The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.
I concur with Hussman’s assessment that we will likely see elevated inflation levels. Weimar Republic or Zimbabwe style hyperinflation in triple or quadruple digits is unlikely at this point.
No free lunch
Milton Friedman famously said that there is no free lunch. It is encouraging that Obama has voiced concerns over the size of the deficit and its sustainability. It is also encouraging that he is getting close, but he hasn't uttered the word "sacrifice" yet. Meanwhile, the American electorate appears to be in denial over the sacrifices involved, which mean some combination of much higher taxes, fewer government services and lower Social Security and health care benefits.
Is California the future of America?
Down one road are the difficult adjustments that the U.S. and the world needs to make. Down the other road is inflation (most likely) and America going down the road of California's state of political paralysis. The Economist recently commented that [emphasis mine]:
California has a unique combination of features which, individually, are shared by other states but collectively cause dysfunction. These begin with the requirement that any budget pass both houses of the legislature with a two-thirds majority. Two other states, Rhode Island and Arkansas, have such a law. But California, where taxation and budgets are determined separately, also requires two-thirds majorities for any tax increase. Twelve other states demand this. Only California, however, has both requirements.
People want services and benefits, but they aren’t willing to pay for them. Something has to give (and the result is likely rising inflation). Here is a rant from David Merkel of Aleph Blog:
Those are trillions of dollars that we are looking at, and a 14% growth rate over the last eight years, significantly outpacing GDP growth...
We are viewing the slow failure of the US Government. It may not be for years or decades, but the lack of willingness of the current administration to address the growing shortfall shows that they are more similar to the Bush, Jr., administration, than different from it. After all, who ran the biggest deficits? Obama, by a long shot.
Watch this space. You may also want to sign up for my free inflation watch e-mail newsletter.