Once seen in that light, the Federal Reserve will take whatever action is most favorable to the largest firms in the financial sector. By and large, the incentive cycle is steady inflation followed by occasional recessions to squeeze out inflation expectations and purge bad investments. The larger firms weather the storm of recession and acquire and/or bankrupt smaller firms. The eventual end to this process is when the financial sector becomes so concentrated and so successful at riding the boom that the financial sector itself becomes the heart of a bubble.

At that point, a recession results in a catastrophe like the Depression — unless the Fed is willing to destroy the currency in order to wipe out the debts of the biggest firms. Since a hyperinflation destroys the credibility of a currency and makes it substantially more difficult to inflate later, the incentive will be to avoid hyperinflation right up until the point where such a strategy is the only way to save the fortunes of the largest firms.

In other words, unless Goldman Sachs is going to fail, expect a recession. If Goldman Sachs is failing, then expect a depression — unless the Fed can see this far enough in advance, in which case expect hyperinflation.

Most of the debates in bearish circles regarding the nature of the crisis we face boil down to an assessment of how alert and/or how effective the Fed is. That assessment seems largely based on the temperament of the commentator rather than any real economic theory (its basically Kremlinology for the Fed).

* There is substantial evidence that the Fed was created to more or less the exact specifications desired by major Wall Street banks — notably the Jekyll Island meeting of 1910.

Some of the weaker elements don’t get out of the bubble soon enough, or don’t shift enough of the risk out, and get caught on the downside (Bear Stearns), but by and large, the bankers make out very well from these bubbles. I agree with Janszen that the next bubble that they’re trying to blow is an energy/infrastructure bubble. I think I’m just a little less confident than he is that it won’t all just collapse due to an unforseen complication.

Well, I do think it distorts the credit market in favor of capitalist banking interests–something quasibill can probably comment on more intelligently than I can. But my point here is that it distorts the labor market by raising interest rates whenever it gets too tight, and is motivated to do so by viewing a tight labor market as the main source of inflationary pressure.

So, would you say that the Federal Reserve distorts the economic “laws” of supply and demand? And thus distorts the credit market overall in favor of capitalist banking interests?

I am trying to understand your perspective clearly here.

If what some people are saying about M2 being pumped up 10% a year for the past few years, I’d guess labor is taking a lot more than a modest pay cut. Of course, that means the Dow is falling by almost !0% a year when it appears to be stable or modestly rising.

2 - It’s always dangerous to focus too much on inflation/deflation. More important is to focus on who has the privilege of printing new money to cover their losses.

That said, the inflation question is very complicated with respect to how it affects labor. The counter-balance to the tendency Kevin highlights is the ability of unions and other strong bargaining position labor to prevent downward modifications of labor costs during deflationary or times. The flying monkeys of the FIRE economy (sorry, I love that phrase - I’m an Oz fan) have a theory called downward wage rigidity, and they claim that low to moderate inflation (1-3%) is absolutely necessary to allow them poor ol bosses to make a decent return on their investment over time, as the greedy workers will refuse to take wage cuts. The inflation forces the workers to take real pay cuts, even if they get nominal year end raises.

Funnily enough, Bernanke’s policy until the S started HTF was to ‘target’ CPI inflation at 1-3%. He never publicly endorsed DWR, but it sure looks like that’s what he was following. And we should always note that CPI understates real inflation by at least a factor of 2 (vulgar liberarians often commit the broken window fallacy when they argue that CPI overstates inflation).

Now, all bets are off, because his buddies need to be bailed out. The central bank appears to be ready to throw everyone else under the bus (even other partners in the ruling coalition) to maintain the centrality of financial sector in the economy.