It is not often that I read an insightful economic analysis in the American political media. This morning, I came across a piece by Scott Minerd, chief investment officer of Guggenheim funds, that was reprinted at Real Clear Politics. It is essential reading for anyone who desires to understand America's current economic problems. Here is the link.
Minerd concludes quite accurately that America's leaders have decided upon inflation as a mechanism to get out from under the mountain of debt that is facing the country. In simplest terms, this boils down to paying back debt with devalued dollars. Here is an example: If the federal government borrows a trillion dollars this year, those dollars must be viewed in the context of an American economy that produces sixteen trillion dollars worth of goods. In five years, if there is 5% inflation, that same sixteen trillion dollars of goods will be priced at well over twenty trillion dollars, but the amount of money borrowed this year will not change. The dollar will buy less, but it will be those dollars that will be used to repay the loan.
The problem with using inflation as a methodology to extinguish or control debt is that inflation is extremely difficult to control. No one has ever done it successfully. The problem is one well known to those who have examined the economy of the 1970s, the last time that inflation grew out of control. Prices begin to rise and the effects of those increases spread through the economy. Wages go up, commodity prices go up, and interest rates go up all because people try to price the inflation into their economic actions. Just think about it. If you were working for $20 per hour, but you knew that prices would rise each year by 5%, would you be satisfied with a 4% raise? Of course not, that raise would mean that your purchasing power would actually decrease by 1%. So you would seek a raise of more than 5%. Indeed, everyone would do that. So would the companies signing long term contracts to sell materials. Banks who were lending money would behave in the same way. After all, making a loan for 4% when there is 5% inflation guarantees that the bank loses money in the long term. So, after a while, that 5% inflation would be all priced into the economy. At that point, people would try to get ahead of the next increases, so just a bit more than 5% would be priced into the economy. This additional price increase would cause inflation to get above 5%. Soon everyone would adjust to the new higher rate, and then people would push for even bigger price increases. Until something was done to stop the cycle, the inflation rate would just get higher and higher.
So how can inflation be stopped once it is begun? The usual answer is through a severe economic downturn that reduces demand. Just look at the effect that the last recession had on home prices which had been inflated for decades. They went down by 30% or more in many places across the country. The problem with this "remedy" is that it causes unbelievable pain to millions.
America deserves to have leaders who honestly explain the consequences of never ending borrowing. I do not believe that an educated population would choose future economic catastrophe. Sadly, however, there are too many in the ruling classes that either do not understand or who refuse to be honest. It does not matter, though, if America is ruled by the ignorant or the dishonest. The result will be the same in the long term.
Minerd concludes quite accurately that America's leaders have decided upon inflation as a mechanism to get out from under the mountain of debt that is facing the country. In simplest terms, this boils down to paying back debt with devalued dollars. Here is an example: If the federal government borrows a trillion dollars this year, those dollars must be viewed in the context of an American economy that produces sixteen trillion dollars worth of goods. In five years, if there is 5% inflation, that same sixteen trillion dollars of goods will be priced at well over twenty trillion dollars, but the amount of money borrowed this year will not change. The dollar will buy less, but it will be those dollars that will be used to repay the loan.
The problem with using inflation as a methodology to extinguish or control debt is that inflation is extremely difficult to control. No one has ever done it successfully. The problem is one well known to those who have examined the economy of the 1970s, the last time that inflation grew out of control. Prices begin to rise and the effects of those increases spread through the economy. Wages go up, commodity prices go up, and interest rates go up all because people try to price the inflation into their economic actions. Just think about it. If you were working for $20 per hour, but you knew that prices would rise each year by 5%, would you be satisfied with a 4% raise? Of course not, that raise would mean that your purchasing power would actually decrease by 1%. So you would seek a raise of more than 5%. Indeed, everyone would do that. So would the companies signing long term contracts to sell materials. Banks who were lending money would behave in the same way. After all, making a loan for 4% when there is 5% inflation guarantees that the bank loses money in the long term. So, after a while, that 5% inflation would be all priced into the economy. At that point, people would try to get ahead of the next increases, so just a bit more than 5% would be priced into the economy. This additional price increase would cause inflation to get above 5%. Soon everyone would adjust to the new higher rate, and then people would push for even bigger price increases. Until something was done to stop the cycle, the inflation rate would just get higher and higher.
So how can inflation be stopped once it is begun? The usual answer is through a severe economic downturn that reduces demand. Just look at the effect that the last recession had on home prices which had been inflated for decades. They went down by 30% or more in many places across the country. The problem with this "remedy" is that it causes unbelievable pain to millions.
America deserves to have leaders who honestly explain the consequences of never ending borrowing. I do not believe that an educated population would choose future economic catastrophe. Sadly, however, there are too many in the ruling classes that either do not understand or who refuse to be honest. It does not matter, though, if America is ruled by the ignorant or the dishonest. The result will be the same in the long term.
1 comment:
From Article- Durations-------
In the same way the Great Depression and the depressions before it lasted eight to 10 years, we will likely continue to see constrained economic growth until 2015-2016 (roughly nine years after U.S. home prices began to slide). Only then will the excess inventory in the real estate market be absorbed,
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