Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Coronavirus: UK Parents Demand ALL Schools OPEN September, 7 Million Children Abandoned by Teachers - 9th Aug 20
Computer GPU Fans Not Spinning Quick FIX - Sticky Fans Solution - 9th Aug 20
Find the Best Speech Converter for You - 9th Aug 20
Silver Bull Market Update - 7th Aug 20
This Inflation-Adjusted Silver Chart Tells An Interesting Story - 7th Aug 20
The Great American Housing Boom Has Begun - 7th Aug 20
NATURAL GAS BEGINS UPSIDE BREAKOUT MOVE - 7th Aug 20
Know About Lotteries With The Best Odds Of Winning - 7th Aug 20
Could Gold Price Reach $7,000 by 2030? - 6th Aug 20
Bananas for All! Keep Dancing… FOMC - 6th Aug 20
How to Do Bets During This Time - 6th Aug 20
How to develop your stock trading strategy - 6th Aug 20
Stock Investors What to do if Trump Bans TikTok - 5th Aug 20
Gold Trifecta of Key Signals for Gold Mining Stocks - 5th Aug 20
ARE YOU LOVING YOUR SERVITUDE? - 5th Aug 20
Stock Market Uptrend Continues? - 4th Aug 20
The Dimensions of Covid-19: The Hong Kong Flu Redux - 4th Aug 20
High Yield Junk Bonds Are Hot Again -- Despite Warning Signs - 4th Aug 20
Gold Stocks Autumn Rally - 4th Aug 20
“Government Sachs” Is Worried About the Federal Reserve Note - 4th Aug 20
Gold Miners Still Pushing That Cart of Rocks Up Hill - 4th Aug 20
UK Government to Cancel Christmas - Crazy Covid Eid 2020! - 4th Aug 20
Covid-19 Exposes NHS Institutional Racism Against Black and Asian Staff and Patients - 4th Aug 20
How Sony Is Fueling the Computer Vision Boom - 3rd Aug 20
Computer Gaming System Rig Top Tips For 6 Years Future Proofing Build Spec - 3rd Aug 20
Cornwwall Bude Caravan Park Holidays 2020 - Look Inside Holiday Resort Caravan - 3rd Aug 20
UK Caravan Park Holidays 2020 Review - Hoseasons Cayton Bay North East England - 3rd Aug 20
Best Travel Bags for 2020 Summer Holidays , Back Sling packs, water proof, money belt and tactical - 3rd Aug 20
Precious Metals Warn Of Increased Volatility Ahead - 2nd Aug 20
The Key USDX Sign for Gold and Silver - 2nd Aug 20
Corona Crisis Will Have Lasting Impact on Gold Market - 2nd Aug 20
Gold & Silver: Two Pictures - 1st Aug 20
The Bullish Case for Stocks Isn't Over Yet - 1st Aug 20
Is Gold Price Action Warning Of Imminent Monetary Collapse - Part 2? - 1st Aug 20
Will America Accept the World's Worst Pandemic Response Government - 1st Aug 20
Stock Market Technical Patterns, Future Expectations and More – Part II - 1st Aug 20
Trump White House Accelerating Toward a US Dollar Crisis - 31st Jul 20
Why US Commercial Real Estate is Set to Get Slammed - 31st Jul 20
Gold Price Blows Through Upside Resistance - The Chase Is On - 31st Jul 20
Is Crude Oil Price Setting Up for a Waterfall Decline? - 31st Jul 20
Stock Market Technical Patterns, Future Expectations and More - 30th Jul 20
Why Big Money Is Already Pouring Into Edge Computing Tech Stocks - 30th Jul 20
Economic and Geopolitical Worries Fuel Gold’s Rally - 30th Jul 20
How to Finance an Investment Property - 30th Jul 20
I Hate Banks - Including Goldman Sachs - 29th Jul 20
NASDAQ Stock Market Double Top & Price Channels Suggest Pending Price Correction - 29th Jul 20
Silver Price Surge Leaves Naysayers in the Dust - 29th Jul 20
UK Supermarket Covid-19 Shop - Few Masks, Lack of Social Distancing (Tesco) - 29th Jul 20
Budgie Clipped Wings, How Long Before it Can Fly Again? - 29th Jul 20
How To Take Advantage Of Tesla's 400% Stock Surge - 29th Jul 20
Gold Makes Record High and Targets $6,000 in New Bull Cycle - 28th Jul 20
Gold Strong Signal For A Secular Bull Market - 28th Jul 20
Anatomy of a Gold and Silver Precious Metals Bull Market - 28th Jul 20
Shopify Is Seizing an $80 Billion Pot of Gold - 28th Jul 20
Stock Market Minor Correction Underway - 28th Jul 20
Why College Is Never Coming Back - 27th Jul 20
Stocks Disconnect from Economy, Gold Responds - 27th Jul 20
Silver Begins Big Upside Rally Attempt - 27th Jul 20
The Gold and Silver Markets Have Changed… What About You? - 27th Jul 20
Google, Apple And Amazon Are Leading A $30 Trillion Assault On Wall Street - 27th Jul 20
This Stock Market Indicator Reaches "Lowest Level in Nearly 20 Years" - 26th Jul 20
New Wave of Economic Stimulus Lifts Gold Price - 26th Jul 20
Stock Market Slow Grind Higher Above the Early June Stock Highs - 26th Jul 20
How High Will Silver Go? - 25th Jul 20
If You Own Gold, Look Out Below - 25th Jul 20
Crude Oil and Energy Sets Up Near Major Resistance – Breakdown Pending - 25th Jul 20
FREE Access to Premium Market Forecasts by Elliott Wave International - 25th Jul 20
The Promise of Silver as August Approaches: Accumulation and Conversation - 25th Jul 20
The Silver Bull Gateway is at Hand - 24th Jul 20
The Prospects of S&P 500 Above the Early June Highs - 24th Jul 20
How Silver Could Surpass Its All-Time High - 24th Jul 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

The Path To Runaway U.S. Inflation

Economics / Inflation Nov 06, 2009 - 10:35 AM GMT

By: Ganesh_Rathnam

Economics

Best Financial Markets Analysis Article"I see green shoots," said Fed Chairman Ben Bernanke on 60 Minutes back in March, doing his best rendition of Haley Joel Osment from the movie The Sixth Sense. Since then, every poor economic headline in the lapdog media has been preceded with the word "unexpected," as if the clueless chairman's pronouncements were suddenly the Gospel, and the economy had indeed recovered.


Phantom US Economic Recovery

Common sense tells us that if phenomenon A causes problem B, then B cannot be rectified unless A is first removed. As an adherent of the Austrian School of economics, I can confidently tell you that a sustainable US recovery is not at hand. An upward blip in the GDP reading (itself a flawed measure of material well-being) must not be mistaken for a sustainable recovery, especially when government borrowing is unprecedentedly high and a lot of the input parameters, not the least of which is the GDP deflator, can be fudged.

I'll borrow an analogy from Peter Schiff. Imagine if you will a victim at the unfortunate end of a Brock Lesnar knuckle sandwich. The blow has knocked him out cold and the medics try to revive him. The best suggestion they can come up with is to have Lesnar pound the man's head even harder with his fists. When the man has seizures from the repeated pounding, a medic (coincidently named Bernanke) screams gleefully "Hurray, he's moving."

Sadly, such is the response to our present crisis by the policy makers in Washington, DC. To solve a problem caused by malinvestments resulting from easy credit at 1 percent interest rates, the Fed is supplying even more easy money at 0.25 percent. None of the malinvestments have been allowed to be liquidated.

Housing prices have been propped up, banks and auto companies have been bailed out, regulations have been increased, debt covenants have been violated, unemployment insurance has been extended. In addition, there's the cap-and-trade bill, the healthcare bill, and a "czar" around every corner.

All of these increase the already-humongous burden on wealth creators. In short, the problems that caused the Great Recession have been compounded. Real output must then necessarily decline. How can anyone logically assert that we are in the beginning of a recovery?

Declining output is not the answer to keep a system with a debt-to-GDP ratio nearing 400 percent (800 percent if you include Social Security and Medicare obligations) solvent. From this vantage point, one can conclude that the real recession is ahead of us, not behind us.

One then must decide whether it will be a deflationary recession or an inflationary recession. Intelligent people can disagree on this, but my take is inflationary.

What's Happening Below the Surface?

Since the Lehman collapse over a year ago, the cracks in the banking system have been papered over with an unprecedented amount of money created out of thin air. However, underneath that surface, the real pool of savings is continually being channeled away from wealth creators to malinvestments such as housing, autos, and banking.

"For a fractional-reserve-banking system to stay solvent, the money supply needs to be continually increased by at least the weighted-average interest rate."

This means that total output will decline eventually because there are no investments being made to maintain capital and improve productive capacity. There may be blips here and there, but they are more likely to be the result of capital consumption than of any sustainable increase in output. Meanwhile, for reasons detailed below, the money supply will constantly increase. We then have the textbook case of more money chasing fewer goods, leading to rampant price escalation.

Deflation Begets Inflation

If you happen to catch a NASCAR race on TV, you might hear a driver screaming over his radio, "Tight, tight, tight … LOOOSE!" This cry is followed invariably by a crash.

What the driver is referring to is his race car's inability to turn the corner. A "tight" condition means the car doesn't want to turn and is heading straight for the wall. A "loose" condition means the car turns too readily and wants to spin out. When a car is difficult to turn, the driver ends up putting so much wheel into it that when the car eventually does turn, it overshoots, spinning out of control; and the driver rear-ends the car into the wall.

This is exactly the scenario I envision for the impending price inflation. Bernanke and company are screaming that there is deflation everywhere they look. To combat this deflation, the Fed will keeping printing money and adding reserves by buying all kinds of assets. This will continue until general prices violently overshoot on the other side, causing runaway price inflation.

The M2 Money-Supply Barometer

The M2 money supply is used by a lot of economists as a barometer to gauge price inflationary pressures. Over the past six months or so, this metric has declined marginally. So if one defines deflation as a reduction in the M2 money supply, then we are indeed experiencing deflation.

On the surface, consumers are finally getting religion, curbing their spending habits and paying down debt. Paying down debt is a deflationary activity because it reduces money supply. Unfortunately, not everyone will be able to pay off their debts.

For a fractional-reserve-banking system to stay solvent, the money supply needs to be continually increased by at least the weighted-average interest rate. This means that money supply needs to grow exponentially.

Consider a system with $100 in loans due in a year at a 10 percent interest rate. The total amount of money in the system is only $100 but the amount due at the end of the year is $110. Where will the $10 come from? It has to be lent into existence at some point prior to when the $110 is due.

"It goes without saying that deflation would have been very painful for any debtor. Consider the most indebted entities: the government, banks, powerful corporations, homeowners, and private equity funds run by insiders."

Absent this increase in money supply, the loan will default. On the other hand, an ever-increasing money supply will quickly lead to runaway price inflation, because real output will be unable to keep pace with money-supply growth.

In a sound-money, 100-percent-reserve-banking system, an overwhelming majority of loans would be made to wealth creators. These loans would be funded by real savings and would eventually be liquidated (to simplify the explanation) by the lenders purchasing the produce of borrowers. These can therefore be called self-liquidating loans. I'm not implying there would be no bad loans, just that bad loans would be minimal compared to our current system, because underwriting would be very strict and the fallout of bad lending decisions would stop with a bank's shareholders.

The vast majority of housing loans and auto loans made during the last boom cannot really be classified as self-liquidating because both of these (I hesitate to call them assets) do not produce anything that can be exchanged for money.

Loan Defaults And Banking-System Collapse

In a fractional-reserve-banking system where debt is being paid down, money supply will decline and eventually prices will follow suit. Businesses will reduce wages to stay profitable. Any debtor will find his debt burden becoming more onerous as there is less money to go around.

Eventually, defaults will begin, with assets moving from debtors to creditors. The banking system will implode and depositors will be wiped out until reserves in the system entirely back up deposits outstanding.

This is precisely the process that should have been allowed to happen since 2008. Left alone, nothing could have prevented this catastrophic collapse. Asset prices would've declined massively, considering that the system had about $10 in credit money for every $1 in reserve (before Bernanke injected about $1 trillion more in reserves).

Why Inflation, Not Deflation?

It goes without saying that deflation would have been very painful for any debtor. Consider the most indebted entities: the government, banks, powerful corporations, homeowners, and private equity funds run by insiders. Given these debtors, is it any wonder that the government chooses bailouts rather than letting the market work its exorcism? Every time there is even the slightest deflation, we'll hear Bernanke et al. saying that all hell will break loose unless something is done about it.

"Deflation causes debt defaults, which in turn cause bank failures, which in turn result in inflation when the government bails out depositors."

If the market were allowed to work, loan defaults would cause bank failures en masse. Bank failures would also wipe out the savings of depositors, because the banks' debt holders will have seniority in bankruptcy proceedings. Yes, all hell will break loose, but only for the people who took imprudent risks like borrowing recklessly or depositing money in unsound banks.

If one bank is allowed to go under and its depositors allowed to be wiped out, you can bet your last dollar that there will be a run on every bank the next day, exacerbating the problem exponentially. The entire banking system would be ruined in a couple of days, with utter chaos, pandemonium, and possibly violence being the rule rather than the exception.

Rather than letting all debtors and depositors be wiped out (and defaulting on its own obligations), the government will intervene via the Fed to shore up the system. The Fed will print money to purchase troubled assets.

The Fed will also print money to fund the US government, because tax revenues will decline precipitously but government mandates will increase (normal operations, transfer payments, unemployment payments, wars, etc.). Once the FDIC runs out of funds to make depositors whole, it will tap into a $500 billion credit line with the Treasury, which in turn will sell bonds to the Fed to raise the money to repay depositors.

Note that when a bank fails but the depositors are made whole, the original money is still in the system and new money is added; this is inflationary. M2 destruction is replaced by M1 creation.

Deflation causes debt defaults, which in turn cause bank failures, which in turn result in inflation when the government bails out depositors. In trying to save debtors and depositors, the policy makers ensure that everyone loses purchasing power via inflation.

This cycle cannot continue endlessly. One fine day it will blow sky-high. Any event may trigger it, from foreigners unloading US dollars and Treasuries, to US citizens realizing that their money is fast losing its purchasing power.

Conclusion

Being a follower of Austrian Economics, I know that real output will continue to decline. Declining real output will result in lower real savings. Lower real savings will put pressure on debt repayments and defaults will result. Private defaults will wipe out banks and depositors, and they will also cause the government to default on its debt.

The Fed will bail out all the affected parties by creating money. Bailouts cause malinvestments that lower real output, beginning the cycle again. This cannot continue forever: it will eventually result in a runaway-inflationary depression.

Ganesh Rathnam works for an asset management firm in India. He has an MBA from the University of Minnesota as well as a master’s degree in mechanics, also from the University of Minnesota. See his website: ImpassionedLibertarian.com. Send him mail. See Ganesh Rathnam's article archives. Comment on the blog.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules