In the sound-money community you hear a lot
about “the crossroad.” That's the point at which an overindebted country suddenly realizes that it has to
choose between two (and only two) very different paths. One leads to
deflation, with excess debt being purged from the system through
mass-bankruptcy and falling prices. The other leads to inflation, with the
debt being eliminated by lowering the value of the currency in which
it’s paid off. It’s been clear for years that the U.S. was
approaching this fork in the road. And last week, with the Fed chopping half
a point from short term rates and promising more action as needed, we may
have arrived. Whether inflating away this much debt is even possible remains
to be seen, but that we’ll try looks certain.
Now the mainstream press is climbing aboard the
metaphor. Today’s Wall Street Journal has a story featuring
a nifty drawing of a rollercoaster with track that
branches toward two equally forbidding tunnels. One is labeled inflation, the other deflation:
Which Way Is Scarier?
The Federal Reserve cut interest rates last week
in order to address a pressing concern: the risk of recession and of a
breakdown in credit markets. By lowering rates before it really wanted to,
however, the central bank has revived another fear that had been dying
down: inflation. That has left the Fed and the investment world in a tight
If the Fed gets it just right, the economy will slip through this crisis
and keep expanding with only modest inflation, making investors happy. If
the Fed's rate cuts are too little, too late, recession fears will return,
sending another cold wind through credit markets and the stock market. If
the Fed cuts rates too much, inflation could loom.
What was troubling some investors after the Fed rate cut last week, a
reduction in short-term rates by half a percentage point, to 4.75%, was the
latter risk -- the risk of inflation. Until the
credit crisis struck, the Fed had signaled no
intention of cutting rates so soon. Lower rates typically stimulate the
economy by making it easier for companies, consumers and investors to
borrow. If the Fed continues cutting rates before inflationary pressures
have been stifled, it risks pushing inflation higher. The Fed has
acknowledged the concern, noting in the statement announcing last week's
rate cut that "some inflation risks remain." Inflation could come
from the still-booming global economy and from the lower rates themselves,
which push more money into the economy, making it easier to raise prices.
Note that the Journal still holds out the hope of
some kind of middle way (maybe a bike trail running alongside the
coaster?) in which our omnicompetent
central bankers guide the economy to another decade of non-inflationary
growth. As usual, this misses the underlying dynamic, which is that the past
two decades of low inflation and steady expansion have been purchased with
ever-greater amounts of debt. In the 1960s it took about a buck-fifty of new
debt to produce a new dollar of GDP. Today it takes about six bucks. And
that’s assuming the GDP numbers are accurate (they aren’t) and
that reported debt is all the debt we’re creating (it isn’t). If
you include the unfunded liabilities of U.S. entitlement programs and
over-the-counter derivatives, both of which are growing exponentially, the
trend in societal productivity looks even worse.
As for what the conventional wisdom now considers normal and good,
the latest Fed Z-1 report reveals that in the second quarter (prior to the
start of the credit-sector meltdown) U.S. households increased their
borrowing at a seasonally-adjusted annual rate of about a trillion dollars. Businesses
increased their borrowing at a 10.6% rate and state and local governments
11.9%. Total debt in the U.S.
economy grew at a seasonally-adjusted annual rate of $3.7 trillion, and now
stands at $46 trillion, up from $29 trillion in 2001.
The pace of debt creation has no doubt slowed a bit since the second
quarter—hence the panic in the financial markets and the Fed’s
dramatic rate cut. So here’s the dilemma: To engineer another decade of
moderate growth and low inflation, the Fed will have to convince us not just
to keep borrowing but to step up the pace, despite falling home prices,
soaring foreclosures and surging prices for gas, food and healthcare. And it
will have to convince foreign investors to keep accepting dollars at close to
the current exchange rate even though it’s been declining in value for
years. Neither will be an easy sell. And even if the Fed succeeds for a
little while longer, all it will have accomplished is to spread another layer
of toxic debt across the top of the financial landfill.
Sorry, but this time the crossroad has just two forks. And we’ve made our choice.
By : John Rubino
Rubino is co-author, with GoldMoneys James Turk, of
The Coming Collapse of the Dollar
and How to Profit From It (Doubleday, December 2004), and author of How to Profit from the Coming Real Estate
Bust (Rodale, 2003) and Main
Street, Not Wall Street (Morrow, 1998). After earning a Finance MBA from New York University,
he spent the 1980s on Wall Street, as a Eurodollar trader, equity analyst and
junk bond analyst. During the 1990s he was a featured columnist with
TheStreet.com and a frequent contributor to Individual Investor, Online
Investor, and Consumers Digest, among many other publications. He now writes
for Fidelity Magazine, CFA, and Proto.