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Oil at $110 and an ever falling dollar seem to make stagflation a probability and hyperinflation a real threat. I believe these alarming conditions are merely an inflationary blow off that punctuates the desperate actions of an irrelevant Federal Reserve; like a star going nova before imploding. Although the Federal Reserve has changed the bearings and switched to 100 octane on the printing presses, it is not enough to stem the incipient deflation from the collapsing real estate bubble and its attendant economic shock wave.

We have entered 2008 in much the same way the seemingly invincible Japanese entered 1990, teetering on bankruptcy. Japan’s banking system was an accident waiting to happen by allowing sub-prime, and even defunct business, loans to be held as good receivables. Their Central Bank oversaw such practices and no doubt assumed the bad debt would be consumed by future growth. Sound familiar? Our Federal Reserve presided over substantially the same delusion during our real estate bubble by allowing banks to sell loans at AAA rates to sub-prime borrowers. The good debt was then wrapped into tidy little institutional packages and sold as AAA paper, because it was mortgage backed. When the credit quality of all that “good debt” is finally market to market, money simply evaporates and the shock wave resonates far past ground zero. Bear Stearns’ (NYSE:BSC) epitaph is being written with sub prime ink. If the #5 investment bank is on life support, how healthy are those beneath them?

The exceptionally aggressive and a-historic action from our government is just getting started; at least it sounds better than “panic has set in”. The procession of interest rate cuts and emergency actions is in response to the scent of deflation now permeating the Washington D.C. muster stations. The first stimulus plan will roll off the press in May to resuscitate a drowning consumer but it’s far too little to have any meaningful effect. As well, deficit spending might otherwise restore sanity, as it did during WWII, if our economy wasn’t the voracious credit-hungry fiat monster that it has become. In our case, there is no surplus from which to draw these rebates - only recycled debt; and our deficit is becoming an almost meaningless number. The most that rebates or more deficit spending can do now is calm the public on the way down. As J.M. Keynes might put it, we lack enough real money to support aggregate demand in a functioning economy and more debt just won’t do. Credit can be free but it will only further indenture a country already drowning in debt.

Although the S&P estimate of 300 billion may in near the mark in terms of the actual failed debt, the cause of the binge remains - an absence of organic growth. Artificially inflating our entire residential real estate market and then financing the margin with bad debt is evidence of desperation, not creativity. Our capacity to foster organic growth has been waning as we lose share to more competitive nations or simply outsource our domestic capacity away. We accepted the economic growth from our past bubbles as organic, and we pledged that as collateral to borrow our standard of living. Now we find out that it was mostly financial engineering. Each bubble’s pop replaced lost money with debt and we agreed to the notion of more credit somehow equaling growth. Inflating our most precious asset class, however, was the swan song of the big bubbles and the buck has stopped.

We’re now faced with the unpleasant task of cleaning up and getting back to real growth. In so doing our standard of living will be reduced because we simply cannot afford it. In reality, we haven’t been able to afford it for decades. We are in debt to ourselves to the tune of 65 trillion in unfunded mandates and to our foreign neighbors to the tune of 6 trillion. We are too far behind the curve to “grow” our way out of our debt unless we really get creative and annex Mexico with strict enforcement of payroll deductions.

America has been balancing between inflation and deflation only because the Feds are driving up the cost of pulp by driving down the value of the greenback. The fact that the asset deflating has such deep and diffused financial roots creates an insurmountable void far greater than any other asset class could. Home mortgages are the center of our financial universe. The shock wave from the deflation is so magnified by the leverage that it is overwhelming the opposing flood of fiat. While the headlines argue about whether or not we’re in a recession, we have already slipped into a deflationary spiral:

1) Deterioration of balance sheets.

2) Decline in investment and consumption.

3) Decline in employment and wages.

4) Return to 1.

1990 Japan is the most recent example of this spiral and, despite very aggressive measures to reflate their burst bubble, it cost them ten years. They cut interest rates from 6% to 0%, added over one trillion dollars over 10 stimulus packages, cut taxes, gave away shopping vouchers, bailed out banks and probably even threw in a few Ginsu knives. In the end all they got was a substantially weaker government, one now even deeper in debt. Because Japan’s riotous run up included simultaneous real estate and stock bubbles it was an order of magnitude greater than our real estate bubble alone. That and our abhorrence for savings will most likely get us out in only three years. Look for the dollar to stabilize, not from confidence in our own government but because Europe and the rest of the world will be forced to turn on their presses to shore us up. We are such voracious consumers that America herself is now too big to fail.

Source: Warning Signs of a Modern Depression: See 1990 Japan