Red Ink: The Real Threat to Future Economic Stability

In Thursday's Market Observation column for Financial Sense, I noted the continuing deterioration in our nation's finances:

The latest results of Washington’s spending-and-borrowing spree are in and, as you might expect, they don’t look pretty. According to the Congressional Budget Office, the U.S. budget deficit hit a record $1.4 trillion in the fiscal year just ended; at 9.9% of gross domestic product, it was the largest such shortfall since 1945. In addition, September’s monthly deficit was the 12th in a row, a losing streak that has not been seen in least four decades.

I also highlighted some recent remarks by an old market hand suggesting the steady accumulation of red ink has reached dangerous proportions:

More ominous, perhaps, is the fact that the FY 2009 deficit turned out to be just over 40% of outlays. According to research highlighted by Hayman Advisors in their October Letter, the fact that such a sizeable share of government spending is being financed with borrowed money has, historically at least, been a harbinger of trouble ahead:

There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.

Given the extremely bad habits Washington has adopted during the past two years, one has to wonder, as Hayman Managing Partner Kyle Bass puts is, whether America has “reached the critical tipping point”?

As it happens, another savvy commentator, Dylan Grice, a member of Societe Generale's Strategy Research team and a colleague of Albert Edwards -- one of those rare individuals who is always worth paying attention to -- has also highlighted the unsettling historical relationship between reckless government spending and runaway inflation in a research piece entitled "Popular Delusions: Inflation Is Always and Everywhere a Fiscal Phenomenon":

Even before the “Great Recession”, unfunded fiscal obligations made government finances an accident waiting to happen. The crisis has merely brought forward the day of reckoning. The question isn’t whether developed governments will “default” on them, with attendant consequences for other asset classes, it’s when and how. Yet long-term inflation is priced at 2% in the US. This could be the biggest pricing anomaly across markets today.

Believe it or not, the first great inflation occurred in third century AD Rome. The territorial limits of empire had been reached several decades earlier and the huge army, which in former times had financed itself (through the conquest of new, plunderable and taxable lands), was now needed to protect the border from barbarian invaders.

Just like the baby boomers of today's developed world, that cohort of Roman society which had once been its engine of growth became its unsustainable financial burden, straining imperial finances so thoroughly that the government could only fund itself by debasing the coinage. The silver content of a denarius, which had been 75% in 180AD, was a mere 0.02% by 270AD. Fiscal pressure had caused the first inflation and the Empire would never regain its former greatness.

And since this early Roman experience the theme has repeated itself again and again. Medieval Europe, Sung China, revolutionary France, America during its civil war, Weimar Germany and arguably even post WW2 Britain and America, all saw inflations in which money was the vehicle, but the root cause was a government unable to pay its way.

Albert Edwards has always said the Ice Age would end in substantially higher inflation because political desperation to avoid Japan's fate would drive government debt to such extreme levels that default would be inevitable. Driven by an age old dynamic, this is exactly what is playing out now.

From where I sit, those commentators who believe that a bursting credit bubble precludes inflation, or who are focusing on what the Fed will or won't do next, may be discounting the real threat to future economic stability.

Comments

[Kimball Corson:]

Your thinking aligns with mine. See my new post entitle Toward a New Macro Economic Theory. Stock variables like total debt matter big time. The Keynesians by focusing on current flow variables have the tail wagging the dog.

Oct 11 03:54 AM

[LilBob:]

C.H. Smith had an intriguing article the other day suggesting that given the decline in real estate and other assets, the printing press is an inadequate tool to create inflation. I find Mr. Smith's article interesting, and I tend to fall somewhere in between that and this article. Just as I've been doing for some time with real estate, I find myself cautioning others more about blanket statements regarding inflation. At it's root inflation is a consumption driven phenomenon. In some sectors, notably energy and (in some cases) health-care and education, we seem to be observing the "threshold of elasticity" effect: the price point at which a good or service which was initially thought to have inelastic demand characteristics begins to show markedly increased signs of demand elasticity. If prices go too high too quickly you don't get inflation, you just get a continued recession and a lot of unsold goods. Inflation of home prices is likely to be nil for some time due to continued oversupply of the market. Durable goods and consumables also aren't likely to rise significantly until unemployment returns to the 5 to 7% range, and we see a corresponding uptick in utilization of consumer credit to accelerate velocity of the money supply. Fuel prices-especially propane and home heating oil-are likely to rise considerably with the onset of winter and a dollar that is relatively weaker in the energy markets.

As I see it, the future lies with entrepreneurs. If we see a well-spring of new ventures that focus on wealth creation: critical services and durable goods manufacturing; and a corresponding decline in those market sectors that serve to agglomerate existing wealth without contributing significantly to the nation's total ouput: food service, hospitality, discount retail, then the nation should be able to handle the inflation that does occur.

Oct 11 04:49 AM

[L. F. Herbo...:]

Most people do not recognize the critical forces that are in play which greatly affect the strength and vitality of the United States economy. Clearly, government deficits and it's overall debt contribute heavily to undermining the strength of its currency. As importantly if not more so, however, the inability to be competitive in the global marketplace, also is a significant factor for maintaining economic confidence and strength in the nation's currency.

The US has lost so much ground in the last 30-40 years, that the political decision makers can only pursue monetary policy to stimulate economic growth or mitigate economic decline. In the US, we have seen successive generations of politicians who have squandered our precious capital resources derived from taxation by allocating the same to multitudes of government projects that have marginal or little value. The resulting jobs created are usually of short duration and any real benefits to our national competitiveness are seldom witnessed.

Even after the recent economic decline of 2008-2009, our politicians and appointed officials continue to follow the same behavior. This tells me that we are clearly headed for either a complete collapse or a slow and sustained period of economic decline (with or without inflation), that will seriously undermine the prosperity and the affluence of our nation. I wish it were otherwise, but this simply may be the curse of an affluent society.

L. F. Herbolsheimer

Oct 12 04:16 PM