Friday, August 6, 2010

The Deficit, Inflation and the Theater of the Absurd

Let’s face it folks the economy is in a severe recession. As both a cause and effect of this recession the US banking system took a crash in the Fall of 2008, a crash that is still ongoing some two years later.

What the recession and the banking crisis has caused are a fall in cumulative demand levels and a fall in cumulative asset value. People are spending less, and asset values have fallen, in both nominal terms and as compared to any basket of hard commodities.

It is in these two measures of economics that divide current American macroeconomic thought into two camps. The first group looks at cumulative or aggregate demand levels, while the second looks at cumulative or aggregate asset values—each camp sees their particular object as the basic underpinning of economic growth, development and prosperity. So when either of these camps see their chosen metric slide, they become unhinged. They declare a crisis and further declare that “something must be done”.

Well something has been done, repeatedly, over decades: it's called The Deficit.

To counter falling demand levels, the Federal Government launches massive spending programs, financing the spending with debt issued by the Treasury. And now that the first massive spending program has had negligible results they are of course looking at creating another big spending package some time soon. This will of course keep the demand camp happy.

At the same time, to combat the fall in asset values, the Federal Reserve Board has entered into an asset purchase program that is just as massive, unprecedented and irrational as the spending programs. Through a complex and deliberately opaque scheme, the Fed has relieved the Too Big To Fail banks of their toxic assets, and given them cash. The Too Big To Fail banks then turn around and use that cash to purchase the very Treasury bonds which are being used to finance the massive spending programs. What results is a big incestuous kabuki dance of collusion and corruption between the Treasury, the Fed and the TBTF banks. Whether it will be the courts or history that lays bare the underlying criminality only time will tell. But on the face of it, it looks criminal to me.

So herein is the yin and the yang, the Janus if you will, of The Deficit, more Federal spending on the one face, and more propping up of asset values on the other.

But don’t be confused, The Deficit (upper case) I refer to is not the fiscal or budgetary shortfall. I am defining The Deficit as a structure of policy, a political mentality. This mentality is shared by both demand and asset based economists. In this realm of The Deficit, the larger economic policy questions are no longer either/or; instead they become both/and.

Under this construct all policy options are on the table, because according to this macroeconomic policy known as The Deficit, the budgetary shortfall (the deficit, lower case) can never result in the US going bankrupt. Both sides of the political aisle are in concurrence. As Dick Cheney phrased it, “deficits don’t matter.” So then develops a political attitude that The Deficit as an economic policy can just continue indefinitely.

Never mind that historically The Deficit is without precedent: Never before has a reserve currency provider accumulated this much debt, based on a currency that floats on nothing more than military power. So this then becomes the critical issue: The dollar is a fiat currency. The Roman, French, Spanish, British, Austro-Hungarian empires, all went way into debt on numerous occasions, but none ever did it on the basis of a purely fiat currency. The US is the first to do so.

The Deficit as policy of US has had several definable effects:
1. It has allowed the Federal Government to finance all of its spending programs, satisfying the demand camp. No need for political talk of “tough choices”—the Federal Government has been transformed into the Great American Teet.
2. It has allowed the TBTF banks to deny the fact that they are broke. The FED’s toxic asset purchase program has kept the banks solvent in a perceptual if not practical sense; they have the cash to pay off their liabilities. At the same time and more importantly from the FED's point of view, it has propped up deteriorating asset values, again in a perceptual if not practical sense.
3. It has created budgetary shortfalls after budgetary shortfalls of overwhelming proportions. Debt is rapidly approaching 100% of GDP, with no end in sight.
4. Lastly, and most importantly and dangerously, it has instilled a generalized delusion amongst policy makers and politicians alike that the budgetary shortfalls and accumulated debt do not matter, and that liquidity and stimulus simply must be provided in the face of a crisis. The rationale being that the economy is incapable of withstanding the shock of a change in policy.

It is argued by some that the most important of all of these effects is that as the accumulated debt has crossed the 100% of GDP mark, nothing bad has happened. This has given far too many a false sense of security, chicken little was wrong today, things are the same today as yesterday. Warm in their self-delusion the policy makers have in essence said “Who cares about the deficit, let’s keep on spending.”

But this begs the question: What if the sky does fall? What if we are just experiencing the lull before the storm? Just how long do they think we can continue down this path of accumulating budgetary shortfall after budgetary shortfall? It has to lead to some kind sort of reckoning, right? Think of it like a drinking game, it sure feels good while you're at it, but you know full well that come the dawn you’ll feel like death warmed over.

So then the delusion becomes a self-fulfilling prophesy, propigated via those in the know, the oh so clever, spouting sensible sounding words claiming that The Deficit will not harm us in the long run. We then get tag teamed by another bunch arguing that the accumulated debt, just from its sheer size, will become its own growth engine, and will create economic growth to such a point that “The Deficit” will pay for itself. To the politicians whose only desire is to get re-elected, this bit of financial wizardry almost seems believable, so they adopt it as policy.

If anyone dares contend that The Deficit and monetization might in time lead to hyperinflation, they are attacked, ridiculed and scoffed, in effect are told, “We’ve got deflation, folks—forget about inflation, never mind hyperinflation: We’re going spend our way out of the deflationary trend”. It’s then further argued that after deflation is brought under control by more spending the economy will begin growing again, and that’s when we’ll be able to address the deficit.

Do some research on the financial blogs about this point. Most of them, who should know better, argue that because we were in a deflationary environment, there are no current or foreseeable inflationary pressures. They will then move on to contend that since we are in a deflationary trough and inflation is unlikely, that hyperinflation is an impossibility.

These oh so clever people, and the people who believe them, what I refer to as “the usual suspects,” make a common mistake. They confuse inflation with hyperinflation. Sure they do look alike on the surface, they are both money losing value against commodities, wages, etc., over time. So their conclusion becomes that hyperinflation is just inflation on steroids. This is not just a fallacy but a very dangerous one.

Yes inflation is the result of economic over-heating, wage pressures or raw commodity prices, forcing up consumer prices up all across the economy. In other words, inflation is the economy consuming commodities, raw materials and/or labor, to meet demand. These are all real and measurable factors in economic terms.

Hyperinflation on the other hand is an intangible, a psychological effect. It is the manifestation of the loss of faith: The loss of faith in the economy, the currency that is the instrument of the economy and a loss of faith that the politicians can do anything about it. It is not prices rising because the economy is expanding too quickly (whatever that means); it is prices rising because nobody believes that money is worth the paper it’s printed on.
Within the realm of hyperinflation there are two interconnected subtypes. Firstly you have the Zimbabwe-style hyperinflation as an example of out of control government money-printing. This example fosters the notion that hyperinflation only results from this kind of disorderly printing. Yes it is hyperinflation but it primarily the result of ageing despots grasping at dwindling power. It is not the systemic or psychological kind.

Secondly there is Chile’s hyperinflation in 1973 that led to the September 11 coup and Weimar Germany’s hyperinflation that led to you-know-who. These are the systemic or psychological kind, driven by a combination of real and perceived scarcity. This is what happens when the scarcity of basic commodities abruptly leads to a loss of faith in money. It becomes a psychological contagion, the belief that no amount of money will allow you to get what you need or want. This psychological dislocation of the population then leads the government directly into the first type, out of control printing. That in a nutshell is hyperinflation.

As was predicted by the deflationists in 2008 the US economy is most assuredly in a deflationary trough, the evidence is all around, and all too obvious, so I am not arguing otherwise. What I am contending is that the current deflation can tip over into hyperinflation, and rather quickly. The thing that could tip us over from deflation into hyperinflation is of course “The Deficit”.

Not simply the budgetary shortfall itself, but the policy embodied by “The Deficit”: The twisted delusion that the solution to the problem is to throw more money at it, spend more money, dump as much liquidity into the market as needed, to prop up the twin aggregates of demand and asset values.

This deluded corrosive sense that fiscal and budgetary shortfalls don’t matter is what I believe will tip us into hyperinflation. Policy makers and politicians have lost all fear of excess liquidity and spending as an instrument to overcome any problem. They will have no compunctions about adding to the deficit when the next crisis hits. That’s when hyperinflation will bare its teeth and bite us you know where.

If I had to venture a guess as to what will trigger a hyperinflationary catastrophe it would be either one of the larger Asian economies comes unglued or a sudden and unexpected commodity spike or. Not necessarily a big one, but it’ll be dramatic, and enough to cause a panic.

The stage will then be set, the audience is seated, and the curtain will rise on the first act of the hyperinflationary play. The opening scene will be a market panic, and it’ll be fast. By the middle of the first act the policy makers and politicians will take center stage and once again turn to The Deficit, opening the spigots of more liquidity and more stimulus. As the curtain falls on the first act the financial markets will finally begin to react to the realization that the debt is unsustainable: It will become obvious even to them that either all those the T-Bills cannot be repaid, or that if they are, it will be done through monetization, out of control printing at the FED.

As act two opens the psychology sets in and the panic begins feeding on itself. The decimal point will start shifting to the right with every new measure. Everyone will want to get off the stage, out of the dollar, and they’ll all want to be the first to hit the exit.

Anyone who watches the markets knows that they can turn on a dime, and that in the short term they are not rational. In panics they are no more rational than a junkie in need of a fix. As the second act closes everyone will be getting out of dollar denominated instruments. The cascade grows, as Wall Street fat cats and Main Street little guys try to move everything they can into hard assets: Precious metals, land, food, anything that is required consumption or can be seen as a store of value.

So then the final act will be hyperinflation as has been defined above: A loss of faith in money, and the belief that no amount of it will buy what you need.

The Deficit. He is both the producer and the director, orchestrating every move from the pit in front of the stage.

So as the final act unfolds faith in the dollar is lost, hyperinflation runs rampent, as government continues providing stimulus and liquidity which the populace will see for what it is, nothing but worthless paper. How the story ends I do not know, I wish I did.

I do know that actions have effects—I do know that massive deficit spending of a fiat currency will have consequences. I do know that the policy embodied by The Deficit has brought the US and indeed the worlds economy to the brink of seld-destruction—with no way to pull back from that brink. So before you think you can settle comfortably into your balcony seat there are only two questions that need to be answered: One, when will the economy finally tip over the edge, and two, what will give it that final push? Perhaps there is another question, one of a more personal nature, What have you done to prepare and protect yourself and your family?

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