The Cassandras and the Optimists
Nelson Hultberg
hultberg@afr.org
May 11, 2004
In response to a question about an upcoming pennant race back in the 1950's, Leo Durocher of the New York Giants once replied, "Whom knows?" This charmingly crude retort pretty much sums up our best answer today to how the great economic upheaval looming ahead of us will unfold. The thousands of convoluted variables shifting in and out of importance daily, that comprise the global economy, make human efforts at forecasting about as reliable as our predictions on the weather. Still, despite the exasperating uncertainty over it all, there are several strong probabilities that we can glean from the political-economic tea leaves if we are good enough students of history and human nature.
I engaged in debate the other evening about these probabilities with some acquaintances who held the view that I was an unreasonable Cassandra spreading undue alarmism. As they saw it, deflation was impossible, the economy was robust, America had endured far worse before, and she would do so again. What follows are some answers to their optimistic scenario.
Deflation Not Possible
Their first objection to my "alarmism" was that deflation is not possible with a paper currency.
This is probably true, I replied. It would be difficult for the money supply to deflate as long as the boys at the Fed have access to a printing press and the willingness to use it. But bubbles can, and will deflate. For example, Basic Investment 101 says that the bond and Dow bubbles must burst and deflate in the face of intense dollar inflation on the part of the Fed. (The real estate bubble is a wild card in this scenario and could go either way). The problem that many people have with this issue is that they see the clash of inflation and deflation as an either-or kind of thing. This is a false picture brought on by viewing deflation in only its narrow monetary definition and ignoring its relation to prices (more on this later). In my last article I said we would see both Scylla (inflation) and Charybdis (deflation) in tandem, which is a more accurate picture of what must unfold.
How precisely the tandem will come upon us we can't say with precision, of course. But as I see it, there will be wild dollar inflation from the Fed because that is all they know how to do. And they will feel that they have to do something in the face of a melting down economy. But their dollar inflation will not sustain the Dow; it will kill the Dow and send it to the bottom of the charts around 4000. Thus, we will have dollar inflation and Dow deflation. The same scenario will take place with Treasury bonds. As the dollar inflates, bonds will deflate. Greenspan's two major bubbles (the Dow and Treasuries) will burst in a slow motion collapse that grinds down over the next 5-10 years. And since the Dow is such an integral aspect in the people's perception of how wealthy they are, there will be a catastrophic transformation of mood among the millions of investors that look to the Dow as the indicator of "how we are doing economically in America."
This second bursting of the Dow (and the dramatic mood change it evokes) will bring on a painfully STAGNANT economy along the lines of the 1970's stagflation. Only this time it will develop into hyper-stagflation, or what Franklin Sanders has termed a "hyperinflationary depression." This will be the Kondratieff winter of 2000-2015. It will manifest differently than the last Kondratieff in the 1930's, just as that one in the thirties manifested differently than the prior winters of the 19th century. This difference of manifestation is due to the cultural and technological differences of our era and also to the fact that we have learned from the past. Unlike our predecessors in the 1930's, we now know about the Kondratieff cycle. And because we do, we will take defensive action to try and avoid its winter season as it descends upon us. All we will accomplish, however, is to delay and exacerbate the winter's ultimate intensity. We will not prevent it from its highly deflationary, debt-purging role.
A final crushing blow will be some sort of ruinous restructuring of Social Security that will be painted by our government as a "new realistic plan for America's seniors in the 21st century." But the public will perceive it for what it is -- a royal screwing by our oleaginous windbags in Washington. And their mood will further reflect such a perception by turning darker still.
Therefore, inflation is coming in a big way because the manipulative charlatans at the Fed have nothing else in their arsenal. But their "dollar" inflation will NOT keep the ravages of deflation from afflicting the various bubbles of our economy. The Dow and Treasury bonds are headed south to Antarctica. The jury is still out on real estate; it might escape deflation in the meltdown because the public will have to have some place to funnel their depreciating dollars that the Fed is so benevolently printing for them. Of course, gold will benefit greatly (and probably silver also).
So we will have an economy in which some sectors are deflating, while other sectors are inflating. The key is to get our money into the ones that are inflating. While the establishment lemmings will get fleeced by the Wall Street-Washington touts hawking the idiocy of bonds and equities to the bitter end, those of us in the hard money community know better than to listen to snake oil spin to sell paper illusions. The choice for us will not be difficult at all. We will stash our wealth in gold (and in silver for those who are certain it will become the "poor man's money").
Why the Optimists Are Wrong
Part of the problem for today's punditry is that they define the term "deflation" as only a shrinking money supply. Consequently, they insist that a depressionary scenario is impossible because the Fed can print money whenever it wishes and will dispense that money to whatever extent it needs to. Therefore in the eyes of the Keynesian establishment, no deflation can ever take place with the Fed primed at the printing presses and their helicopters gassed up at the airport.
The flaw in this kind of thinking is that deflation has other connotations. There is "monetary" deflation, and there is also "price" deflation. There are two types of deflation just as there are two types of inflation. All free-market advocates realize that monetary inflation brings on price inflation. It is the prior increase in the ACTUAL SUPPLY of money that brings on general price inflation. The monetary increase causes the price increases -- elementary cause and effect that sadly escapes the Keynesians. Deflation operates in a like manner, only in the opposite direction.
There is a far more essential point about all this, however, that is vital to understand. The strict cause and effect relationship between money creation and prices that leads to general price inflation does not always apply to the deflation scenario. For example, once an economy has reached an advanced stage of monetary inflation, it can experience a "price deflation" without a decrease in the ACTUAL SUPPLY of money. All that has to take place is a decrease in the RATE of monetary expansion on the part of the Fed, and prices will start nose-diving. The actual money supply itself does not have to decrease; there just has to be a slowing of the speed with which the Fed is expanding the money supply. For example, if the Fed has been expanding money at an average annual rate of 6% over several years and then slows the expansion to an average rate of 3% for several years, it will bring on price deflation in sectors that are vulnerable (i.e., asset classes such as real estate and equities).
Since monetary creation today is primarily debt creation, the Fed's monetary policies to regulate the economy are putting the American people deeper and deeper into debt with each passing year. The speed of this debt creation is increasing at an alarming rate, yet it is bringing less and less increase in national income and GDP.
For example, Michael Hodges shows us in The Grandfather Economic Report that the amount of debt creation needed to generate national wealth today is almost 2 times what it was just 20 years ago. In 1983, it required $11.5 trillion in debt to generate $5 trillion in national income. Today it requires $37 trillion in debt to generate $8.7 in national income. [click]
What this means is that debt has to be created at a faster and faster rate in order to keep the economy growing. If the Fed does not continually increase debt at a faster rate every decade, it runs the risk of the economy slowing to a halt. The vulnerable sectors of equities and real estate will start to deflate. The bubbles will start to burst.
Twenty years ago, we needed $2.3 in debt to create $1 in growth. Today we need $4.3 in debt to create $1 in growth. How much debt will we need next year? Next decade? This is a monstrous debt spiral trap that we have climbed onto. This is why the Fed has to keep inflating the money at prodigious levels. If it doesn't, we face an economic meltdown.
More and More Credit Needed
The question is: How much more debt can be loaded onto the American people? The Keynesian credit train that we boarded in 1936 is no longer just chugging along creating mild amounts of debt as in the fifties and sixties. The train is now streaking down the tracks in order to keep the economy afloat. At some point the debt load it is creating will become insufferable to the consumers and businesses of America. They will then undergo a dramatic change in mood. They will then stop borrowing and start saving. They will start paying off debt instead of incurring more debt. This will slow the rate of monetary expansion and bring on price deflation in those asset sectors that are vulnerable.
It is at this point that the Fed will be forced to ratchet up its "liquidity injections" to a fever pitch in order to induce enough monetary growth to avoid crashing the economy. They will have to start monetizing heavily. They will have to gas up the helicopters. They will have to run the risk of bringing on hyperinflation and the terrible fate of Germany's Weimar Republic of the early 1920's.
Eventually the Fed's choice will be either to continue onto Weimar, or attempt to slow the speed of credit expansion so as to avoid collapse of the currency. But if the Fed engineers do attempt to slow monetary growth, then just the slowing itself will induce the prices of various sectors to DEFLATE. Thus serious price deflations are coming to our economy in the upcoming years even though the Fed will be pushing credit/debt expansion and outright monetization to ever-higher levels.
This is what I mean when I talk of deflation visiting us in tandem with inflation. I mean that prices will be seriously deflating in various sectors, not the actual supply of money throughout the economy. The two most crucial sectors susceptible to price deflation will be the asset classes of equities and bonds.
Does this mean then that an actual deflation of the supply of money is impossible? Not at all. Actual monetary deflation could take place also. For example, if things get bad enough, if prices deflate far enough in such sectors as equities, bonds, and real estate, then all businesses and consumers could draw in their horns drastically. There would take place a catastrophic mood change throughout the economy. Velocity of money would slow to a crawl. People would cease to borrow and spend. They would become very cautious and rush to pay off debt. Those who couldn't handle their debt load would default. Bankers would tighten up their loan qualifications to protect their bottom line. If severe enough, these actions could bring about an actual shrinking of the money supply because modern day money is basically credit/debt. It is not cash. It is all merely computer entries of promises to pay. When those promises dry up, then what we now consider to be money dries up.
This would be a classic deflationary spiral in which the total money aggregates for the economy actually shrink. It would be a disaster. While unlikely, it is not impossible. The collective mood of the billions of spenders and investors that make up modern day economies cannot be predicted with certainty. Monetary deflation could happen. It all depends upon how vigorously the Fed is willing to pursue the outright printing of new money, and then how vigorously the people will be willing to spend it.
The Terrible Choice We Face
What are we to conclude from all this? The level of credit and debt that we are now creating CANNOT continue to be increased at a faster rate indefinitely? Eventually the credit/debt expansion on the part of the Fed will encounter what a runaway freight train with ever-increasing speed must encounter. Either its engineers slow the speed, or the train flies off the tracks. It will be the same for the Fed; either it slows credit expansion, or it flies off the tracks into a Weimar-style oblivion. But if it slows the speed of money/debt creation, it puts the economy in terrible jeopardy because the Dow cannot survive such a slowing. The fact that all optimists think it can is one more example of how men hide their heads in the sand in face of uncomfortable truths.
The paramount question before us then is how long before the Fed's money/debt train must begin to slow in speed so as to avoid a Weimar-type scenario? Impossible to say, but hopefully the reader can see the dilemma we are now in. The Fed must continue to expand credit and debt at an ever-increasing rate because just slowing the "speed of expansion" will bring on price deflation in the crucial asset sectors such as equities and real estate that have been expanded into bubbles.
This is why Scylla and Charybdis will descend upon us in tandem, and why eventually the crisis will be horrendous. Contrary to the grand Keynesian illusion, the Fed cannot just moderately inflate and maintain a steady expansion of debt in the economy over time! Credit/debt creation loses its power to stimulate over time as the total debt of society increases. This leads eventually to the necessity of helicopter money, i.e., massive printing of new money that doesn't require the multiplier effect of fractional reserve banking to be effective. It is just injected straight into the economy via monetized deficits for military, pork and welfare spending. It is actual cash that ends up in the pockets of consumers and doesn't require them to apply for a loan. This is the last straw grasped for by a desperate Fed trying to maintain a decent GDP growth rate. This step will, of course, lead to rapidly rising prices, and if done too vigorously, runaway inflationary prices and the complete collapse of the currency.
The only alternative will be to bite the bullet and accept the necessity of a ravaging meltdown in order to work off all the debt. The reason why the meltdown must be ravaging is because the level of "debt creation" we have engaged in for the past 30 years has been gargantuan, and its growth is now accelerating like a heroin addict's dosage levels. This must bring a severe corrective phase to balance such insanity. This is the way the laws of nature work; actions bring reactions in proportion to the size and intensity of the original action.
This is the horrific dilemma that now confronts the boys at the Fed. This is Scylla and Charybdis starkly staring them in the face, and saying, "Which one of us do you prefer? You must choose; you cannot have an inbetween scenario! You have broken the laws of nature with too much abandon for far too long! Your greed and power lust are now coming home to roost. You must pay with suffering."
Not Yet Rome
This type of talk did not endear me to the optimists at all, so they changed tactics and zeroed in on what they felt was the real lunacy of the Cassandra scenario. They protested that even if we are in for some hard times, we are not yet Rome and we will not see that happening anytime soon.
I agreed. But what we will see, I said, is a velvet-glove dictatorship taking over America in the next 20 years under the guise of a "new kind of freedom" that will very subtly attempt to smuggle us into a one-world tyranny. Yes, we will get through this massive debt problem. But the question we must ask is, "In what form will we get through?" As I see it, martial law and a rewriting of the Constitution to accommodate the jack-boots natural propensity to bang down doors is quite possibly the way in which we will "get through the debt problem."
Optimists must sooner or later come to realize that there is no moderate, soft-landing scenario that we can bring about between Scylla and Charybdis. It is too late for that! We must choose, and both alternatives bring with them a high probability of some kind of ruthless dictatorial takeover of our country. This, a rational person gleans from history and human nature. Men will opt for tyranny when chaos is clawing at the edge of their survival. They will forfeit their liberty in hopes of establishing stability.
This is why our role in the gold community is not just to try and profit from the meltdown scenario, but also to educate the people as to how we must climb out of the maelstrom. We, who have been blessed with a sounder grasp of the cause and effect relationships taking place here, must try to help our fellows understand the nature of the crisis descending upon our society. We must try and explain to them the true nature of the chaos and its Federal Government-megabank origin. We must educate them that liberty and economic chaos do not go together. On the contrary, liberty and economic order go together as Adam Smith and the Founding Fathers understood. It is our centralized, manipulatory government that has brought us to the chaos. It is government that is obliterating the harmony of our economy in the way that a bear disrupts an industrious beehive in pursuit of the honey that those bees are producing. Government's paws are large and clumsy, and they wreck everything they touch in the path of their greedy reach.
Thus it is a fallacy to say that we must bring about a more centralized and more interventionist government in order to alleviate the chaos that is descending upon us. A true free-market will alleviate the chaos and still allow us to retain our rights and our freedom. It is not capitalism that has wrought our misery; it is government intervention into capitalism throughout the 20th century beginning with the Fed and World War I that has brought us to such a chaotic dilemma. Government is not the solution; government is the problem!
Can such a message be accepted in time? Whom knows? But a man must try to fight the forces of evil that he sees rising up around him. Even if he is doomed to defeat, he must fight. What kind of life have we lived if we let the black limousine boys win by default? If we have to go down, let us at least go down fighting with all the intellectual vigor that we possess, all the activist passion that we can muster.
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