An Economic Nightmare Before Christmas

Like many pragmatic economists I have always warned that rapid expansions of government debt would result in inflation and higher interest rates. The explanation was always simple: rising supply of government debt inflates the money supply and weakens the government’s ability to service its debt through legitimate means.

But in recent months, government has flooded the market with hundreds of new Treasury obligations and telegraphed its intention to increase the deluge even more. In response, both bond prices and the dollar have risen. This benign reaction has led many to the happy conclusion that the doom and gloomers are wrong and that bailouts and economic “stimuli” can be financed with deficit spending without any adverse consequences on interest rates or consumer prices. Recent action in the foreign exchange markets suggests these hopes will prove illusory. The renewed strength in gold, together with the long over do rupture of the correlation between the movements of foreign currencies and U.S. equities, is further evidence that recent market dynamics are changing.

When the financial crisis of 2008 kicked into high gear in September, the U.S. dollar began to rally furiously. While America’s economic ship was sinking from stem to stern, its currency was becoming the must have asset for public and private investors around the world. The dollar benefitted from the positive flows that result from massive global deleveraging. Treasuries got an added boost from a reflexive flight to “safety.” As a result, politicians were able to fill out their Christmas wish lists with complete confidence that Santa would deliver. However, as these dollar-positive forces appear to be giving way, the Grinch is about make an unwanted appearance.

Last weekend Barack Obama announced his intention to implement a New Deal-style stimulus and public works program. What he somehow forgot to mention is that the United States is wholly dependent on the willingness of foreign creditors to supply the funds. But a weakening dollar makes continued foreign purchase of U.S. Treasuries a much more difficult decision.

Once the dollar begins to collapse beneath the weight of all this new deficit spending, accumulation of contingency liabilities, and the socialization of our economy, commodity prices and interest rates will head skyward. In addition, once all the going out of business sales at U.S. retailers are over, and excess inventories have been reduced, watch for big price increases at the consumer level as well.

Once the government runs out of foreign and private sector bidders for new treasuries, the Federal Reserve will be the only buyer, and the hyper-inflation cat will be completely out of the bag. Sensing this, the Fed has recently indicated a desire to begin issuing its own bonds. However, since dollars are already recorded as liabilities on the Fed’s balance sheet (dollars are in actuality Federal Reserve Notes) the Fed already issues debt. The difference now is that they are proposing to issue interest bearing debt. Perhaps the Fed feels this will make holding its notes more appealing. However, since the interest will be paid in more of its own script, I do not believe this con will work.

In the end, rather than filling our stockings with Christmas goodies, our foreign creditors will likely substitute lumps of coal. Of course given how high coal prices will ultimately rise as a result of all this inflation, in Christmas Future perhaps our stockings will be stuffed with nothing but our own worthless currency. It might night burn as well as coal, but at least we will have plenty of it.

Comments

[investor88:]

Peter has again hit the nail on the head, nailed down the paradox of a super dollar and declining interest rates despite massive printing by the US govt. This paradox of a free lunch [ie you just print whenever there is a problem, bail out this and that, at no cost ] cannot last forever; the day of reckoning should come [in the form of financial instability] because humans are not fools.

It pays to be cautious and not believe Ben or Paulson or Obama has got the magic wand to wave as and when they like. There is such a thing as paying for your lunch.

2008 Dec 14 06:34 AM

[prudentinve...:]

The notion is that part of the free lunch will be at the expense of those who currently own dollar paper: China, Japan, Russia, and, of course, the much abused domestic savers who own CD's, bonds, etc, and made the mistake of trusting their own currency. After this part of the "free lunch" is digested, and the holders of dollar paper have been bankrupted, then the indigestion hits those who have swallowed the free lunch!

2008 Dec 14 08:22 AM

[Did U Think...:]

Peter has been talking about inflation for some time but let's face it, this is one area where he has missed badly and China is the other. He and his investors have gotten their clocks cleaned in China and as soon as this sucker's rally subsides the clock cleaning will continue into 1H 2009. THAT is when you will want to buy China.

But on inflation Peter fails to mention all the stuff that Mish Shedlock has pointed out about the money that the fed is creating not getting into the econonmy (i.e. liquidity trap). This is why there has been no effect despite the fact that a lot of money has already been thrown at this problem.

Peter makes the classic mistake of many intellectuals. He is right about some things and so he believes that means he will absolutely be right about all things. Investing is all about predicting the future and then betting it will happen with your money. But smart investors change their views if the facts fail to support the existing views. By this definition, Peter wasn't very smart this year. He could well be doing worse than those he laughs at.

But enventually he will be right - inflation will become a concern once more. The only question is whether this will be in 6 months or 6 years.

2008 Dec 14 08:26 AM

[Ageless:]

First of all - I like the way you express yourself. Your common sense approach is refreshing and your use of words and phrases make me want to read what you write.

Your book, CRASH PROOF, offers sound advice. Your perspective of the coming day of reckoning is right on the money.

We too offer a clear glimpse of our economic future in our latest book, RETURN OF THE BOOMERS. Dan Pink says this book offers a bold call to heroic U.S. leaders to take steps now to preserve America's competitiveness. Take a peak at our website - if you are interested in reading more about the "next economic shoe to drop" we will be pleased to send you a complimentary copy as your opinions are always welcomed and sincerely appreciated.

If you have another book in mind, may I suggest the title "MISDIRECTION" - it fits with your perspective.

2008 Dec 14 08:32 AM

[peterthepai...:]

six months looks a little early...

2008 Dec 14 08:34 AM

[Jonponwon:]

Peter is, of course, quite right. The US $ has long been the world's reserve currency and the east has not yet truly realised that the centre of gravity of wealth in the world has shifted to it. The result is that a herd spooked by a pride of lions has taken off in a familiar direction (dollar territory) without realising that it is a path that leads to a cliff.

The truth of what Peter says can be judged against events on a smaller scale, those now taking place in the UK. There the until recently phenomenally high flying pound has plummeted to earth as a result of a fiscal stimulus conceived in an economic madhouse, and which threatens to raise debt to £1tr within a year. The UK government is making debt the country cannot hope to repay without hardship that a democratically elected government will not be able to impose. It raises the spectre of nothing less than dictatorship. If we are fortunate (a word I use advisedly) we will get a Pinochet who will restore the fortunes of the commonwealth. If not, sic transit gloria mundi, and the UK will follow the Ottoman Empire into international obscurity.

The UK 's ill-health is so severe and its depth so unrealised that it has not even been diagnosed. Its manufacturing base accounts for a mere 18% of GDP and the country relies on invisible (and illusory) exports like financial services to bolster the economy. Since its entire banking service almost totally collapsed recently, none but the bravest will rely on it for a long time to come. The result is that the UK finds the pound without friends and it has sunk to humiliating lows.

The UK is probably now in irretrievably bad economic health and must be regarded as the sick man of Europe, a desperately sick man, who will live on as a severely handicapped invalid. And all because it has already done what Peter is trying to prevent the US from doing.

2008 Dec 14 08:41 AM

[CaptainJJack:]

I can never understand this kind of analysis. Either the velocity of money is dropping or it is increasing, it cannot be doing both.

Either we are facing deflation, massive deleveraging and high unemployment, or we are facing massive inflation, increasing velocity of money applied to a much higher money stock (and higher economic activity), and higher employment.

Even when we had "stagflation" in the late 1970s, we had relatively high employment, much much higher money velocity, and when Volker increased the Fed interest rates, in late 1979, employment went down a LOT -- and so did velocity and prices, especially commodity prices.

I have a different view. I believe that the Fed will print money by buying the treasury debt and keeping interest rates low. This will offset the huge reduction in the velocity of money (I believe that consumers can get credit, by and large, but they are CHOOSING to save or pay down their debts), and in the short run, we will have VERY low inflation because I think the Fed is pushing on a rope.

Longer term, whether we have hyper inflation depends on two things. First, will the Fed take back the money it printed, by selling the bonds it bought from the Treasury and raising interest rates, when the velocity picks up. I believe they will do this, but it will not be timely (i.e. there will be a pick up of inflation).

But MUCH more important is what Treasury does with the money it borrowed. If the borrowed money is put to work on high return public investments, say improving the energy grid, improving research on fuel and energy alternatives, etc., then the productivity improvement returns to the economy will offset the borrowing cost. (Examples from the past would be building the first bridge across the Rubicon and building the US interstate highway system.)

On the other hand, if the money is wasted on pork, or used to subsidize consumption through massive, unfunded tax cuts, we will have the hyper inflation (and also higher employment) you predict -- until the new bubble bursts, again.

I am guessing that we will not be too smart nor too stupid, and we will muddle through.

2008 Dec 14 08:55 AM

[Beatle juice 2:]

Auto makers want $15 billion, 3 million employees that is $5,000 pre employee, figure

2008 Dec 14 09:29 AM

[OldLimey:]

Jonponwon: You're dead right about the UK's parlous state. With regard to the possibility of dictatorship, the ingredients are there: an overly powerful executive branch constrained by little more than convention (and, to a very limited extent, the judicial branch); CCTVs on every corner and ANPR cameras sprouting everywhere to monitor vehicle movements; increasing centralisation of databases holding extensive personal info; and draconian anti-terrorist legislation which the authorities have shown themselves increasingly ready to use in cases with absolutely no connection to anything that any reasonable person would call 'terrorism' (e.g, the recent arrest of a senior opposition MP for doing no more than using leaked info to embarrass an incompetent and increasingly paranoid government). All that is needed as a catalyst is willingness to use all these tools under the cover of crisis. Enter Gordon Brown and the social engineers who now control the Labour Party. This country is in very, very deep trouble - politically as well as economically.

CaptainJJack: the real danger is that although velocity is dead in the water, as soon as it starts moving again then given the expanded monetary base we now have the authorities are going to have to act quickly and decisively. Some, myself included, feel that for whatever reason (political, intellectual) this might not happen - and inflation will be the outcome.

2008 Dec 14 10:01 AM

[TAMR666:]

ALPHA IS A MUST! SUBSCRIBE NOW!

2008 Dec 14 10:48 AM

[Asbytec:]

I have to agree with Ponzi and CaptJack. We're in a liquidity trap. The fed is trying to bust the credit log jam by ramming it full of money. When it breaks, they will mop up as quickly as they can. In fact, the Fed has used SFP bills (albeit sparingly) to this end.

We will see inflation, and as mentioned, it's just a matter of time. Rising joblessness, recession deepening, wary lenders, and falling prices do not create an atmosphere for lending. So, the trap will hold for a good long while and should keep inflation at bay. If and when it breaks, however, look for swift and decisive action to tighten. If not, well, we're in bigger trouble. I believe they know that.

Is anyone going long on the euro? Not me. They have the same problems.

2008 Dec 14 10:49 AM

[John Lounsbury:]

The discussion of the author, combined with ponzi and CaptainJJack comments, have given a very well rounded view of the isues and perils we face. Well done.

Peter Schiff - I don't know if "...the long over do rupture of the correlation between the movements of foreign currencies and U.S. equities" is a typo or not. If it is a typo, you should deny that and say you wrote it on purpose. It is actually a brilliant double entendre, without an indelicate overtone.

2008 Dec 14 11:35 AM

[Rafe:]

These ideas about the coming of uppance are of course very logical. What bothers me it that it seems all this should have happened long ago. Other countries have been funding US debt for a long time. How can anyone predict when they will finally pull out when we still don't fully understand why they haven't done so before?

My take is that the US Federal Reserve has been acting as the Big Bank for the world. Foreign entities deposit (lend) money to the Big Bank, knowing they can redeem their loan (withdraw their deposit) at any time. I'm not sure people (and maybe countries) care exactly what is happening deep inside the bank, as long as its doors are still open and their money appears to be safe at or near face value.

Since there has been no viable alternative global bank available, countries and investors worldwide have been using the US for that purpose. Where, then, will they put their money if the US Big Bank goes out of business? Switzerland?

I'm not claiming this system can go on forever! Obviously it can't. But I don't think a theory that fails to explain why the world is still lending to the U.S. now, can be relied on to predict when there will be a serious (currency-destroying) run on the Big Bank.

2008 Dec 14 01:11 PM

[carey_jim:]

Instead of facing financial collapse, America might have to consider two "ugly" possibilities:

1) Reducing military spending

2) Redistributing a very large part of the wealth of the upper 1 percent of the American population who own 33% of the wealth (stocks, bonds, real estate, etc.) to the bottom 80% who own only about 10% of the wealth. sociology.ucsc.edu/who...

If these two unpleasant things don't happen rationally, history might exact its pound of flesh as it has, periodically, in the past, through war or revolution or just social upheaval.

In terms of wealth and income distribution, contemporary America is at about the same place as it was during the time of the "robber barons" at the turn of the last century, just before World War I when the FTC and the Federal Reserve were created.

It was also the time when the Supreme Court first ruled that a Federal income tax was not "unconsitutional" (and "socialistic" as it said of the1894 Federal income tax which it DID rule unconstitutional) and the first time the Sherman Antitrust Act was invoked to break up large corporations (Standard Oil and The American Tobacco Company.)

But then again, as Henry Ford said, "History is more or less bunk. It’s tradition. We don’t want tradition. We want to live in the present and the only history that is worth a tinker’s damn is the history we make today"

Maybe it's time to make history instead of being unmade by it.

2008 Dec 14 01:13 PM

[CLH:]

Yes inflation will follow deflation. The last deflation was the 1930s and inflation followed-----in forty years. Many will be dead and gone. Forget inflation.

2008 Dec 14 01:23 PM

[Tony Daltorio:]

Please turn off CNBC - it is affecting your ability to think rationally.Is the US economy's GDP collapsing by 50% or is unemployment at 25% ala the 1930s? The answer is NO! Deflation is a myth conjured up by the bond market crazies to make money. Inflation is the train coming down the track. The chances of long-term deflation in the US of more than a few months in duration is zero! The government does not want to pay back their debt in dollars that are worth more but in dollars that are worth much less.


On Dec 14 01:23 PM CLH wrote:

> Yes inflation will follow deflation. The last deflation was the 1930s
> and inflation followed-----in forty years. Many will be dead and
> gone. Forget inflation.

2008 Dec 14 02:10 PM

[mallarde:]

I agree that distribution of wealth is a problem that Americans reflexively refuse to discuss -- as though it makes you a Marxist.

You cannot have a healthy society or economy if a huge proportion of the population cannot earn enough in wages to live comfortably.

Instead of trying to stuff the American "consumer" with more debt, the government should concern itself with cutting the illegal population out of the labor market. That alone would help lift wages and allow the American working class and young people to start spending cash again.


On Dec 14 01:13 PM carey_jim wrote:

> Instead of facing financial collapse, America might have to consider
> two "ugly" possibilities:
>
> 1) Reducing military spending
>
> 2) Redistributing a very large part of the wealth of the upper 1
> percent of the American population who own 33% of the wealth (stocks,
> bonds, real estate, etc.) to the bottom 80% who own only about 10%
> of the wealth. sociology.ucsc.edu/who...
>
>
> If these two unpleasant things don't happen rationally, history might
> exact its pound of flesh as it has, periodically, in the past, through
> war or revolution or just social upheaval.
>
> In terms of wealth and income distribution, contemporary America
> is at about the same place as it was during the time of the "robber
> barons" at the turn of the last century, just before World War I
> when the FTC and the Federal Reserve were created.
>
> It was also the time when the Supreme Court first ruled that a Federal
> income tax was not "unconsitutional&a... (and "socialistic&q...
> as it said of the1894 Federal income tax which it DID rule unconstitutional)
> and the first time the Sherman Antitrust Act was invoked to break
> up large corporations (Standard Oil and The American Tobacco Company.)
>
>
> But then again, as Henry Ford said, "History is more or less bunk.
> It’s tradition. We don’t want tradition. We want to live in the present
> and the only history that is worth a tinker’s damn is the history
> we make today"
>
> Maybe it's time to make history instead of being unmade by it.<br/>
>
>
>
>

2008 Dec 14 03:18 PM

[carey_jim:]

I would give anyone two to one odds on a million dollar bet that America will not become Marxist in the next twenty years, no matter what else happens here.

The irony is, that if I lost the bet, the winner would have to travel to a non-Marxist, capitalist country like Russia to collect the million dollars because it would be illegal to have a million dollars in America.

The Russian oligarchs, who are former communist commissars or "nomenklatura," would have no problem with the winner making a cool million from my losing bet.

Any takers?



On Dec 14 03:18 PM mallarde wrote:

> I agree that distribution of wealth is a problem that Americans reflexively
> refuse to discuss -- as though it makes you a Marxist.
>
> You cannot have a healthy society or economy if a huge proportion
> of the population cannot earn enough in wages to live comfortably.
>
>
> Instead of trying to stuff the American "consumer" with more debt,
> the government should concern itself with cutting the illegal population
> out of the labor market. That alone would help lift wages and allow
> the American working class and young people to start spending cash
> again.

2008 Dec 14 05:34 PM

[jdl51:]

Well, you've got to hand it to Bush and company. They've managed to nearly triple the national debt in eight years and ruin the economy to such a degree that no one can afford to buy anything resulting in the worst deflation since the 1930s. You'd think with all that spending we'd at least have something to show for it besides rusting vehicles in Iraq. So much for trickle down. Until people are willing to spend, you won't have to worry about inflation and from the looks of it, that won't be for at least a year or two at best.

2008 Dec 14 07:35 PM

[nmelendez:]

I really do not think the illegals in the US work at The Big 3 in Detroit, Raytheon or Boeing making 30 to 40 bucks an hour. The real problem is the H!B visas. Ever heard of the software engineer had to train his replacement from India? They informed him he had 6 months. And your Senators and House members are looking to increase the quotas.
The objective is not to bring the world to US standard, its to bring the US standard to the worlds level(INDIA, CHINA).


On Dec 14 03:18 PM mallarde wrote:

> I agree that distribution of wealth is a problem that Americans reflexively
> refuse to discuss -- as though it makes you a Marxist.
>
> You cannot have a healthy society or economy if a huge proportion
> of the population cannot earn enough in wages to live comfortably.
>
>
> Instead of trying to stuff the American "consumer" with more debt,
> the government should concern itself with cutting the illegal population
> out of the labor market. That alone would help lift wages and allow
> the American working class and young people to start spending cash
> again.

2008 Dec 14 09:01 PM

[sdcougar:]

Re: the dollar, as someone put it, the dollar is winning the beauty contest in the leper colony. Whom would you vote 'Miss Leper' ?

2008 Dec 14 10:46 PM

[mkreisel:]

Peter Schiff, Jim Rogers, Marc Faber, and even Warren Buffett prepared for a repeat of the 1970s and got 1930s handed to them instead.

2008 Dec 14 11:23 PM

[auto44:]

Gold and oil ,oil and gold , gold and oil, oil and gold, but no paper.

2008 Dec 14 11:42 PM

[auto44:]

Print money give it to the state governments, states give it to the road bridge hospital and railroad builders The builders give it to employees who give it to the banks and real estate agents. The only real cost is the price of the paper and ink it has been this way for a long time.
what is the big mistery? If you are old like me you may remember the term revenue sharing.

2008 Dec 14 11:50 PM

[The Demotiv...:]

What percent of the dollar rally do you think was hedge funds liquidating short dollar/long euro postions to raise redemption cash?

I see the dollar rally as short covering in one of the most lopsided trades in world history.

And when their need to raise cash is over, or even just decreasing, the dollar sinks.

The DXY chart with the sharp run up and now a head and shoulders seems to concur.

Flight to safety? Sure, to some extent. The bigger flight to safety was getting out of a losing trade as it got worse.

2008 Dec 15 01:06 AM

[scootie2008:]

Mr Schiff seems to imply that somehow the US is irresponsible and the rest of the world is more rational and conservative. I think this is the fundamental problem with the argument. If the US ship sinks, the global economy goes with it. The FED is the defacto world lender of last resort.

2008 Dec 15 08:44 AM

[Eze:]

I fear comments from people like Peter. There is no doubt that he is a seasoned analyst and knows what he is saying. So when he says that there is danger ahead, take it or leave it, he has seen danger, and that is why I am afraid of this whole situation. I have lost a lot of invested funds in stocks, and all my prayers now is " please, let the bulls return".

2008 Dec 16 07:15 AM