The American Crisis and the Case for an Inflationary Depression

by: Negative Carry

The collapse of the commodity bubble beginning late this summer erased inflationary worries from the minds of many. Crude at $145/bbl, natural gas at $24/MMBtu, and gold at $1,000/oz were characteristic of the artificially inflated prices of this commodity boom, which began in 2002.

The secular bull in commodities was caused by perceptions of massive demand in emerging markets, particularly the BRIC nations - Brazil, Russia, India, and China - which were growing at unprecedented rates. As they became increasingly wealthy and industrialized, these economies represented growing new demand for energy, food and production inputs.

This great demand, coupled with the perception of quickly diminishing supply (most famously in crude oil), caused the strong price surge in commodities, and self-perpetuated the idea of emerging market demand growth. However, as a global recession sets in, the massive anticipated demand growth from emerging markets is slowly proving unfounded, causing the commodity bubble to collapse. Nevertheless, the decline in commodity prices does not eliminate the threat of inflation in the United States; if anything, it supports such a thesis.

The recent economic collapse can be traced to Alan Greenspan's extremely dovish interest rate policies in the 1990s, which led to artificially strong growth in America's economy. Greenspan's policies caused huge leveraged investment in artificially strong assets, particularly real estate and equities, since low interest rates prevent savings and encourage leveraging capital as credit is cheap. The growing excess liquidity, invested in diminishing opportunities, resulted in a classic speculative bubble.

The housing bubble came crashing down in 2007, leaving Americans significantly less wealthy. Financing home, car, and other big purchases pervades American culture, and consequently, the housing correction affected Americans all the more, as their mortgages suddenly were significantly more expensive than the houses they were paying for.

Encouraged by the cheap credit of Greenspan's low interest rates, banks and mortgage lenders also issued massive amounts of irrational loans to poor-credit borrowers at risk for default. These borrowers, who didn't qualify for safer "prime" fixed-rate loans, were issued Adjustable Rate Mortgages (ARMs), convertible hybrid loans, and other "subprime" loans.

As the Federal Reserve finally started raising interests in response to the bubble collapse, these high-risk borrowers suffered further, as their mortgages grew increasingly expensive. Many of these borrowers were forced to default on their loans, which caused a liquidity crisis in mortgage lenders. It also caused a liquidity crisis in banks, who had accumulated large positions in mortgage-backed securities during the credit boom. This led to a credit crisis, as banks became unwilling to lend almost anything at all with their depleted capital reserves.

The housing correction was followed by a crash in the equity markets, which also had an immediate impact on Americans. Millions of Americans have allocated their savings in mutual funds and pension funds, which are being drastically hurt with the stock market crash. Americans have depleted savings and retirement funds because of the market crash, as well as diminished wealth because of the housing correction. And this is all before the fall-out of the credit crisis sends businesses to bankruptcy, increases employment, and all of the other consequences affiliated with a deep recession.

Alan Greenspan's artificially cheap credit policies caused an internal economic crisis, which coupled with President Bill Clinton's strong encouragement of globalization and foreign trade led to a dependence on debt that will deepen the current recession into a possible depression and cause rampant inflation.

Since the collapse of the Soviet Union in 1989, nations around the world have privatized their economies and issued important reforms. These reforms are behind the emergence of China, India, and other growing economies in the global economic system, particularly through increased trade and foreign direct investment. Since the United States possesses the global reserve currency in its Dollar, it can safely run large trade deficits, causing it to represent huge demand for foreign exports.

The nations exporting to America, whose growing GDPs indicated growing demand for commodities (which are priced in the global reserve currency, USD), represented great demand for U.S. Treasuries. This caused America to issue massive debt to these nations, but used this to finance further consumption. Greenspan's dovish policies in the 90s resulted in significantly low interest rates, which led to America's unprecedented growth as cheap credit financed more business, more houses, and most importantly more consumption. This led to the formation of a debt bubble, as the United States entered a cycle of consuming foreign exports, issuing debt to its trade partners, and using the debt to consume more of their exports.

Theoretically, the United States can continue to print more dollars as long as a demand for them exists abroad, which has as emerging markets grew sizably in recent times. However, the demand for U.S. debt has drastically fallen as the world economy contracts as a result of the credit crisis in America and foreign nations attempt to finance domestic growth. On November 9, China announced a $586B domestic stimulus package, more than triple the size of America's 2008 package. Australia announced a $10.4B package and Japan a $51B.

Not only is there an immediate need for economic stimulus at home, there is decreased demand for exports abroad (particularly in the United States), so nations are focusing on domestic growth instead of externalizing it through foreign trade. This has a two-fold effect on the United States: it places a formidable burden on America's industry as the U.S. can't simply consume its way out of recession, and it prevents the U.S. from just issuing more debt to finance domestic stimulus.

These have alarming consequences in the context of current recessionary conditions. Consumption accounts for over 2/3 of America's economy, and facing depleted wealth, tight credit, and a huge foreign debt, the United States appears to be in fragile condition. The United States has an external debt of $13T, more than any other nation in the world and about equal to a year of GDP.

Now that foreign nations are forced to finance domestic growth internally, they have slowed their U.S. debt purchases and will slowly stop buying American treasuries altogether. This will essentially force America to repay its debts abroad, which it obviously cannot do at the commencement of a deep recession without an enormous budget surplus. However, the United States deficit is getting increasingly large, as bank after bank is bailed out.

The recently-passed Troubled Assets Relief Program (TARP) allocates $700B to liquifying troubled banks, who are overleveraged and undercapitalized, and other troubled companies, the next of which may be the Big 3 automakers. Add that to the $53T owed by the U.S. government for unfunded Social Security, Medicare, Medicaid, veterans' pensions, and other similar programs, and the prospect of the United States paying off its debt appears even slimmer.

The economic conditions will only worsen this deficit, as more and more Americans will be uninsured (as unemployment skyrockets) and forced to retire primarily on Social Security (as pension funds lose value). The government will be forced to socialize more and more, financing it through more issued debt; this as foreign demand for U.S. debt dwindles. So, as external debt worsens, public debt follows suit, leaving no way to finance debt payments or government programs. The Federal Reserve will undoubtedly respond by printing more and more money, but without foreign demand for U.S. debt, this will lead to rampant inflation.

In inflationary conditions, food and energy prices will skyrocket, hurting the American people even further, whose wealth having been diminished in nominal terms, let alone real terms. In the 1970s, President Richard Nixon's wage and price controls led to double-digit inflation rates, which Federal Reserve Chairman Paul Volcker corrected with a strong dis-inflationary hawkwish policy. This ushered in a deep recession with some of the worst unemployment levels since the Great Depression, however, and simply raising interest rates will not do the trick to fix the 21st century inflation.

The commodity price collapse since the summer of 2008 does not indicate inflation is out of the question - it indicates global economies are contracting deeply. As global equity markets collapse, investors are liquidating and deleveraging, fleeing to the traditional safe haven currency, the U.S. Dollar.

This is a temporary response, and is behind the strong selling pressure in gold and partly behind the commodity decline. Recessions of this nature almost always lead to a period of deflation, as aggregate demand diminishes and banks are reluctant to lend any capital they have.

However, this crisis will not remain a deflationary recession forever. When the United States debt bubble finally collapses, the U.S. will be forced to default on its debt and devalue its Dollar, as the Fed pumps more and more liquidity into the system. The CDS price for 10 year US Treasury bonds has already increased by 2500% over the past year, and with more deficit spending ahead, the U.S. Dollar's perceived stability will diminish, as will its demand. Increased supply and decreased demand - characterizing rampant inflation. This will send our recession into a depression, and usher in America's first inflationary depression.

There are two ways to fund external debt - decrease government spending or increase taxes. With TARP passing, government programs further socializing, and Ben Bernanke stating he will increase money supply as long as he has to prevent a 1990s Japan deflationary scenario, government spending is going to increase significantly, rather than decrease. Taxes are all that is left in the arsenal of the U.S. government, and with the diminishing purchasing power of it citizenry, higher taxes will not be met with popularity. Tax revolts, food shortages, and riots are not out of the question when this inflationary depression occurs.

What is left to do? Liquidate all mutual and pension funds into gold and/or Swiss Francs. Precious metals are the only commodities that aren't significantly susceptible to global economic conditions. A recession decreases the demand for oil, for example, because households and businesses will cut costs. However, the demand for gold and other precious metals doesn't lie in its utility in production, but rather in its store of value.

This makes gold a great inflationary investment, as it preserves purchasing power. Gold under $900 is a bargain, and I see it above $2000 by 2010 and above $3500 by 2011. The Swiss Franc is 20% backed by gold and boasts a 0.6% inflation rate, and its demand is only going to rise, as the United State's dominance in foreign currency reserves will diminish and foreign nations and wealthy investors will seek a safe haven currency.

My pessimism for the American economy can best be represented by the fact that I see the Dow Jones bottoming all the way down to around 3,300. However, the United States has leverage aside from its currency reserve status and economic dominance. It is the sole nation in the world that can be self-sustainable if need be, having substantial energy, food, and industrial commodity supplies.

In addition, it has the ultimate leverage of all - the largest and most powerful defense system in the world. At the end of all of this, whether or not after war, demagogy, or whatever doomsday scenarios can be conceived of, I believe the United States will come out as the reigning superpower in the world and through forced domestic investment and industrial development (particularly in alternative energy), will develop even further into the strongest economic powerhouse in the world.

Before any of this optimistic speculation influences your opinion, however, I insist you come to terms with the economic collapse that will precede any such positive event. I will leave you with this, a chart of the America's real total credit market debt-to-GDP, which is higher now than it has ever been, including during the Great Depression and World War II. This clearly shows our debt bubble, which is still inflating and will keep inflating until the U.S. Dollar defaults.

click to enlarge

Long recommendations: GLD, TBT, UDN, SDS, DXD, QID-OLD, Swiss Franc (CHF) FXF
Short recommendations: US Dollar (USD)