BEST OF JIM COOK

WEEKLY COMMENTARY

March 15, 2005

INFLATE OR COLLAPSE!

By James R. Cook

"Inflationism is the oldest of all fallacies."

Ludwig von Mises

"Below the favorable surface [of the economy], there are as many dangerous and intractable circumstances as I can remember…. Nothing in our experience is comparable….We are skating on increasingly thin ice."

Paul Volcker

My wife scoffed at me the other day. Admittedly she’d had a glass of wine before dinner and that might have been the reason. All I said was that in 1932 and 1933 the U.S. mint didn’t issue any coins other than pennies. Business slowed so much that nobody needed any new coinage. "Imagine that happening today," I said. She rolled her eyes and suggested that could never happen today. "We’re way beyond anything like that," she explained. "You’re wrong," I said. "It could be worse than 1932. You have no idea how serious our monetary problems are." She’s been hearing similar comments from me for several decades. She gave me a weary look and then changed the subject.

When your wife doesn’t buy your gloom and doom arguments, perhaps you might want to clam up about them. Sorry, but I’m not going to do that. In fact, I’m going to try and make my arguments stronger than ever. Here’s the way I see it. If the U.S. keeps on inflating our money and credit, we’re going to see prices sharply rise for everything. But what happens if money and credit growth hits the wall? Although the central bank does everything in its power to push out new money and credit, certain things could upset their apple cart and foster deflation. As economist Kurt Richebacher notes, "Given the preposterous leverage underlying all U.S. asset markets, the Fed is running an immense risk of bursting the asset and credit bubble with a bang."

The following events could trigger the onset of deflation and a depression.

1. Rising interest rates.
2. A steeply falling dollar.
3. The end of government bond purchases by foreigners.
4. A derivatives accident or major financial failure.
5. The bursting of the housing bubble.
6. A stock market crash.
7. High and rising inflation.
8. Major debt defaults.
9. Economic slowdown and recession.
10. Reduction of consumer spending.
11. Credit shrinkage and stagnating money supply.
12. Faltering liquidity in the bond market and carry trade.
13. A big rise in unemployment.

Most of these painful economic events could happen at any time. Because of our debts and deficits, no major country has ever been so vulnerable to negative economic circumstances. We either inflate or we collapse. The great Austrian economist Ludwig von Mises put it this way. "The attempts to lower interest rates by credit expansion generate, it is true, a period of booming business. But the prosperity thus created is only an artificial hot-house product and must inexorably lead to the slump and to the depression. People must pay heavily for the easy-money orgy of a few years of credit expansion and inflation."

If my wife can’t imagine the mint shutting down, she certainly can’t imagine any of the other financial suffering we would endure in a depression. I can. Here’s a sample. Interest rates soar and the real estate bubble bursts. Residential values fall by one-third in the first leg of the crisis. As real estate values plummet, many homeowners lose their houses while others walk away from their mortgage debt. Foreclosures and price reductions kill off the lenders and financing becomes impossible. Mortgage brokers and real estate agents face layoffs. High interest rates choke off new construction and the real estate boom dies a horrible death. Builders fail, unsold and defaulted properties become a glut on the market. The construction industry fades away and large quantities of skilled construction workers are thrown out of work.

The stock market plunges as panic grips the land. Mutual fund orders pile up unsold. The value of pension funds and retirement plans whither away. The highly leveraged bond market begins to seize up, as too many bondholders head for the exits. Bond prices collapse and billions are wiped out, as trapped bond speculators and hedge funds force feed bond portfolios into an illiquid market. Chaos reigns on trading floors around the world.

Large chains of superstores go into bankruptcy and close down. Coffee franchises, book chains, glitzy restaurants, sporting goods chains, expensive luxury stores and specialty shops fail in droves. Stores and chains loaded with too much debt expire. Overbuilt malls lose tenants as retailers large and small fold. Consumers freeze spending as their excessive personal debt devours them. Fifty percent of all retail establishments go out of business within two years.

The travel business is crushed. Airplanes fly half empty. Travel agents, resorts, cruise lines and airlines take a huge hit. Many die off. Motels, hotels, spas and resorts perish. Automobile sales plummet and major auto makers with heavy debt go bankrupt. Huge layoffs accompany these failures and consumer incomes shrivel.

Asian nations begin to pound the bid for treasuries as interest rates soar. American officials hold one press conference after another to sugarcoat the deteriorating financial condition of the U.S. The dollar cracks as an astronomical volume of transactions smashes down the currency. Massive government intervention fails to hold, and the dollar plummets. U.S. interest rates scream upward, but panic selling of the currency crushes its value. The cost of imported goods goes into the stratosphere. Inflation in the U.S. reaches double digit levels virtually overnight.

The shell-shocked financial industry cannot recover. Brokerage firms close and massive layoffs grip Wall Street. Bitter investors initiate a blizzard of lawsuits, but the coffers of investment banks and brokerage firms are empty.

Unemployment across the nation begins to skyrocket. Demands on government safety nets and social services soar. Government tax receipts collapse. The deficit multiplies in size, but government borrowing freezes up. National bankruptcy looms. Left-wing politicians scream for confiscatory taxation as their minions can no longer be subsidized by the government. Government programs are drastically underfunded or are terminated.

The economy shuts down except for transactions in necessities and basics. Farm crops can’t get to market until a semblance of order returns to financial markets. Some commodity prices sink drastically while others soar. Land prices plummet. Commercial properties collapse in value as vacancies accelerate. Auction houses lay off employees as art, antiques and collectibles fail to find buyers and liquidity evaporates.

Political leaders, Treasury and Federal Reserve officials become villains in the eyes of the public. Social unrest rears its ugly head. Months of financial panic end in depression. The dollar is worth a fraction of its former value, and high inflation persists. Business activity stagnates and a long period of hard times ensues. In Washington, the U.S. mint announces it will not be minting any new coins for circulation.

For those who are as skeptical as my wife about any of these events taking place, here’s why some of them will happen. Although the government states that inflation is low, and Wall Street and stock investors endorse that view, it’s not true. The rate of inflation can’t be judged accurately by a few items the government arbitrarily chooses to measure. The accepted inflation rate should be based on what people spend their money on. That includes everything from soup to nuts, including investments and real estate. The inflation rate that covers everything is (my guess) at least 10% annually.

Here’s the rub, inflating requires more and more inflating. According to Ludwig von Mises, "Because an inflationary policy works only as long as the yearly increments in the amount of money in circulation are increased more and more, the rise in prices and wages and the corresponding drop in purchasing power will go on at an accelerated pace."

Despite talk of reining in loose money, the monetary authorities believe the risks of contraction are too great for a serious curb on inflating. In reality, it would be much better to take the bitter medicine now and liquidate the excesses of the inflationary period. However, the bias will remain inflationary and will continue to be that way until inflating fails.

As analyst Doug Noland points out, "The U.S. credit bubble is creating unrelenting and unwieldy dollar liquidity that continues to inundate global financial systems….. Excess is only begetting greater excess…." Dr. Richebacher says, "In terms of credit growth, this is the greatest inflation orgy in history."

All the paper money that ever existed in the world, prior to what we use now, inevitably became worthless. Hundreds of paper currencies in scores of countries wound up in the wastebasket. As Voltaire once noted, "Paper money always returns to its intrinsic value – zero." One of the definitions of money is that it’s a store of value. That’s not the case with our dollar. It continues to lose value. Who can make a convincing case that it won’t wind up like other worthless paper currencies? In their new book The Coming Collapse of the Dollar, James Turk and John Rubino point out, "Whether ancient or modern, monarchy or republic, coin or paper, each nation descends pretty much the same slippery slope, expanding government to address perceived needs, accumulating too much debt, and then repudiating its obligations by destroying its currency."