The Two Faces Of Inflation:
I will begin with Credit Inflation which often goes overlooked due to societys general lack of knowledge concerning how the banking system operates. I find this quite odd because people who work so hard for their money don't really know how their banking institution functions. Maybe that's just me, but who knows? Credit Inflation comes about through the practice of fractional reserve banking which in essence is legalized counterfeiting. Let me explain....
Suppose I go to Bank A and apply for a loan of 9 million dollars. The bank agrees to do so if I am willing to pay a interest on the loan. In the U.S., a 10% reserve requirement is necessary. In other words Bank A can loan out the 9million as long as it has 1million in reserves. People refer to this as the money multiplier. Bank A must make a 1million dollar demand deposit at the central bank to originate a loan of 9 million. This is done by "pyramiding" / using other deposits in the bank or from another banks if needed to temporariliy increase the money supply from 1 million to 10 million. All is well and good assuming banks are able to cover losses on loan defaults, also called "loan loss reserves" which have to be earned from profit (the interest collected in the past). Before discussing the ramifications of having a central banking system inadequate loan loss, it is worth taking not of the entire banking system.
1) The money multiplier = 1/reserve requirement. In our case 1/.1= 10
2) Assuming banks remain fully loaned up (which they have to in order to stay competitive) the money supply = Cash + (Total Bank Reserves * The money multiplier).
So What? Well the moral hazard of having such a low reserve requirement + artificially low interest rates (talked about later) = Economic Boom! Well isn't that great? Nothing could be further from the truth because central banking on a fiat money system "paper backed by nothing" makes for a perfect storm that will bring a currnecy to its knees or collapse "hyper-inflation".
What is an interest rate really? This is what you are willing to give up in the future for something now. In a free market people have everchanging time preferences. When people have a high demand for money (whatever the reason, it could be because they got fired, and need money to support their family until they can find another or a technological revolution has taken place i.e railroads, automobiles, the internet and thus wish to invest borrowed money to earn a large sum in the future) the interest rate will also go up because a constant supply and increasing demand to a rate that tells Joe Blow peoples time preference. This allows entrepreneurs to most accurately forecast the proper allocation for their funds. On the flipside, if a rate is artifically manipulated, as is our case, even great entrpreneurs missallocate large amounts of capital because he/she incorrectly interpreted people time preference. (This is the main cause of artificial booms)
To avoid disscussing a inordinately long Topic, lets go back to the 2000. Alan greenspan cut interest rates from 5 to 1%, which goes against free market principles and it became more enticing to borrow money becuase people preferred money now instead of the future. The free market would have had rates increasing for the reasons previously discussed. This led to even more massive missallocations of capital- as we are all seeing unfold.
The aforementioned paragraph is where this crisis began in terms of credit inflation. It marked the only recesion where housing prices increased! The Fed Inflated there way out of a recession that should have lasted longer, spurring a unrivaled confidence of the economies strength, which only augmented the duration and size of the housig bubble. This was not confined to residential loans but investment loans, personal loans, etc). As we all know people became enarmoured by the housing market, bidding up prices to unrealistic levels. Banks were making all the loans they could and as interest payments came in, they made more and more loans. This bubble lasted over 4 years and caused massive missallocations of capital (Las Vegas being a great example).
Well we all know what happened thusfar but the true crisis hasn't presented itself: the price we have to pay for living far beyond are means for over a decade. Now is where the true wealth destruction comes into play. Over 800 billion of Reserves has been injected into the banking system which is obviously to cover the loan losses. When a stripper turns day trader or house flipper, you know the defualt rate will be significant. To avoid statistics, think about the potential permanent increase of currency due to loan defaults. The central bank's 800 billion covers 7.2 trillion of potencial losses or can now be used to create 7.2 trillion of more loans (which the government is trying to do and illustrated through cutting the interest rate to 0%).
For those who didn't really understand what the hell I was talking about here is a great article which serves as a great analogy from a mises daily article: