It's becoming increasingly clear that 2008 will be a catastrophic year for the US economy, and therefore probably for that of the world as a whole. The reasons boil down to two: continuing and snowballing fallout from the subprime mortgage fiasco (exacerbated by an orgy of debt-leveraging), and record-high, continuously advancing oil prices.
But will the impact be inflationary or deflationary? This matters, because the diagnosis determines how governments and financial institutions should respond, and what private citizens should do to protect themselves.
Part of the answer depends on how one defines the terms.
Some economists are in the habit of defining inflation simply as rising wages and prices. From this standpoint, high oil prices (caused by depletion and scarcity) are inflationary.
Others define inflation as an increase in the money supply. Some would take that a step further by defining inflation as growth in the money supply that outpaces growth in the productive economy.
In the current instance, Peak Oil is occurring at the same time as the bursting of the real estate bubble, in which a rapid decline in the value of property is effectively causing money and credit to evaporate from the economy. This is being called a liquidity crisis, but for financial institutions it actually amounts to a solvency crisis, and will likely result in the collapse of several major banks. From a monetarist point of view, that's deflationary.
The remedy? The Federal Reserve is lowering interest rates (to expand credit) and the government itself is considering an "economic stimulus" package, which will evidently consist at least partly of a direct tax rebate - checks in the mail to tens of millions of citizens. Some have likened this to dropping new money out of helicopters, and are calling Fed Chairman Ben Bernanke "Helicopter Ben." Helicoptering in new money is inflationary. It will cause a decline in the value of the dollar (in deflationary times - like the 1930s in the US - currencies typically hold or even gain in value because there is not much money to go around).
The US dollar is in fact losing value - a sure sign of inflation.
So here again is the dilemma: given these factors in play, how does one know what's in store for the economy? What does one call the emerging condition?
It may be enough just to call it a "depression." Even mainstream publications are now using the "D" word, at least conditionally. But most depressions are deflationary, and there is the nagging problem of high energy prices that are now beginning to filter down through the economy, skewing food prices up as well; and there's that declining currency value as well. Aren't those symptoms of inflation?
As oil becomes more costly, a greater and greater percentage of societal resources will be going to energy and food production, draining other sectors. This is in fact inherently deflationary (even though the price hikes may be interpreted as inflation), because the proportion of societal resources going to support consumption (infrastructure, wages, and credit) will inevitably have to decrease. Jobs in most sectors will vanish.
Yet as the crisis unfolds, there is every reason to think there could be periods of hyperinflation - though only in certain sectors of the economy. We are seeing evidence of every desire, on the part of the Fed and the government, to increase the money supply and thereby forestall the credit crunch ensuing from the subprime mortgage disaster. But where, exactly, should they inject that money? There really aren't many options. Through more government debt? That's a foregone conclusion. By propping up banks - that will nevertheless be in no position to pass on that money by making new loans? There may be other ways as well, but they will all show up as symptoms of inflation or hyperinflation. They will all also result in the destruction of the efficacy of the currency itself.
In other words, as this mess unfolds we may see extreme symptoms of inflation alongside those of deflation.
For an economy, this is the worst of all possible worlds. We have never seen anything quite like it. Maybe it's a "Perfect Storm" economy.
Fortunately, there is at least one upside to all these downers: the collapse of the current debt-and-growth based economy may finally force a redesign of the money system and the "science" of economics. But this will take a while, and it will help if there are good ideas out there being widely discussed and promoted, such as the notions of a steady-state economy or an energy-backed currency.
Meanwhile, if you're interested in finding shelter during the storm, get thee to the productive side of the economy. Grow something, or learn to make or repair something useful.