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Thu

19

Mar

2009

Inflation: The Miracle Cure
Thursday, 19 March 2009 06:05
by Stephen P. Pizzo

I'm not saying it's a good thing. I'm just saying it's the only thing left that can get us out of our current financial system death spiral.

I'm am also saying that both Fed Chief Ben Bernanke and President Obama know it's the only way.

Oh and our biggest lender, China, knows it too
Chinese leader Wen's remarks put focus on U.S. Treasuries
USA Today – Investors this week may be watching the U.S. Treasury market a bit more closely than usual. Any heightened scrutiny would be thanks to Chinese Premier Wen Jiabao, who said Friday he was "a little bit worried" about the safety of his government's U.S. Investments. "We lent such huge funds to the United States, and of course we're concerned about the security of our assets," (Full Story)
They have good reason to worry. Because, you can be sure, the Chinese have boned up on how the US got itself out of a similar mess back in the late 1970's. Back then the US was staggering under the massive debt built up by Lyndon Johnson's and Richard Nixon's “guns and butter” policies. Like George W. Bush, Johnson and Nixon were trying to fund and fight an very unpopular war – Vietnam.

And like George W. Bush the way Johnson & Nixon managed that tricky juggling act was by assuring Americans they would not have to sacrifice, that he could fight a war, not raise their taxes and boost domestic spending too boot.

To pull of such a stunt all three of these Presidents, had no choice but to borrow – and borrow, and borrow.

Much of that borrowing came in the form of the sale of US Treasury Notes (I.O.Us) By the time Jimmy Carter stumbled into office a lot of that debt, some held by US citizens, more held by other governments – was coming due, and at the worst possible moment.

Two decades of profligate government spending and borrowing finally hit Main Street. Recession had set in, further eroding tax payments driving the national bank account further in the red. The economy was stagnant.

What to do?

What they did back then was inflate the currency. The Federal Reserve turned on the presses and the money supply exploded. By 1978 gold broke through the $800 and ounce mark – adjusted for inflation, today that would equal $2591 an ounce.

Asset values soared. In California -- where at the time I was selling real estate -- home prices were increasing at a rate of 2% a month... or 24% a year.

There's your first clue.

Today US home values have declined by as much as 50% in some places today. Most of those homes have mortgages and a lot of those mortgages are underwater – meaning more is still owed on those homes than the homes are currently worth.

Which is one big reason so many lenders are in trouble. And home prices continue dropping. Just stopping that decline won't be enough to get lenders out of trouble. To truly fix the banks home values have to get back up as close to where they were before the crash – and get there fast.


To date the Fed has used every trick in it's toolbox without much affect. There's only one tool left that can pull off such a whiplash recovery; inflate and inflate with a vengeance. Because at this point academic debates over what constitutes “true market value,” and "mark to market accounting, are all very interesting, but way too late in coming. Lectures on good fiscal hygiene are useless now. It's time for steroids.

Which brings me back to all that Chinese hand wringing we heard last week. What the Chinese were really saying was, “We don't know, or even care how you're going to get out of this mess, as long as don't do it by inflating your currency.”

If you were the Chinese Finance Minister you'd be worried too. China is now sitting on something just shy of a trillion bucks in US Treasuries. Those bonds (IOUs) are denominated in US dollars, meaning we must repay, and China must accept repayment, in US dollars.

Therein lays the “magic” inflation cure. While we can't do a damn thing about how much we owe China, by inflating the dollar, actually making it worth less against other currencies, we get to pay China back with discount dollars. It's as if you borrowed $100,000 from someone and was able to repay them in something else worth only half that much. You and I can't do that, but the US government can.

And will.

I only mention all this because you are hearing all kinds of folks in DC complaining about the size of the stimulus package, the bailout trillions going to Wall Street and failing banks and soaring domestic spending. Most Democrats in Congress are for it all, claiming their purpose is to create jobs. Most Republicans are against it because all the domestic spending balloons the deficit.

Both sides are lying through their teeth. They know that home values cannot claw their way back to pre-crash levels any time soon, and that until they do things will only get worse. They know the only way the financial sector is going to become fully recapitalized and stabilized is for all those junk and other assets they have on their books to dramatically rise in value.

And the only way that's going to happen any time in the near future – and it damn well better happen in the near future – is to inflate, and inflate with a passion.

Of course they are not going to admit that anything of the sort is afoot. After all, the Fed has spent the last quarter century fighting inflation as if it were the Federal Reserves own personal version of al Qaida. That's been the Fed's raison d'être. So, how could they now admit to purposely igniting the flames of inflation, turning arsonist? They can't. And they won't.

Besides, even if they could tell us, they can't let on to our borrowers, the Chinese, who are already giving us the hairy eyeball. Should the Chinese start dumping their dollar-denominated US bonds, and/or stop lending to us by refusing to buy additional bonds, we would be supremely screwed.

But it's already begun. For the time being we are in a deflationary spiral. Each day the value of all those CDO, MBS, derivatives and homes plummet things get worse – for everyone. No amount of Presidential jawboning is going to change that. So onto Plan B. Think of all the stimulus, from TARP to TALF to the budget and the Fed's trillions in financial help to banks and others, as lighter fluid being pumped through the veins of our financial system. At some point all that stimulus will hit critical mass and ignite -- inflation. So, buckle up. Because when it hits it's going to be 1978 all over again, squared.

As the humongous surplus of stimulus dollars start chasing the finite supply of goods and services it will start to drive up prices, salaries, stocks and real estate values. Up... and up, and up, and up they'll shoot. Irrational exuberance will return to Wall Street. The stock market will shoot up because, as the real value of the dollar declines it will take more dollars to stock, even though the intrinsic value of those share has not changed at all. But the higher dollar volume will drive the DOW and NASDAQ up and up and investors will begin chasing it once again.

Once asset values reach market valuations that relieves the pressure on banks, companies like GM and securities markets life will begin to return to pre-crash normality.

But don't be too quick to breathe a sigh of relief. Because at that point the Fed will have another tiger by the tail – the risk of hyper-inflation. Just ask the citizens of Zimbabwe how that's working for them, where inflation is now running somewhere around 250 million percent a year.

Because it's a lot harder to put a fire out, than it is to start one.

P.S. From My Shameless "Told You So" Division

Oh, and BTW the damn way... I know it's not very attractive of me, but I do have to point out at this point that none of this should have come as a surprise to anyone who claims to be an economist. After all, I'm not an economist. I didn't even go to college. But even this dim bulb saw it coming. So don't believe it when the people who stood around a let it happen tell you “no one could have seen this coming.” Hogwash. Here are excerpts from previous NFR columns. They currently live in my Word Press archives HERE:

On November 22, 2004 I wrote:
All this was a long-winded way of warning that over the next four years the US budget deficit – regardless of what Dick Cheney says – will matter. In fact, it will begin to matter more than anything else. Those of you old enough to remember ‘stagflation” will recognize what’s coming. Stagflation is when we have stagnant growth and rampant inflation. Stagflation hit in the late 1970s and early 1980s when Lyndon Johnson’s “guns and butter” Vietnam War policies came home to roost. Debt always comes home to roost.

Sooner or later the piper has to be paid. That day will arrive for the US during this Bush term as China, Japan and the EU move away from the US dollar.

Sorry, Uncle Sam, your credit card has been refused.

December 8, 2005
Now it is true that the gold bugs are not always right. Sometimes they dive into their foxholes only to miss another sunny day at the beach. But when gold makes the kind of dramatic moves it’s making now, they’re usually right. The last time I saw a move like this it was back in 1979-80 when the deficits we ran up paying for the war in Vietnam came home to roost. Inflation soared as did interest rate. That in turn popped what had been a very hot housing bubble. And gold took off, eventually reaching $850 an ounce in April 1980. Today we have much the same going on. The only difference is that the deficits this time are so enormous they are trigging trouble a lot sooner than the Vietnam era “guns and butter” policies. But like now, in late 70’s we are also coming to the end of a six year housing price boom. Unlike 1979 this time the war that broke us is still on. And, despite all the recent blather about withdrawing, we will continue spending billions of dollars a month in Iraq for years to come. (We broke it, now we have to pay up to fix it.)

January 25, 2005
It would be unfair though to conclude though that the Bush folks don’t have a plan up their sleeves, because they do have a plan. And it’s a plan that worked pretty well once before when the country had big bills to pay and not much money with which to pay them. It’s called inflation…. and lots of it.
That’s how we paid off the bill left by the last president to believe he could have both guns and butter, Lyndon Johnson. Johnson, like Bush, had an un-winnable war on his hands, Viet Nam. Johnson’s expensive domestic agenda was not tax cuts but his “Great Society,” vision that created new social programs on a massive scale. The Johnson administration bill came due during Gerald Ford’s administration. And, without the money to pay it they allowed inflation to run free. By doing so they were able to repay old debt with cheapened dollars. And that’s the Bush plan. I know it’s their plan because, now that we are this far down the deficit road, it’s the only plan left.

May 15, 2006
Reagan thought deregulating savings and loans would spur home construction and create jobs. It didn’t. And his tax cuts failed to produce more high- paying jobs or higher tax revenues, which dropped off a cliff while defense spending soared.
Bipartisan pork kept domestic spending climbing as well. It was Vietnam-era “guns and butter” economics all over again. To cover the fall in tax revenues, Reagan whipped out the National Platinum Card. By 1987, the United States was the world’s largest debtor nation. (Update: Since this was written US government debt has doubled to $8.3 trillion)
Warning: Political conditions today mirror the Reagan era. Reagan’s popularity among voters convinced Democrats it was in their best short-term interest to support his proposed tax cuts.

April 25, 2006
Pimped Reasoning: Deficits don’t matter. Instead of taxing Americans to pay for national operations overhead and spending on discretionary operations, just borrow the money by issuing government bonds.  (Meet the Pimps: Politicians providing tax relief to wealthy contributors and corporations in return for campaign contributions. Politicians that want to provide pain-free pork to home state voters by borrowing rather than taxing to pay for bridges to nowhere, etc.)

Unpimped Reasoning: Deficits do matter – eventually. Sooner or later those bonds have to be repaid. In the meantime the nation has to pay interest on a growing national debt. Both interest on the debt and the eventual repayment of principle will have to come from someplace. Either future taxes will have to be raised — far more than they would have if the spending had been paid for with taxes at the time the obligations were created. Or the government will increase the money supply by simply printing more money. That will sparking hyper-inflation but allows the government to replay those bond obligations with devalued dollars. The last time we did that – to repay the debt we built up during the Lyndon Johnson “guns and butter,” Vietnam War years – it sparked the hyper inflation that racked the economy during the Carter administration.

The result then was stagflation – the worse of all possible worlds.
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