In 1922 Ludwig von Mises described in his book Socialism why a socialist system could not last. This was not a popular view. The illusion of socialism’s success had real staying power; it took 70 years for the USSR to wheeze its final proof of his position, fooling most people (e.g. analysts at the CIA) right to the end.
The financial theory I follow is best explained by Robert Prechter in his books and firm’s newsletters. This currently puts me in the "deflationist" camp so mine is also not a popular view. Most people look at the past 75 years and expect Helicopter Ben to try inflating the U.S. out of this economic tar pit, but I think Prechter’s differentiation between credit inflation and currency inflation has merit.
Significant across-the-board deflation hasn’t occurred for over 75 years. In order to witness such a rare event, the prevailing mood must change so that the banking system’s zombie condition is revealed. Even a headless frog can be made to jump and appear lively to the willfully myopic.
The Fed’s managers have two tricks to create fiat money inflation; both require the cooperation of people outside their little cabal. The main one they’ve used since long before Ben Bernanke was born is to create credit out of nothing, but that requires third parties willing and able to lend and borrow. Credit is only potential money. It must be borrowed to become money and make price-sustaining demands in the market, and for a lifetime this is exactly what occurred.
This system worked all too well. There is now at least $50 trillion (add the full value of derivatives and unfunded government liabilities and it might be five times higher) in dollar-denominated credit in existence, all pushing upward to keep prices where they are. The value of all that credit rests on trust that people can and will make good on the resulting debt.
If people can’t or won’t borrow then the Fed’s managers could potentially reflex to the other way to create money, the one they have never widely used: they could order the Bureau of Engraving to crank up the printing of bank notes to directly battle a credit contraction, using cash to backstop the banks via Dr. Bernanke’s rhetorical helicopter drop.
If a football field is 360 feet long and 160 feet wide, $50 trillion in Benjamins (the largest denomination now, thank you Drug War) is a football field of cash stacked almost 35 stories high (assuming there’s no airspace between bills) weighing 550,660 tons (that’s five times the weight of the average cruise ship) if my figures are correct.
How many helicopters does Dr. Ben have?
Better still, our rulers could throw in the towel on tracking our cash and issue larger and larger bank note denominations to reduce the size of the pile, as did Zimbabwe’s equally wise rulers.
Long before a fraction of this dead cotton and wood could be inked, prices for the existing debt would crater and interest rates skyrocket as investors, banks, the Chinese, and everyone else desperately tried to trade it for anything but dollars. The illusion of value is sustained only as long as people delude themselves that an asset stands behind the dollar somewhere. Printing bank notes en masse would reveal fiat money’s backed-by-nothing reality in full, something our wizards wish to avoid at all costs.
How do you spell immediate insolvency via credit collapse?
"15% interest rates on T-bonds."
Today our central bankers have lowered the price of their short-term credit to zero. Borrow a million from us, they say, no…borrow a hundred million and pay us back when you get around to it, no questions asked.
Would you borrow a million bucks and buy four or five houses in suburban Las Vegas?
Carrying the debt may be interest-free but property has costs. The value might still decline. Taxes and insurance premiums must be paid. You probably aren’t optimistic enough to take that million at zero interest and buy some houses now, are you?
Five years ago you might have. Conditions have changed (down payment required, for instance) and all the king’s horses and all the king’s men….
The Fed has no way out, and neither do you and I. Banks now teeter dangerously on their collateral, most of it mortgage paper of questionable value. Meanwhile people whose mortgage balance exceeds their home value are widely advised to walk away.
In desperation those managing the federal government put real estate on life support by assuming nearly all home-lending responsibility (see fig. 3) but it’s no cure; where are they going to dig up qualified borrowers?
After 75 years of ever-faster spinning, revving like a jet turbine in the end, their credit inflation machine finally tore itself apart. The economy (as represented by the stock and real estate markets) tumbled down an elevator shaft last year, landing hard in March at record levels of pessimism.
The rally since then has done its job. Excess pessimism has been replaced by bullish conviction. The economy is still a shambles but pundits and politicians have imaginatively sounded the All Clear.
The problem is that nothing revealed by the economic plunge has changed. The Fed has run out of people willing or able to borrow, and a new condition of distrust infects congressman and constituent alike. The federal government is run by people, not machines, and they too will likely demonstrate their own kind of aversion to reckless debt assumption. The recent frenzy of federal borrowing should wane, either bending to public outrage or the necessity to protect Uncle Sam’s credit rating as long as possible (though it, too, will eventually get sucked down into the vortex, probably after most other existing credit has gone the way of the Dodo).
The markets will reveal when this temporary pill-popping of crystal meth credit has worn off; when they fall, the economy will likely collapse every bit as hard as an addict crashing off a huge meth high after sprinting up 25 flights of stairs with the broken femur and punctured lung he sustained in the previous plunge.
What might that look like? Imagine if three out of four of us lose our nice, well-paid jobs and the lucky ones find re-employment at a third what we earned before. Imagine a 1,500 square foot home selling for the same number of dollars in 2012 as a 1,500 square foot home sold for in 1964. It could happen. After all, the main difference between now and then is accumulated credit inflation, and credit has no physical reality. What is a home’s price if the buyer must pay cash?
I think that the architects of our elastic fiat dollar may discover that the rubber buck they stretched for 75 years can still snap back. Should that occur, wiping out much of a lifetime of accumulated credit inflation in a bomb-like release of energy, it will punish everyone whose occupation and standard of living grew to rest on it: us all.