Money has two fundamental aspects to it. Firstly, it is a unit of exchange. In a complex economy, specialization means that people are unable to barter the goods or services they produce because usually they aren't directly useful to another person, or because they do not make a complete, finished product. Instead, people in an economy use a item to represent a certain amount of effort. This allows groups of people exchange complex products, and thus to make them. A group selling a good or service will receive an amount of these representations of effort from another group or groups, and either exchange said units with yet more groups or distribute them to individual members. What exactly is used to represent effort is rather irrelevant as long as everyone believes that it will hold the same value from when it is received until it is given away. Being able to store value is the second aspect of money. When put to use in an economy, money operates as a commodity. If there is more supply it follows that its price (to say, value) will go down and the amount needed to receive a good or service in exchange will go up. In a transaction, each side is bidding for what the other has. A seller offers a widget for a certain amount of the buyer's money, and the buyer offers a certain amount of money for the widget. Since it is easier to change the amount of money involved than the nature of the widget at hand, the two sides of an exchange will eventually come to an agreement on the amount of money the buyer gives to the seller.
Inflation, to the average person, mean that prices are going up as a whole (prices of particular goods may go down in the short term). The price increase is really a side effect of there being an increasing supply, or amount, of money in circulation, making each unit less valuable. The accepted practice in developed economies is for the central bank to create mild inflation (1-4%), making prices are roughly stable for a reasonable period of time (1-3 years), but less certain beyond that. In other words, people believe that money will store value in the short term, but realize they need to invest instead of hoarding over the long term. Higher levels of inflation, however, cause problems because people become less certain about exactly how much everything will cost in the near future. Uncertain pricing makes long term planning much harder. Higher inflation also causes people to spend any money they receive immediately because they don't know how much value their money will store next year, if anything. Reduced savings means reduced credit, or lending. When money is available, lenders ask for very high interest rates to make sure they receive at least an equivalent amount of value from the money they get back. High rates discourage borrowing for investment, and scarce credit reduces borrowing further. Eventually, productive investment (investment that makes businesses or individuals more productive) dwindles to nothing. A decline in productivity follows due to aging equipment that cannot be replaced. The economy ceases to grow (in "real" terms), and eventually reverses, collapsing demand as people slowly become poorer. A very high level of inflation, often called hyperinflation, collapses demand much more quickly because people see no point in exchanging money that has no value.
Deflation, obviously, is the opposite phenomenon. The average person sees prices going down because supply of money is contracting. If the money a person holds will be more valuable next month, there is little incentive to buy anything but necessities today. There is also little point in risking that money in some business venture because its value is guaranteed to go up already. Governments try to avoid deflation at all costs, because if everyone delays consumption and hoards money, demand for everything non-essential collapses. Less demand for goods means prices fall because an oversupply of goods develops. With deflation, what is good for a single person is bad for the economy as a whole. In an economy that has advanced enough to where most investments can't be financed out of a single person's savings, the collapse in consumer demand cascades back through the economy as business default on loans and go bankrupt, throwing people out of work and extending the cycle. Eventually, once capacity is destroyed and the economy stabilizes at a much lower level, credit will be cheap and businesses will invest again. But stabilization may take several years; in the meantime many people will be without work and (presumably) destitute.
Credit is an important feature, or phenomenon, of an economy that uses money. Having credit gives a person or business (or government) the ability to spend money it has not yet earned - with the understanding that it will be repaid. A lender of some sort assesses the borrower's ability to repay the loan and probability of actually doing so. After that, the lender extends the opportunity to borrow a certain amount of money to the borrower. Using the credit means spending the money it represents, and thus the borrower takes on debt. Sometimes the entire debt is due at a single point in the future, but usually it is reduced over time by repaying the lender in small increments. The existence of a debt means that the lender has a claim on a portion of the borrower's future income.
During the past six or seven years, American lenders relaxed their standards and extended credit to borrowers that should not have received it, and would not have under normal standards. Credit standards were relaxed for nearly all types of loans - mortgages, home-equity loans, auto loans, credit cards, leveraged buyout financing, short-term business debt (commercial paper), government bonds, and more. How exactly the credit standards were relaxed differs by the type of loan, but it happened across the board.
At the same time the interest rates lenders charged to borrowers were very low. This is due to the actions of the lender at the heart of the economy, the central bank (in America, the Federal Reserve). The central bank controls the supply of money in use by selling or buying highly secure assets - usually those issued by the government of the same country - from major banks. To grow the money supply, the central bank creates money by decree, or fiat, under an authority granted to it by the country's government, which it then uses to buy the assets. As money moves through the system, the money is deposited and lent out several times. But because of reserve requirements, at each institution the amount lent is smaller than that deposited. Each unit of money created by the central bank ultimately becomes several units on various lender balance sheets, but the chain ends at some point. More importantly, a central bank can make short term loans of reserves that private banks have deposited with it to other private banks. For an extended period of time it did so at historically low rates. When banks find they have excess equity they make loans and use the credit extended by the central bank to fund the loans until longer-term creditors are found. The central bank's interest rates filter down through the banking system until they ultimately arrive at the end borrower. And for a while consumer loans were indeed very cheap.
Between relaxed standards and cheap money, more people in America were extended more credit than ever had been the case before. More credit means an increased supply of money. More plentiful and less valuable money bid up the price of assets and expanded consumption, which fueled the cycle. Ultimately everybody who wanted to borrow and met the relaxed standards took out a loan of some sort. But it turned out that the standards were too relaxed, and a lot of the loans were bad, meaning they wouldn't be repaid in full or at all. The cost of money from the central bank increased as well, and people with adjustable loans were forced to make larger payments, creating another set of loans that wouldn't be repaid. Other people could still make payments, but found they had a lot less money to spend otherwise. These changes put the cycle of lending into reverse, collapsing asset prices.
To lenders, a loan to borrower is considered an asset because it provides a stream of income, namely incremental payments from the borrower. A lender usually tries to guarantee repayment by requiring collateral, which is an asset in possession of the borrower, be signed over to the lender if the incremental payments stop. Some loans are unsecured by collateral, but those tend to be for smaller amounts and shorter time periods. If the borrower stops paying, the loan goes into default and the lender claims the asset and tries to sell it to cover the outstanding amount. But if asset prices are falling, the lender may not be able to recover the whole amount. This has a negative effect on the lender's balance sheet.
A lender's balance sheet has to be just that - balanced. On one side (usually the left visually) there are assets, which are loans of different types. On the other side there are two things. One is liabilities, or debts. In the case of a bank, liabilities would include various types of deposits. The other thing on the right side is equity, or the difference between assets and liabilities. This should be a positive number. This equity is the lender's "skin in the game", the game being to create and maintain a flow revenues from assets that is higher than the flow of payments to the liabilities. The difference between a lender's flows of money is called the spread, and that is the lender's profit - if the spread is positive. The lender invests a certain amount of money when borrowing and lending begins in order to reassure the holders of the lender's liabilities, the creditors, that they will be repaid. A typical lender's equity is nowhere near the amount being lent. Being able to control this larger amount of money is called using leverage. The ratio of assets to equity is the amount of leverage, and is usually expressed as 10:1 or 20:1.
But here is the critical point about leverage: using more makes the balance sheet more fragile, which is to say it is more likely to become un-balanced. If the value of the assets falls below the amount of liabilities, the lender is insolvent. The lender's initial equity disappears, and the lender's creditors are no longer guaranteed repayment. Less leverage means that assets prices can decline more before insolvency happens. With more leverage, the risk to the lender's creditors is greater. Each of the assets has a certain amount of risk that the lender determines when originating the loan. A lot of risky assets should mean that the lender keeps the leverage low in order to keep the net risk to the creditors low. But more leverage means more profits compared to the lender's original investment, or equity. Thus comes the need to limit a lender to a certain amount of leverage, because a lender has an incentive to use as much leverage as possible. Creditors rarely have the time or ability to assess a lender's net risk, so they hand a small fraction of their stream of payments over to an expert who supervises the lender's risk full-time. This expert usually has the ability to force the lender to reduce risk if it appears to be too great. Leverage ratios can also be specified by contract when the number of parties involved is low.
Lenders in America over the past six or seven years have made more and more risky loans at higher and higher levels of leverage. The proximate cause is that the lenders were insufficiently supervised. The ultimate cause is another heated debate. Now, with many of these risky loans going bad, lenders have to adjust their balance sheets to get the amount of leverage, and thus risk, back to something that the various regulators approve. One way lenders try to do this by selling assets and paying off liabilities until the numbers look good. But since asset prices are falling, successfully re-balancing is either difficult or impossible. In fact, a great number of lenders in America are already insolvent due to falling assets prices. An insolvent lender can operate for a while as long as there are sufficient cash reserves to augment the flow from the balance side to the liability side of the balance sheet. But eventually the lender has to shut down, at which point it fails to repay creditors in full. A lender can be saved, however, by receiving new equity from an outside party. The original lender loses the initial investment, and the outside party assumes the role of the lender. The new equity is used to acquire new assets (make new loans) and the risk to creditors returns to an acceptable level.
Failure to repay loans is the source of deflation. When a borrower defaults, the quantity of money between the initial credit extended and the total amount recovered is destroyed. Gone. Even in good times some borrowers default, but the amount of money created by the banking system through loans and injections is greater than the amount destroyed in defaults. In bad times, with more defaults and less new loans, the destruction of money cascades through the system and the economy. The central bank, the ultimate creditor, usually responds to bad times by lowering the rate at which it lends, giving banks more chances to lend profitably, creating more money and thus inflation. But if the destruction happens rapidly, the central bank may be unable to stimulate enough new lending to counteract the reduction of money. The ability or inability to counteract the destruction of money is at the heart of the deflation or inflation debate.
People who believe significant deflation will happen argue that the central bank will be unable to add money in time to prevent the current level of cascading defaults from escalating beyond control. Already both the demand for consumer goods and their prices are falling. Defaults on mortgages and other loans are increasing and a large portion of the financial sector is insolvent. The central bank has taken a huge amount of debt onto it's balance sheet already, at the same time that money was injected into banks. Despite the gobs of cash flowing, lending has not resumed because there is no demand, and there will be no demand until supply and production capacity are reduced, which may take several years.
People who believe significant inflation will happen argue that the central bank will do anything to prevent deflation, and thus will resort to extraordinary measures to make the supply of money increase. In normal times a central bank is tries to be very careful and predictable about increasing the supply of money in order to keep prices roughly stable. But because the central bank can create money at will, it can inject as much money as it wants by purchasing assets of all types - government bonds, corporate bonds, municipal bonds, securitized loans, commercial paper, and more. It can also inject more money directly into failing banks to re-capitalize them. The rest of the government can also borrow even more money to use on various measures to increase employment by creating demand in areas that are not oversupplied. So even though prices and final demand may fall for a short time, the massive new supply money will find its way into the hands of consumers soon enough to prevent a catastrophic decline in demand.
The debate evokes some passionate arguments because deflation and inflation favor different groups of people. Under inflation, the value of the money being paid by the borrower to the lender becomes less valuable over time, meaning it is easier for borrower to make each payment. However, savers, or the lender's creditors, see their net assets lose value if the periodic payments from the lender don't increase the amount of money held by the savers as fast as rate of inflation. Thus, inflation favors borrowers over savers, and much more so when the rate moves from lower to high. Naturally, deflation reverses the equation. A borrower finds each payment becoming harder to make because the value of money being repaid is greater each time. The savers finds their net worth increasing even if the periodic payments from the lender are negligible. Thus savers benefit from deflation, and possibly even when a high rate of inflation moves lower.
Do not regard anything in this paragraph or the entire document as financial, legal, or romantic advice. The conventional wisdom for the two courses of action for people who have a positive net worth is as follows. If you believe deflation will take place, you should pay off as much debt as possible and move all your liquid assets to cash or highly secure cash-alikes (CDs and Treasury bonds, basically). The demand of nearly everything will collapse shortly, causing bankrupt companies, states, and municipalities left and right. If you are particularly pessimistic, you should convert at least some of you money to physical gold, buy guns and ammo, and stock up on canned goods. If you believe inflation will take place, you should covert most types of liquid assets into “stuff”, be it physical possessions or commodity futures. Stocks and bonds will fail to keep up with inflation, with some exceptions, but there won't be widespread defaults. Any debt you owe will shortly become of no concern. If you are particularly pessimistic and have been waiting for housing prices to fall, it's time to pull the trigger while a low interest rate can be locked in and the down payment you have saved is worth something. Having a little physical gold wouldn't hurt, either.
So, finally, here is where I stand. First, I believe high inflation (but not hyperinflation) is better than deflation. Deflation collapses demand rapidly and catastrophically, whereas high inflation grinds it down slowly. This is to say I believe that the net harm to the participants in the economy will be less from high inflation than from deflation. Second, I believe that the Federal Reserve believes it has to prevent significant deflation at all costs. America has experience deflation before and the consequences were not pleasant. Thus the Fed will find many ways to shovel as much money into the economy as is necessary to fire up inflation. Given Americans' low level of savings, the money will be put to use sooner rather than later. There is a chance that the inflation will get out of control and become hyperinflation, but America isn't Zimbabwe or Weimar Germany, and controlling inflation is well understood.
There are complicating factors to note. One is that a significant portion of America's debt (the federal government has a large amount of inter-agency debt as well) is held by foreigners that are not necessarily America's best allies. Higher inflation would reduce the value of overseas holdings significantly, but one or more bond-holders retaliating by dumping dollar assets in bulk would make the situation even worse by collapsing their value and driving up interest rates. Another factor is that the federal government was already running a serious budget deficit prior to the recession. An ever greater demand for funds may make investors nervous about buying yet more treasuries. Inflation risk and thus currency risk would drive up interest rates at a time when they need to be low. Yet another factor is the vast amount overcapacity or oversupply already present in the global economy. In America itself there are far more homes, retail buildings, restaurants, office buildings, and automobile factories than needed. There will be very little need for new investment in those areas for several years. Collapsing demand means factories for other types of goods will be underutilized as well. Globally, there is even greater overcapacity in the automobile sector. Nearly every other type of manufactured consumer good is oversupplied due to massive productive investment in China over the past decade. For internal reasons China will attempt to continue exporting at all costs, even to the point of further devaluing its external currency. This will feed the deflationary spiral and make new investment in other regions much less likely. How these factors and others I might have overlooked will affect the Federal Reserve's attempt to create inflation is beyond my ability to analyze.
No matter which happens, we are living in interesting times.
Disclosure: As of this writing, I own my residence and have no debt of any kind. I also have a modest retirement portfolio consisting of cash and a small amount of an inverse bond ETF (one that will go up when bond prices go down and interest rates go up). The composition of the portfolio will be rebalanced shortly using an assumption of inflation.
(Slightly waspish side note: During my wanderings of the internet I have found that most of the supporters of the deflation argument are of a libertarian or conservative bent, and thus ranting on the websites that “the system needs to be reset” regardless of the collateral damage flows naturally from their world view. I held the slightly less vindictive position that there should be no bailout of irresponsible borrowers until recently, believing that the best course of action was for prices to fall and markets “clear” as soon as possible. But that was before I realized how large the credit bubble was, and thus how great the collapse could be. So now, even if the result is failure and deflation, I feel every attempt should be made to keep demand and employment up. This includes massive cram-downs of existing mortgages, which would be fairly explicit rewards for irresponsible borrowers. But we are way, way, way beyond being able to contain the harm only to people who were irresponsible. Real people of all spending habits will be hurt as a consequence of the lending insanity of the past six or seven years, and the lower the number the better. On the other hand, prosecuting malfeasance at high levels of the financial system should be vigorously pursued, and there should be no hesitation about wiping out shareholders of existing institutions.)
