A MUST READ primer on DEFLATION.

Full article on The Automatic Earth

Inflation is the expansion of the supply of money and credit versus available goods and services. Some 95% (or more) of our money supply is credit, and by no means all of it was created by any central bank. There have been numerous engines of credit expansion during the mania years – fractional reserve banking, the whittling away of reserve requirements, lack of attention paid to credit-worthiness, securitization, derivatives, the development of the shadow banking system, conflict-of-interest at the ratings agencies, fraud etc. When the all-inclusive credit Ponzi scheme crashes – meaning that the overwhelming supply of virtual wealth disappears and we are left with only real wealth – we will have insufficient money to run our global economy.

When the money supply is inadequate, we will be trying to do the equivalent of running a car with the oil light on, which is to say that we will be trying to run an economy with insufficient lubricant in the engine. Money is the lubricant in the engine of the economy in the same way that oil is the lubricant in the engine of a car. Without enough lubricant, the engine will seize up, and then it will not be possible o connect buyers and sellers purely for want of money, exactly as happened in the Great Depression.

The credit contraction we are seeing is an early warning signal for the real economy. Since the large-scale trend change of late April (counter-trend rallies not withstanding), we are witnessing a change of perspective among the commentators, reflecting a loss of confidence and increased fear. Confidence IS liquidity in a very real sense, and as the contagion of fear spreads, liquidity will disappear. The suspension of disbelief that the long rally brought is over, and that will lead to the next phase of the on-going liquidity crunch.