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There are two colossal events occurring in the world right now: Private credit and wealth is being destroyed, and in its place a good deal of money is being created. Much is taking place behind the scenes, driving this epic showdown between natural forces pushing for a return to sustainable equilibrium pitted against the full arsenal of man’s capability to resist. Just as the fog of war can obscure a battlefield until the end, the outcome of this struggle is far from clear. Nonetheless, there are some telling events to note, signs for which to watch, and consequences to mull.

This struggle boils down to whether we will have inflation or deflation. If more credit is destroyed than money is created, prices fall monetarily and we have deflation. If the converse is true, prices rise due to more money chasing either fixed or decreased real economic output. Consider the variables in the general money equation:

“M” is the total money supply, “V” is the velocity of money, “P” is the general price level, and “Q” is total expenditures, or real economic output.

Rearranging, we find that P = (M * V) / Q. Isolating this relationship, we can make some observations, as I’ve already done in Decomposing the Inflation Argument: In the U.S., alone,

1) Money supply (M) has increased by at least $13 trillion in the last 16 months,

2) Economic output (Q), as measured by annualized GDP, is falling at a 6.8% rate,

3) Government is doing everything in its power to boost velocity (V): TARP ($700 billion), mortgage bailouts ($50 billion), $1.1 trillion hedge fund subsidy to buy consumer-backed debt, $787 billion for the American Recovery and Reinvestment Act, and this is only 100 days into the Obama Administration.

The question remains as to whether velocity can be revived sufficiently to prevent deflation? For that we need to have some idea of how much wealth has been lost in the Great Unwinding. The NY Times reported that U.S. household wealth dropped $11.1 trillion in 2008.

An excellent analysis by the Hoisington Investment Management Company, published in their Q4 Review and Outlook (.pdf), shows that in the world’s three more recent debt deflations (dating back to the 1870’s) “the low in long-term interest rates occurred about 15 years after the end of the debt mania.” Translating this to today’s scenario, Hoisington postulates we could be caught in a period of declining long-term interest rates thru the early 2020’s.

On the other side of the argument, we have two significant observations:

1) The Congressional Budget Office calculates Obama’s budget will take us at least $9.3 trillion further into debt over the next decade,

2) Our largest creditors, China and Japan, are daily losing capability to lend us money as their exports shrink. China’s economic growth is cooling to the lowest point in 10 years, and they have actually become net sellers of U.S. debt in January and February. Japan’s current account is expected to turn negative for the first time since WWII later this year.

What this means is that at a time when America is begging to borrow the most it has ever borrowed, the rest of the world is least capable of providing those funds. There are only two eventualities to solve this problem: The Federal Reserve creates money to “buy” Treasury securities, or interest rates rise sufficiently to attract private capital. The net effect will be inflationary.

The consequences of this epic struggle threaten to change our society regardless of how it unfolds. Private capital is being destroyed and replaced with political capital. Government has long ceased to operate within the constraints of the Constitution and is daily expanding its own power. The Founders never envisioned a central authority with the power to create money, socially engineer inflation or deflation, or bail out auto manufacturers, mortgagees, or banks.

Every dollar borrowed and spent places an implicit tax obligation on future private earnings-this burden is growing seemingly without limit. This represents an unprecedented transfer of wealth from taxpayers to bankers and other political beneficiaries. Unemployment is artificially kept in check by expansion of government bureaucracies. Should the government succeed in sparking inflation, it could end up overshooting targets and robbing prudent savers of their life’s work.

We are playing games with our nation’s future and changing our political structure. All this to alter reality and prevent economic correction to sustainable equilibrium. As Al Pacino said in Devil’s Advocate, “Vanity is my favorite sin.”

Disclosure: Short TLT, No positions UDN, FXI, FXY

Source: Debt Deflation, Money Creation and the Aftermath