000 and is represented by the seller's bank "savings". But those savings are a reflection of the value of the house. If the price of the house doubled while they owned it, then £50,000 of those savings is a result of inflation caused by the banking sector creating money.

Supposing the housing market crashes. There is now more money in the banking system than the value of housing stock. The value of that the money has to fall as well. During the Asian crisis 10 years ago, this is exactly what happened. Many banks went insolvent, many savers lost their deposits, and the value of money in the economy fell so as to reflect the new and lower value of assets in the economy. This was exactly what happened in Thailand, but unlike us, their government was simply too poor to bail out savers who happened to have their deposits in the wrong bank.

In the west, we are rich enough to be able to ensure that banks do not collapse, wiping out individual savers. (Indeed, why should some savers be OK just because they were lucky enough to put their deposit in the right bank?) However, what we cannot escape from is the fact that the value of money in circulation now has to shrink to match the falling value of property against which the money was lent. However little we like it, the value of our savings has to fall.