A (Plausible) Path To Runaway U.S. Inflation

 “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 has been preceded with the word “unexpected” by the lapdog media, as if the clueless Bernanke’s words were suddenly the Gospel and the economy had indeed recovered.

Phantom U.S. Economic Recovery

Common sense tells us that if a phenomenon A causes a problem B, 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 U.S. recovery is not at hand.  A sustainable recovery must not be mistaken for an upward blip in the GDP reading (itself a flawed measure of material well-being) especially when government borrowing is unprecedented and a lot of 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 equivalent response to our present crisis provided by the policy makers in Washington DC (perhaps soon to be renamed Barackistan).  To solve a problem caused by malinvestments resulting from easy credit at 1% interest rates, the Fed is supplying even more easy money at 0.25%.  None of the malinvestments have been allowed to be liquidated.  Housing prices have been propped up with tax breaks and Fed purchases of MBS, banks and auto companies have been bailed out, regulations have increased, debt covenants have been violated, unemployment insurance has been extended.  In addition, there’s a cap-and-trade bill and a health care bill, and a “czar” of something seemingly 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 thinking logically then 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% (800% 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 an inflationary recession.

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 channelled away from wealth creators to malinvestments such as housing, autos and banking.  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 a blip here and there but this is more likely to be the result of capital consumption than 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!” followed invariably by a crash.  What he’s 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 turns, it overshoots, spinning out of control and the driver rear-ends the car into the wall.

This is the exact scenario I envision for the impending price inflation.  Bernanke and company are screaming that there is deflation everywhere they see.  To combat this deflation, the Fed will keeping printing money and adding reserves by buying all kinds of assets 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 pay-off their debts.

For a fractional reserve banking (FRB) system to stay solvent, the money supply needs to ALWAYS be increased by at least the weighted average interest rate i.e. money supply needs to grow exponentially.  Consider a system with $100 in loans due in a year @ a 10% 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.  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 as I have detailed why real output will be unable to keep pace with money supply growth.

In a sound money, 100% reserve banking system, an over-whelming majority of loans are made to wealth creators.  These loans are funded by real savings and are eventually liquidated (to simplify the explanation) by the lenders purchasing the produce of borrowers.  They can be called self-liquidating loans.  I’m not implying there will be no bad loans, just that bad loans will be minimal compared to our current system as underwriting will be very strict and the fallout of bad lending decisions will stop with a bank’s shareholders.  Of course, the vast majority of housing loans and auto loans made during the last boom can barely 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 FRB 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 back up deposits outstanding entirely.  This is the exact process that should have been allowed to happen since 2008.  Left alone, nothing could have prevented this catastrophic collapse.  Asset prices would’ve decline 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, private equity funds run by insiders, and home owners.  Given these debtors, is it any wonder that the government choose 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.

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 as 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 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 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 U.S. government as tax revenues will decline precipitously even as government mandates 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, that is inflationary because the original money is still in the system and now we have the new money in addition.  M2 destruction will be replaced by M1 creation.  Deflation causes debt defaults which in turn cause bank failures which in turn result in inflation as depositors are bailed out.  In trying to save debtors and depositors, the policy makers ensure that everyone loses due to loss of 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 or 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 put pressure on debt repayments and defaults will result.  Defaults will wipe out banks and depositors and would also cause the government to default on its debt.  The Fed will bail out all affected parties by creating money.  Bailouts cause malinvestments that lower real output setting off the above cycle again.  This cannot continue forever and will eventually result in a runaway inflationary depression.

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