Inflation vs Deflation

This post by Calculated Risk referencing the recent speech by Fed Governor Mishkin is another piece in the ongoing puzzle of whether the credit mess will leave us with inflation or deflation.

The speech outlines some of the reasons that deflation can be damaging and why it makes sense to have a 1-2% inflationary cushion to protect against it. He gives three reasons:

1. Deflation makes it difficult for labor markets to find their equilibrium because simply have a psychological problem with accepting a lower nominal wage
2. Deflation makes debt more onerous
3. Fed monetary policy will longer work because the fed will "run out of math". If the inflation rate is close to zero, there is no way to create negative short-term real interest rates.

Yesterday there was a related post on Naked Capitalism. The basic question seems to be whether, with a deflationary debt shock of the magnitude we're seeing in the housing market, the fed is even capable of reflating the economy. Printing money is easy, physically, but to reflate, you have to actually get people to spend it. I wonder whether the transmission mechanism that would accomplish this may be broken. The main links in the chain, namely the banks, no longer want to, and indeed cannot, lend this new money out.

One might wonder what happened to the old money. My immediate response is in accord with the post already cited -- it ended up in the hands of the sovereign wealth funds we hear so much about these days. But I still don't feel like I completely understand how this part of the machine works. Exactly how does a US sub-prime loan end up sitting in treasuries in China's coffers? Presumably through the consumer spending the loan encouraged, the resultant trade deficit and foreign reserve build-up, and the subsequent reinvestment of this in treasuries, which kept the dollar high and interest rates low, hence feeding the whole cycle otra vez de nuevo.

Great story. No numbers. Which is what prevents macro economics from being a science.