Inflation solves/ruins everything

Since the global economy peak last summer, a number of key price measures have been falling — commodity prices, interest rates, asset values (like housing, stocks). Most things are much cheaper than they were 9 months ago.

Despite such obvious deflationary threat, there’s a significant undercurrent of concern about igniting the sort of runaway inflation that Paul Volker and Ronald Reagan beat 25 years ago.

The problem, of course, is government spending. First, Bush 43 spent hundreds of billions on bailout. This year House Democrats and the Obama administration spent nearly $800 billion on pet projects in the name of stimulus. Now the administration is proposing an additional $5 trillion of deficit spending over the next decade, pushing the deficit above 10% of GDP and keeping it above 3% (the maximum allowed for EU members) for more than a decade.

On Wednesday, the current president of the EU, Czech Prime Minister Mirek Topolanek, blasted American deficit spending:

"All of these steps, these combinations and permanency is the road to hell," Topolanek said. "We need to read the history books and the lessons of history and the biggest success of the (EU) is the refusal to go this way."

"Americans will need liquidity to finance all their measures and they will balance this with the sale of their bonds but this will undermine the liquidity of the global financial market," Topolanek said.

Saner voices have been cautioning that the only way that the government could pay these huge deficits is to depreciate the value of the dollar so much that they can be paid back for cents on the dollar. Cheap money (and hyperinflation) has been used by 3rd world countries for decades, and also was the key issue of rural vs. city voters in various US elections in the 19th century (including the famous WJ Bryan “Cross of Gold” speech).

As a real estate owner with big mortgages, inflation has its attractions. However, overall, the long term prospects for the American economy would be grim.

One voice of reason came from Obama supporter Michael Kinsley. Hearkening back to the Weimar Republic (does anyone read history?), he laid out the inevitable implications of the bailout and stimulus spending in a Washington Post op-ed last month:

Trouble is, money well spent is still money spent. The reasons that made it a bad idea to run up all that debt haven't disappeared just because something even worse came along. Almost no one in Washington is talking about this. …

But even if the stimulus is a magnificent success, the money still has to be paid back. The plan of record apparently is that we keep borrowing, spending and stimulating, faster and faster, until suddenly, on some signal from heaven or Timothy Geithner, we all stop spending and start saving in recordbreaking amounts. Oh sure, that will work.

There is another way. If it's not the actual, secret plan, it will be an overwhelming temptation: Don't pay the money back. So far, even as one piggy bank after another astounds us with its emptiness, there have been only the faintest whispers about the possibility of an actual default by the U.S. government. Somewhat louder whispers can be heard, though, about the gradual default known as inflation. Just three or four years of currency erosion at, say, 10 percent a year would slice the real value of our debt -- public and private, U.S. bonds and jumbo mortgages -- in half.

Anyone who regards the prospect of double-digit inflation with insouciance is either too young to have lived through it the last time (the late 1970s) or too old to remember. Among other problems, inflation works only as a surprise or betrayal. It can never be part of any public, official plan. Plan for 10 percent inflation, and you'll get 20. Plan for 20 and you'll need a wheelbarrow to pay for your morning Starbucks. But if that's not the plan, what is?

Now this week the other shoe has dropped. As part of their efforts to end America’s two decade run as the unipolar superpower, Russia proposed that the dollar should be eliminated as the global reserve currency. Russia used America’s deficit spending and inevitable inflation as the pretext for their proposal.

The Russians organized a BIRC meeting in advance of the G-20 meeting, and this week the Chinese (who also want to weaken American influence) proposed their own version of the idea. The inept treasury secretary has sent mixed signals as to whether he’s for or against the proposal.

America’s trade deficit with China has made the Chinese the main buyer of American debt. Reuters reported the concerns of Chinese Premier Wen Jiabao almost two weeks ago:

China is the biggest holder of U.S. government debt and has invested an estimated 70% of its $2 trillion stockpile of foreign exchange reserves, the world's largest, in dollar assets.

"We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets. To speak truthfully, I do indeed have some worries.

"I would like, through you, to once again request America to maintain their creditworthiness, keep their promise and guarantee the safety of Chinese assets," Wen said.

If the dollar were no longer (or less often) the world currency, the value of the dollar would fall precipitously. Normally a cheap currency helps exports, but recent decades suggest it doesn’t help the US much since (except for food) our exports tend to be differentiated products rather than commodities.

To recap: high deficits mean eventually the government has no way to pay back its debt except by using inflation to wipe it out. The expectation of inflation becomes self-fulffing. And the prospect of US inflation will cause a loss of confidence in the dollar, a one-time hit as it loses its reserve currency status, and in turn will increase prices to American consumers and business as it costs more in dollars to buy ever more expensive imports.

Plus — as with any inflation — high US inflation would reward spenders, punish savers and potentially wipe out retirees on fixed incomes who had planned their entire lives to live off their defined contribution or non-COLA defined benefit pensions.

Much as I’d to get something for nothing on my real estate, it sounds like a very bad deal for American consumers — and an even worse mess to leave to our children and grandchildren.