One Fine Day

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Since the government and central bank are once again inflating the economy, let’s look back at what happened the last time they did this.

The Bush-Greenspan team used war, fiscal stimulus, and FED money-pumping to produce a housing bubble that drove the unbalanced economic recovery of the early 2000s. Personal saving dropped as sharply as debt rose, but the recovery was halting and anemic. While the Clinton years saw the real GDP rise 35.4 percent in 8 years, the Bush years had a 21.0 percent overall rise.

The stock market recovery was likewise labored and anemic. The broad-based Wilshire 5000 Index did not exceed its year 2000 peak of 14,991.68 until 2007 when it peaked at 15,806.69. The net gain was minuscule.

The inflation and debt-driven recovery drove the dollar index down from a 2001 level of 120 to its current level under 78.

In thinking about the future, it helps to think in terms of "orders of magnitude." The largest hydrogen bomb released 50 million tons of energy. An atomic bomb releases about 500,000 tons. The hydrogen bomb is larger by a factor of 100. If a factor of 10 is an order of magnitude, then the difference in this case is exponential.

We are in the early stages of a resurgent government-produced inflation both in the FED’s balance sheet and also in government debt. In both cases, we are looking at changes that are already several orders of magnitude larger than anything we have ever experienced before. We are going into uncharted waters. There are going to be produced large surprises in the various markets for goods, services, labor, bonds, stocks, real estate, currency, commodities, and gold.

Barack Obama and Ben Bernanke do not want to go down in history as the leaders who presided over Great Depression II. To avoid that fate, they are blowing up the American debt bubble to even greater dimensions than George Bush and Alan Greenspan did. By taking over nearly the entire mortgage market, the U.S. government has vast risk exposures to interest rates and housing prices.

The effects of the Bush-Greenspan bubbles have been centered on declines in real estate prices and the resulting loans gone bad that have made hundreds and hundreds of banks insolvent and doomed to fail. When financial stock indexes like XLF fell 82 percent, it was for good reason. That index has recovered somewhat. It is now down 61 percent. It hit a low on March 6, 2009. It turned up slightly in advance of the news on March 18 that the FED would inflate by over $1 trillion (quantitative easing.)

In the previous episode of inflation, bank and consumer balance sheets became distorted and over-leveraged. The end result was destruction of the capital invested in these sectors, both equity values and loan values. This time around, the effects are going to be different. In this case, it is the balance sheets of the central bank and federal government that are being heavily distorted and over-leveraged. The end result will be a destruction of their capital. This will show up in three main ways: problems with the dollar, problems with government debt, and problems with government taxes and transfer payments.

The dollar will be under continual downward pressure against gold. The dollar index is likely to decline too as the flight to the dollar abates and other central banks shift away from dollar securities as a reserve.

As the Obama programs are enacted, U.S. government debt will continue to soar. This debt will come under a cloud. The default risk will rise, and this will cause the yields to rise and the prices to fall. The inflation component will rise too, with the same effects.

The government will have problems funding its programs. It will be under pressure to raise taxes and cut back on its programs. Since it will be reluctant to do either, the problems will fall upon the dollar and on the government debt. This will place the government in an untenable position because the higher interest costs of the debt will add to the deficit. An undesirable feedback cycle will occur in which deficits cause higher interest costs which cause more deficits which cause higher interest costs, and so on.

No amount of taxation can solve the government’s fiscal problem that lies ahead. Greater taxes will only make them worse by slowing the economy. That option is foreclosed.

How about spending? Will the government when faced with these problems control its spending? No, not in any orderly way. Political maneuvering is unlikely to produce a rational process of control and a reduction in spending. Instead, the political forces are likely to be involved in continual fighting in order to gore someone else’s ox.

The fact of the matter is that Obama plans to increase government spending by an order of magnitude, not take it down by an order of magnitude. The deficit is already approaching runaway status, even without this added spending. Perhaps Obama will be a one-term president. No matter. Past Republicans have worsened the government’s fiscal situation even more readily than Democrats. Little relief can be expected in that direction. Gridlock in Congress may seem the best bet, but it seems that logrolling overcomes gridlock

The two problems — the dollar and debt — are joined. If the FED tries to save the dollar, it affects government debt adversely. The FED can relieve pressure on the dollar by deflating its bloated balance sheet. To do that it needs to sell off the mortgage-backed securities that it has accumulated and not buy the rest that it is now in the process of buying. If it ever does sell off these securities, it will pressure the government debt market. This is very unlikely. Instead I expect it to pay interest on reserves, which will not solve its problems and will only add to the government deficit and start an exponential process of increase in interest paid.

If the government tries to save the debt market by having the FED support it as it is now doing, that affects the dollar adversely.

The central bank and the government are between a rock and a hard place. One or the other or both of the dollar and the debt are slated to have problems.

Enactment of Obama’s health care and energy measures, even in diluted form, will confirm the existing course. Their rejection will be more favorable for the dollar and for government debt. As the political winds shift, so will the fortunes of the dollar and the government debt markets. Investment is now a gamble on politics.

My bet is this. One fine day the bottom is going to drop out of the dollar. There will be a swift and sharp order of magnitude change. The recognition of the problems will reach a point at which it starts to go exponential, not just in terms of people being vaguely conscious that things are not right, but in terms of actually taking action to protect themselves. Foreign central banks may be reluctant to dump their dollar securities and think it better to liquidate them slowly so as not to drive prices down and break the market, but when they observe that others are running for the exits, they will run too. There will be a run on the FED and a run on the U.S. government.

Runs upon the dollar and U.S. government debt are where things are now headed, and that is a scenario that calls for action now. And the more of us that act upon it now, the more likely it is that we bring that reality into existence.

The FED and the government do not want to see runs upon them. They will soft soap everyone as long as they can because rhetoric is the cheapest form of action, but really to prevent these runs from occurring, they have to take concrete measures that suggest a fundamental shift in the fiscal and monetary courses they are now on.

If the major governments of the world could get themselves and their peoples involved in a war like World War I that killed 20 million human beings, can a government not create such economic imbalances that it derails its debt, currency, and economy? It has already happened many, many times in the past. The only novelty now is that it is happening in America.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire.

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