There are some in our government who claim that we face a possible depression if we do not engage in a massive amount of deficit spending and money printing to resurrect the economy. The prescription is intended to cure the credit crisis by forcing banks to step up their lending practices. In their inability to accept or understand the cause of our current crisis in the first place, however, we face increasing odds of a depression as our fearless leaders fight this recession with yet more of the disease itself: inflation.
The recession I have been predicting since January 2006 has arrived, but a depression can still be avoided if we cease these silly government interventions immediately and stop trying to inflate the credit crisis away. Although it sounds heartless -- especially to those who just can't fight their supposedly good intentions to just "do something" -- allowing the economic downturn to run its course is not only the prudent tact our government should take, it is the best option for America. If we continue in this effort to artificially prop up the economy, it will virtually ensure our recession turns into a depression -- perhaps one more severe than any other in our history.
The catalyst for our current recession was the collapse of an asset bubble that had formerly pervaded throughout the economy. In the wake of the credit bubble, the demand for money waned as a result from strained corporate and consumer balance sheets. The rate of monetary growth shrank not because of a government-directed policy, but because of the private sector's new desire to pay off debt. If left to market forces, a severe recession would ensue -- but a relatively short-lived, healthy reconciliation of market imbalances that would allow for a quicker return to renewed growth.
However, back in the spring of this year when the Fed facilitated the sale of Bear Stearns to JP Morgan, it began a parade of now seemingly endless bailouts, stimulus packages and money printing. What is designed to save us from suffering a depression may be the process which ensures that very condition. It could be the beginning of a devastating inflationary cycle caused by a massive increase in the Federal Reserve's balance sheet coupled with the explosion of debt issued by the Treasury.
A phenomenon that is facilitating the expansion of debt is the historically low Treasury yields currently enjoyed by the government. The credit crisis along with ephemeral fears of deflation is causing those yields to plummet. That has misled the government to believe it can issue tremendous amounts of debt without consequence.
The insidious thing about inflation is it can allow a government to temporarily prop up the economy by tricking producers to increase output even though the currency is rapidly depreciating in value. In the short term, this inflation could mollify our current economic malaise as the consumer experiences relief from falling asset prices and the economy enjoys an ersatz recovery. However, what starts out as relief will soon turn to panic when consumer prices begin to spiral out of control.
This is because replacing the consumer's balance sheet with that of the government's will cause our already mounting debt to soar at an even faster pace than is occurring today. The crisis will become acute when the ability of the government to raise money from foreign sources to fund its prodigious spending ends. Without China's money to purchase our scores of trillions in debt, the government's ability to finance its obligations will become compromised. That will further place pressure on the Fed to step up its monetization of the debt. The Fed will also intervene in the Treasury market in an effort to keep interest rates from spiraling out of control. Investment grinds to a halt, the dollar plummets (especially against hard assets) and a depression coupled with inflation--the worst of all possible scenarios--ensues.
This morning, President-elect Obama spoke quite plainly about the need to curtail wasteful government spending. As encouraging as that sentiment is, I wonder if he truly appreciates the size of the axe that needs to be wielded, particularly since he is simultaneously contemplating the next "stimulus package," the largest one yet and merely one more example of aggressive government borrowing.
History is clear that a country cannot print, borrow and spend its way back into prosperity. The sooner we recognize that fact the less severe our economic pain will be.
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