More on the economy

Okay. So the US Treasury is holding its auction and everyone who wants to buy US debt is finished bidding. But there's lots more debt sitting on the table to be sold. So what do we do? Here comes the Federal Reserve to the rescue! In order to obscure the real nature of what they are doing they've come up with a clever term that means nothing. Quantitative easing. Sounds so scientific. But it isn't scientific, it is diabolical. The Fed shows up to the auction window and says, "I'll buy up all the debt you have left." In order to accomplish this they have to literally create money out of thin air. The bank balance of the US Treasury goes up after the sale, the investment portfolio of the Fed goes up by the amount of money they just printed (magically) and everyone is happy. This is an incredible event. I cannot imagine that the Japanese or the Chinese or the oil sheiks are happy about it, at all. One branch of the US government just bought billions of dollars of US debt from another branch of the US government, and everyone pretends that this is a legitimate business transaction. The result is that there are billions of dollars in the money supply that never existed before, until the transaction. This reduces the purchasing power of each of the original dollars, and these foreign countries hold billions of them. I can’t imagine they are okay with this.

Let's pause for a moment to talk about inflation. Let's limit ourselves to ideal systems for the moment. In an ideal economic system with a fixed amount of money and a fixed amount of goods and services, an equilibrium will be reached. The "price" of any good or service in this system will remain stable, because there will always be the same number of dollars to apply to a given amount of goods or service. If the amount of money in the system is increased, but the economic output remains fixed, then the larger number of dollars chasing after the fixed amount of goods/services will ultimately equilibrate at a point where a given amount of goods will require a higher amount of dollars, which we call price inflation. The opposite effect works, as well. In our situation, with the Fed creating extra dollars out of thin air we should expect this to ultimately result in price inflation. Those extra dollars are running around in our economic system and they will demand a price increase so that the extra dollars get "used up". The only other thing to mention here is that this outcome takes a little time to become evident. But it is inevitable. So, here are some facts. The Fed has engaged in quantitative easing, or creating money out of thin air. They will most likely have to continue this because we need to sell $2 trillion dollars of US debt, and there just aren’t that many buyers out there right now. The end result of this activity is that there will be inflation.

But is that the end of the story? Not really. In a beautiful example of positive feedback, higher inflation will result in investors (China, Japan, etc.) who demand a higher return on their investments. That means that interest rates on US debt will have to rise. Which will mean that the US government will have to actually borrow more in order to pay for the borrowing they are already doing (this is not a good trend), and the higher level of borrowing will feedback into higher interest rates and higher borrowing etc., ad infinitum. Making things even worse, at some point the foreign investors will begin to wonder whether the US government is really going to be good for its debts. That loss of confidence in the US government will be a bad thing.

In order to give you the whole picture I must talk a bit about deflation. There are many economists today who are primarily concerned about deflation, rather than inflation. And the fact is that we have been in a largely deflationary environment for the past year, which explains why we haven’t yet seen the runaway inflation that would normally be expected with the introduction of so many new dollars into the economy. Deflation is basically the inverse of inflation, and can be simply defined as the decrease in the available dollars in an economic system to cover a fixed amount of goods and services. In this scenario each dollar becomes more valuable, so the price of goods and services goes down. As we all know, there has been an enormous amount of value destruction in the past year. Housing prices and stock prices have decreased markedly. These price decreases have resulted in the virtual evaporation of large quantities of dollars. To the extent that these realized losses have made their way into the money supply we have experienced deflation. The actions of the US government have been patently inflationary. When combined with the current deflationary environment the observed effect is that things have basically stayed the same as usual.

In theory, and the Federal Reserve is betting everything on this theory, once the deflationary pressure is lifted from the economy the Fed can simultaneously lift the inflationary pressure and we are back to normal and everyone is happy. The fly in this particular ointment is that there is virtually no way that the Fed will be able to stop their inflationary activities. The US government will not suddenly stop spending money like there is no tomorrow. From a political perspective, they cannot suddenly start taxing everyone in sight. They have to maintain the fiction that they won’t raise taxes on the regular Joe. And they cannot entertain a reduction in the services that the nanny state provides to boobus americanus. So when deflationary value destruction ceases to be a predominant force in the economy all we’ll be left with is the inflationary activity of the US government. And we are talking about an inflationary flood that will dwarf anything we have ever seen before in this country. So, inflation is inevitable although it may not be imminent.