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Full Frontal Inflation

By now it’s an article of faith within the sound money community that most major countries have borrowed so much that they’re left with only two options: default on their debt through mass-bankruptcy and a new Great Depression, or inflate it away through stepped-up currency creation.

This is an investment thesis, since a given country’s choice will determine which asset classes rise and fall.

But it’s also a criticism of the people and policies that put us in this box. The presidents, prime ministers, senators, central bank heads and investment bankers who presided over the global economy of the past 30 years screwed up monumentally, leaving today’s savers, entrepreneurs and workers to clean up their mess.

Because acknowledging this stark choice between inflation and Depression is such an admission of failure, it isn’t discussed in these terms on the official side of the debate. There, the tone is more measured and the promise is that the next tweak will more-or-less painlessly return the system to a stable equilibrium of steady growth, full employment and incumbent electoral success.

But at some point the fig leaf has to fall and the truth — that there are no painless solutions, only different types of pain — will have to be stated explicitly. Here’s a glimpse of that future in the form of an old (2010) column by New York Times columnist and Nobel Prize-winning economist Paul Krugman:

Default Is In Our Stars

Not in ourselves.

I think it’s fair to say that a majority of economists believe that excessive private debt played a key role in getting us into this economic mess, and is playing a key role in preventing us from getting out. So, how does it end?

A naive view says that what we need is a return to virtue: everyone needs to save more, pay down debt, and restore healthy balance sheets.

The problem with this view is the fallacy of composition: when everyone tries to pay down debt at the same time, the result is a depressed economy and falling inflation, which cause the ratio of debt to income to rise if anything. That is, we’re living in a world in which the twin paradoxes of thrift and deleveraging hold, and hence in which individual virtue ends up being collective vice.

So what will happen? In the end, I’d argue, what must happen is an effective default on a significant part of debt, one way or another. The default could be implicit, via a period of moderate inflation that reduces the real burden of debt; that’s how World War II cured the depression. Or, if not, we could see a gradual, painful process of individual defaults and bankruptcies, which ends up reducing overall debt.

And that’s what is happening now: as this story in today’s Times points out, the main force behind the gratifying decline in consumer debt appears to be default rather than thrift.

So basically, we can do this cleanly or we can do this ugly. And ugly is the way we’re going.

Some thoughts
Even now, four years after Krugman’s rhetorical trial balloon, policy makers and economists refuse to admit that inflation is a form of default. But things are going so badly for these guys pretty much everywhere that before long they’ll be forced, as Krugman briefly was, to start spinning default-through-devaluation as the smoother, less painful version of an act that in most walks of life is seen as shameful.

Of course, one person’s smooth transition is another’s swerve into a ditch. Savers now accepting 0.5% interest on bank CDs will be shocked to find out that the government is explicitly trying to devalue the currency by 5% a year, giving those CDs a -4.5% annual return and making saving for retirement — or even preserving capital — impossible.

But leaving aside the moral failings of inflation, Keynesian economic theory also has a glaring analytical flaw: a seeming inability to think through the secondary and tertiary effects of policy. To take one obvious example, if a country begins to explicitly default on its debts by lowering the value of its currency, then the rational response for people within that system is to borrow as much as possible at current low interest rates with the goal of paying back the loans in massively-cheaper money. So…the policy of shrinking current debt through inflation actually leads to a surge in new borrowing and (presumably) an even bigger debt problem in the future. But because it generates “growth” in the short run as the proceeds of all those new loans are spent, it appears to work for a while, which seems to be what matters in this theoretical framework.

Krugman’s admission is also a big step on the journey to the Austrian economics crack-up boom, which hits when a critical mass of people figure out that the government is going to make the currency worth less each year for a really long time. Individuals and businesses lose interest in holding the currency, instead spending it on real stuff as fast as it comes in, thus setting off an asset bubble/hyperinflation.

And about WWII fixing the Great Depression, sorry, but the US invasion of Europe followed a decade of private sector debt defaults which lowered total debt/GDP by more than half. By 1939 the US had already deleveraged and was ready to start growing again. The fact that Washington then increased spending and borrowing is almost irrelevant — or maybe actually negative because the bullets, tanks and planes the government bought were subsequently used or destroyed without adding to US real wealth. So a case could be made that the 1950s and 1960s would have been even better economically if WWII had never happened.

Debt during depression

29 thoughts on "Full Frontal Inflation"

  1. The spike in debt/GDP in the 30’s was due to the collapse in GDP. Basic math. It’s a ratio. And therefore, the supposed deleveraging prior to WW2 is baloney as well. Just like your entire last paragraph, and pretty much the whole article, as usual.

    You hard money Austrian econ goons need to come out of your caves and get a life.

  2. I might be simplifying things a little but the big picture is pretty clear from my perspective. Ongoing financial repression will transfer wealth from savers to borrowers (government) which over the long term will reduce govt debt in real terms to normalised levels, but it will take decades to resolve. The challenge for authorities is to keep perceptions and systems stabilised through trading range gold prices and rising asset and equity prices. This is quite a tightrope act as there are so many variables in play and the authorities can’t control all of them all of time. The tightrope analogy seems accurate, when the authorities lose their balance a couple of stuttering steps could see the whole lot come down.
    I don’t buy into conspiracy theories about the way the system is currently manipulated. Those in power have always sought ways to maintain their power and financial repression is the best long term way to “shear the sheep” so that the status quo is maintained. It’s to be expected, really.

  3. The effects of the lingering recession are not spread evenly among the races. My county is about 15% black. But if you see someone walking long the side of the road in a non-residential area, it is almost always a black person.

    As long as Obama is President, this racial disparity will simmer below the surface. But when he is gone in January 2017, I think we will start to see major problems in areas with large black populations. We already saw a prelude in Ferguson, MO this Summer.

    They are maintaining an open border policy with Mexico to allow low priced labor to come in and work the low paying jobs that blacks don’t want. This has bought some time, in terms of wage inflation, but it has negative consequences as well. With the economy not adding jobs, and the population growing, it is only a matter of time before there a major societal problems that cannot be swept under the rug. Perhaps that is what the FEMA Camps are about?

  4. I can tell you one thing they are doing – they are scaring me. I do not easily scare. However, I have worked long and hard and managed to save some money. A year ago I was for all practical purposes fully invested in equities. Then I started getting scared. So I started selling equities and buying silver. Since then I have moved to half cash and I have been buying silver as part of my financial plan every month. I have bought stock in the largest 4 gold mining companies as a proxy for gold. I am scared of gold. The data I see indicates that the gold market is being manipulated. If they lose control of the price of gold and it starts to spike up there is no telling what they will do. It would mean the value of USD is tanking. That will scare the crap out of the establishment and they will no doubt take action to protect themselves. The problem is I have no idea what action(s) they will take. So the uncertainly continues. Also, Russia, China, and other countries have become fed up with our behavior as a nation and our apparent inability to manage our national finances responsibly. As a result they are aggressively moving to stop the use of USD in their transactions. This could become quite serious over time if it continues and it looks like it is going to continue. That scares me as I have no idea what the Fed Gov reaction will be to this activity. I try to avoid the whole conspiracy thing and stick to the facts if such facts are available (the media and the Fed Gov data is often suspect) and the facts do not look good. All the media spin in the world does not mask the fact that full time “bread winner” jobs are declining and part time lower paying jobs are multiplying. Spin does not refute my personal observations of retail outlets going out of business and few, if any, new outlets moving into the abandoned retail spaces of those who could not make it. The out of control Fed Gov spending scares me. The current trend toward unconstitutional behaviors in the Fed Gov scare me. One of the primary functions of the Fed Gov to to protect the rights of the citizens – not take them away. So I am forced to admit that at 56 years old I am getting a little scared.

  5. As David stated above, “The more I learn, the less I understand…….” That’s where I’m at and have been for several years. Nothing seems to work out the logical way the pundits and theory says it should. And after reading the full range of opinions stated above, I don’t think I’m the only one who is having a problem. Does anyone really know where we’re going???

  6. It seems inconceivable that interest rates will rise much. A reversion to mean would push up mortgage (and other) rates by five or six percentage points to around 10%. That would add $1000/month to the monthly bill for a $200,000 mortgage. Housing starts are off the 2008 low, but still pretty weak by historical standards. They can’t risk a rise in rates for the foreseeable future.

    So I think they will continue to cap rates and deal with the fallout. They appear to be shorting gold. I’m not sure how much longer that can continue.

    The masters appear to be pretty good a guiding things lower. Maybe we don’t get any sort of cataclysmic ending. Just a slow grind down to an average standard of living that is about half of the present level.

  7. Without WW II the Great Depression would have lasted much longer. The very large government spending program allowed the private sector to deleverage/pay back A LOT OF their debts.

    Combined with rationing of goods during WW II meant that consumers were forced to save in stead of spending their income.

    1. Sorry Willy, have to call you an that one; “The very large government spending program allowed the private sector to deleverage/pay back A LOT OF their debts.”

      You don’t need a degree in finance to understand that government spending was new debt (The very large government spending…) simply replaced the private debt you refer to.

      The biggest influence the war had on the domestic economy was to absorb the unemployed. Both in defense industries which started long before Pearl Harbor with the lend-lease act, and then by induction into the military of millions of men after Pearl.

      Rationing had little effect economically because the same or more inputs got used and the same or more outputs got used, rationing simply directed them away from domestic consumption to war material. People still managed to find ways to spend as much or more as they had prior to the war and after.

      Deleveraging and excessive saving from fear of bank collapses was still topmost in their minds after the bank holidays and collapses of the 30’s. When my grandfather died in 1985 we found envelopes, some quite yellowed with age, hidden all over his house. Bills taped behind photos in frames, loose floorboards in his shop with loot stashed, and almost nothing other than a few days operating cash in the bank.

  8. Chris Martenson (Peak Prosperity site) did an excellent interview with Lacy Hunt of Van Hoisington. You can get it on iTunes and I believe on YouTube. It’s a must listen if you find this column on DC interesting.

  9. I think that those who think the US (and world) can grow out of debt via inflation are wrong. Not only will prices rise, but larger loans will need to be taken out by the borrowers to afford the ever-inflating goods they buy on credit. Thus, prices will rise and debt will rise as well. Only real wage growth and/or debt destruction can be used to pay off or destroy excess debt.

  10. I have read and studied this stuff for years. I have spent untold hours mulling it all over and discussing it with other people. I work for a Wall Street firm in the FX business so I am exposed to the world every day. The more I learn the less I understand what is going to happen. The problem is I have no idea what the politicians and central bankers are going to do. The people I know who do not work for Wall Street firms by and large have no idea what is going on and if you try to tell them they think you are some kind of crackpot. I have been down that road a number of times. The vast majority of people in America have no clue about any of it. I think that is a dangerous situation. What I do know is there is going to be change. What they are going now can not go on forever – the current system will break. When the people finally come to understand what has been done to them they are going to be outraged and there is going to be a lot of trouble. The government is clearly gearing up big time for trouble with the people. The politicians have been on an out of control spending spree basically since 1971. Governments and central banks appear to be actively manipulating the markets trying to make it work. But I do not know what they plan to do next. There are a lot of lies. You can’t lie forever. The “taper” seems to be nonsense as the extra instruments are being bought up on the sly which is why interest rates have not gone up. Is the Fed Res really going to allow interest rates to rise to “natural levels” ? What would be a natural level for the 10T ? 5% ? 7% ? 10% ? What happens to America is the 10T is 7% ? Should EUR/USD really be 1.29 ? Should the DOW be 17,000 ? Should gold be 1250 ? Should the Fed Res have a couple of trillion in MBS ? Should they have an active trading floor in NY ? Why would the Fed Res have a trading floor at all ? It looks to me like it is all broken. The whole damn thing is broken. I have no idea what is going to happen but whatever it is you can pretty much guarantee it is going to be bad.

    1. I just could not agree more, it is all broken, there is no market clearing mechanism for anything, the value of the dollar is broken so no price levels can be determined, and I need no further proof than the fact that in Roanoke VA gasoline can be bought for $2.89 while in this county in southern Oregon the same fuel averages $3.799. Whether that is due to price fixing or broken distribution models just does not matter, to bottom line it means our money and our way of finance is BROKEN.

      But, when the day dawns where people realize how fucked they are they will respond with anger like you say, and that anger will be a wave broken on the rocks of billionaire and corporate indifference; they own the nation now. They will be safe from the tempest, we will pay, what will finally sink in for the population is that they are and have been for a long time serfs to serve the wealthy ruling elite, and that it was accomplished with the consent of half the voting public who preferred to ballot against their own economic self interest because they were racist, or sexist, or hated gays, or had other priorities besides defending the constitution and the middle class way of life. They are getting what they so richly deserve I can’t bring myself to feel sorry for them. I wonder, when they all have to rely on food vouchers and SNAP to avoid hunger if they will still seek an end to “welfare” for people? What they SHOULD have been fighting was welfare for corporations and billionaires all along.

  11. I actually have several issues with this piece.

    First of all, in Krugman’s first paragraph, I don’t accept that the opinions of “a majority of economists” is necessarily a sound basis for discussion. After all it was ‘the majority opinion’ of those same economists who supported all of the “screw ups” that has gotten us to this point. I don’t think that “excessive private debt” is the culprit. Excessive public debt would be more accurate, or is at least as problematic. One can blame “sub-prime” debt holders for triggering the last official financial crisis (2008) but it quickly became clear that the entire financial system was over-leveraged, and since then it has been sovereign national debts all over the industrialized world that has bogged things down.

    Krugman may think that living responsibly is “naive”, but I think he is naive to suggest that inflation is some clever new invention that can save us from ugliness. In fact, as JR points out, one “rational” response to steady inflation expectations has traditionally been the liberal accumulation of debt, expecting it’s real costs will be discounted. The ever-changing official, “headline” inflation data not withstanding, most people have had (and still do) a pretty good sense of the real inflation rate of prices, and took on debt accordingly, taking advantage of artificially suppressed interest rates courtesy of the Fed/CBs.

    My sense of what is happening now – and will accelerate – is something that may be unprecedented, at least in this latest cycle of central banking and central planning. People are already responding to current inflation levels not by borrowing more but by saving more. For one thing they may not be able to borrow more for lack of income or credit worthiness, but even if they could – barring ridiculously “too good to be true” car buying loans – they are choosing to save in order to pay for necessities that they think may be more expensive in the future. This is probably because people are less secure in their jobs and their income, but I’m speculating.

    I don’t think we’re approaching the “crack up boom” phase yet because the Fed hasn’t been as kamikaze-like as Abe in fanatically committing to inflation – yet(?) – and the ECB may never be able to ruin the euro if Germany’s Bundesbank doesn’t capitulate.

    I hope hyperinflation doesn’t happen because I’m afraid it will involve catastrophic physical booms as well.

      1. “hyperinflation wont happen”

        Why are you so confident of that? Hyperinflation is not a monetary event, it’s a social one – when people lose confidence in their currency. Confidence is all that fiat currencies are based upon because they have no intrinsic value nor do they represent anything of intrinsic value. The US dollar/FRN is backed by “the full faith and credit” of the Federal Reserve Bank or the taxing authority of the US Treasury.

        Nevertheless, I agree with you in that that is not my main concern either, but the current monetary systems are mathematically/physically unsustainable so they will end eventually in some way, and historically that would be sooner than later at this point. How and when is anyone’s guess. What’s yours?

  12. All I know is if the cost of living keeps going higher at the current rate for a few more months I will be living in my car. These 0-2% COLA’s on my fixed income mean I have lost at least 30% of purchasing power in the last 5 or so years, and I am seeing vast price rises worse than what I remember in the seventies. Just this month butter up 119% from $2.18 per pound to $4.79, rib eye steak now $18.99 at Safeway. Rents here up 40% in the last two years. If you can even find a place, so many houses are sitting empty as bank REO’s that all those people have filled the rental market. Gasoline has dropped in the east and on the NYMEX ($2.53 per gallon today) but here we still pay on average $3.799 and some stations still charge over $4.

    We never left the recession here either, so how people are paying for boggles my mind. Yet I saw it coming and it was a major factor in my decision to walk out of my mortgage in 2009 and get my Irish passport so I could leave America. I just gave notice to my landlord last week for November 1. It should be quite entertaining to see all this from afar on a neutral island nation.

  13. People tend to think WWII helped the US economy for broken window reasons — i.e. because of the demand for weapons — which of course is nonsense. But in the early years of war we sat back and took in gold and sent out exports, with people like Ford and Prescott Bush benefiting from both sides. Later we spent US tax dollars creating the tanks and bombers that helped destroy European industry, thus eliminating, for some time to come, many would-be competitors to American industry. And it cemented our world reserve currency status and led to our exorbitant privilege. I think WWII did help the American economy but not for the reasons most folks imagine.

    1. Paper,
      It’s enlightening to read someone who reads history and gets it, but the norm neither read history nor learn from it. we have four wars going and are going to begin the indoctrination that we need to do more by sending our young to die for nothing but imperial ambitions for more wealth to the few Henry types. How many of our lives have been saved by TSA? After WWII, how many wars has the West been successful in winning?–thanks

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