“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.”

–Ernest Hemingway

Anyone thinking that breaking a one-dollar bill into four quarters is a method of creating more money is simply trying to create something out of thin air.  Yet that is the path that we are following.  The Federal Reserve and U.S. Treasury who seem to be tempting the ire of the demons of inflation are now targeting the U.S. dollar with every weapon in their arsenal.  As a nation, we still have a difficult time realizing that we have consumed too much for too long and debt only provided an illusion of prosperity.  Some time ago, I walked into a staged open house.  In the air the smell of bread baking, beautiful furniture adorned each room, and what would any home be without a nice mounted flat screen television?  Yet none of this was real.  The visceral feeling of this staging of course is to give you an idea of what you want.  Or better yet, what you don’t have and should buy.  The advertising machine is designed to keep you perpetually wanting.  The staged home visually makes you forget the dollar and cents of the deal.  Those that control the levers of power of our economic system have decided that tempting inflation is a small price to pay to continue on a spending spree that is clearly unsupportable.

Ernest Hemingway understood the problems of inflation even though an economist he was not.  In fact, many countries have been burned by massive eras of inflation.  Just ask Germany or Zimbabwe what printing money at a feverish pitch does to your economy eventually.  As I have pointed out, we have seen an extraordinary amount of wealth destruction over the past 20 months.  Some estimates have global wealth declining from $40 to $50 trillion; this has decreased with the recent rally.  Yet the fact of the matter is much wealth is no longer filtering itself through the plumbing of our global economy.

So what is the impetus of the recent rally?  How can a market move up so vigorously when the fundamentals like deficits and unemployment seem to be rising with no end in site?  The market is currently believing that the masters of the universe can summon the inflation genie out of the bottle and somehow put it back in once all things are cleaned up.  That is the kind of hubris that brings down entire countries or puts then on a path of mediocrity.  To think that the global economy can be systematically managed by a few people is on par with thinking we had no debt problems in early 2007 as many key leaders voiced.  To understand where we currently stand, let us take a look at historical data with the CPI:

As you can see from the chart above, the CPI almost went negative on a year over year basis.  Much of this had to do with a collapse in energy prices but also a decline in auto sales and the fall of prices in many things including commodities.  This sounds more like the echoes of deflation.  The CPI measures consumer price inflation.  That is, the price of goods.  We can get caught up in Austrian arguments about money and inflation or deflation but for our purposes, we are talking about consumer good inflation and deflation.  For the last 20 months, we have seen across the board consumer price deflation.  What items have been falling in price?  Let us list them:

-Housing

-Energy

-Automobiles

-Commodities

-Stocks

In fact, it is hard to find anything that has gone up in price.  Yet much of this has to do with the stubbornness of the U.S. dollar to yield to currency manipulation and also the myth of decoupling has fallen flat on its face and people have fled to a safe haven, which is still the U.S. dollar.  With all this spending, the U.S. dollar has stood up relatively well:

After 20 crazy months of volatility, the U.S. dollar is virtually unmoved from when the crisis started in August of 2007.  Yet now that the global markets realize that decoupling is unrealistic at least for now, markets are adjusting to this reality.  In addition, the Fed’s new policy of buying treasuries outright is keeping rates on bonds unattractive for foreign investors.  Many are only buying them because of the global flight to safety.  But what happens if rates suddenly start to push up?  A fascinating thing is happening with the Fed buying up this paper.  That is, the rates have actually moved up a few times!  Auctions have been weak because who in their right mind is going to lock in a rate of 2.7 percent for 10 years?

We have committed over $12 trillion in multiple programs to prop up the economy.  This is the equivalent of nearly one year of U.S. GDP.  Yet the problem with this commitment is 80 percent of the money is targeted to banks and Wall Street.  The $700+ stimulus bill that was passed should have really been called a relief bill.  It was needed.  Yet it was merely a mixture of tax cuts, extension on unemployment insurance, funds for various programs, and additional funds to keep programs going.  There really wasn’t much left to create a NASA like program to launch a new workforce.  It was a tiny consolation prize to the public for $11 trillion of gifts to banks and Wall Street.

Committing so much money to the financial sector may in the end become our undoing.  It is obvious to anyone with two eyes that there is no inflation on the horizon.  Yet close to $4 trillion of that money has been used leaving nearly $8 trillion untapped.  We have deficits in budgets that project out until 2018.  If we did not have the status of reserve currency and were any other country, would you really funnel your money here?  Would you as an investor, give money to a person that has maxed out his credit cards, has been late on their auto loan, is arrears on their mortgage, only on the basis that they were once able to pay it?  This isn’t to say other countries are immune.  In fact, the countries of Europe are equally, if not in more dire problems.  They bought into this same form of financial driven market economies.

How quick can inflation hit?  Just take a look at inflation in Germany during the early 1920s:

There have been many cases of currencies collapsing leading to hyperinflation.  Shanghai in 1949, Argentina in 1989, and recently in Iceland.  But what caused the hyperinflation in Germany during the 1920s?  Well initially the government suspended the ability for banknotes to be converted to gold.  Eventually the government was freed from any restraint to print money at will and this they did to finance the war.  Of course prices rose with all the printing.  By 1918 the mark had fallen more than 50 percent against the dollar.  As time went on, even from 1919 to 1923 the government continued to run massive deficits.  The tax rate never was higher than 35 percent of expenditures.  So this gigantic gap was covered by immense money printing.  It also didn’t help that their were massive reparations to the Allied Powers.  In the end, the German government defaulted on reparation payments.  And as the chart above shows, things went from bad to horrific rather quickly.  In fact, in early 1923 unemployment was modest yet by October 19 percent of metal workers were out of work and many others were only working part-time.  When prices stabilized the damage had been done and so had the impact on the psyche of many in the country.  Many blamed international financiers for the problems they were facing.

This isn’t too say we are even remotely close to seeing this.  But you cannot print money at full speed and expect that nothing will change.  Eventually, these actions should cause the U.S. dollar to lose further value and that will make Ben Bernanke the happiest man in the world.  He would love to see nothing more than to see inflation.  Why?  This would make our massive debt seem cheaper and cheaper as time went by.  The debt remains fixed while more money flows into the system.  Bernanke has made it abundantly clear that he will do everything he can to prevent deflation.  Yet Japan did everything it could during its lost decade and land values in many areas saw prices decline by 80 percent from peak to trough.  And what has this left Japan with?  One of the largest amounts of government debt of the global large economies:

Now we are a long way from Japan but we are heading down that path.  Let us take a look at the impact of stimulus:

This chart doesn’t really highlight the entire story since this is government debt held by the public.  In the U.S. we have a sizable chunk of debt held by foreigners.  As we have also mentioned, with $12 trillion committed to various programs, we can expect our debt to explode in the next few years.  So what has Japan garnered from this massive amount of spending?

Many don’t realize that over this timeframe Japan spent $5.5 trillion in stimulus, or 180 percent of their GDP.  And the stock market slowly has fallen for nearly 20 years with short term moves up but overall a lower price level and an economy where nearly 1 out of 3 are part-time workers.  Sure, unemployment is low but a large number are transient employed.

We have yet to see major down moves with the U.S. dollar because every other country is on a race to zero.  We are simply outpacing each other.  Yet what happens when we hit zero as many have?  Quantitative easing?  How is that going to play out?  These are all things yet to be seen.  There is no example in a global crisis where the solution was simple.  I have yet to see an example that shows us that inflation is the healthy way out.  The genie is out of the bottle but will it listen to us once we need to put it back in the bottle?

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