Tuesday, June 16, 2009

A Skeptical Look at High Inflation

Two points are often overlooked by those seeing inflation as inevitable: it's neither good for the U.S. Treasury nor for the super-wealthy who influence Congress.

The gospel of inflation is that it's desirable because old debt can then be paid off with hugely depreciated dollars. Maybe, but there are two flies in the ointment.

Let's say you head the U.S. Treasury. (No, this is not a nightmare; it's only a terribly bleak thought experiment.) Now since inflation won't rise from 0% to 100% in an instant, there will a period of rising inflation.

Let's say inflation jumps to 10% a year--similar to the rate in the late 1970s. Now several peculiar things happen when inflation jumps to 10%; the most important one is that all those trillions in Treasury (and other) bonds which are outstanding are now worth a lot less. Why? Because buyers look out 10 years or 20 years or 30 years and quickly reckon at that 10% inflation or so, that long-term bond will be worth approximately a bucket of warm spit when it finally come due.

Another funny thing happens to interest rates. When we try to sell new T-bills to our wonderful friends overseas for a 4% annual return, they observe that they will be losing 6% a year for the full term of the bond--and that's if the dollar doesn't plummet, in which case the new bond might reach "warm bucket of spit" valuation even before it comes due in 10 or 20 or 30 years.

Even our closest, dearest, most gullible friends will conclude that losing 6% at a minimum is not a wise investment. So nobody in their right mind will buy the new Treasury bonds which you have to sell every week in untold billions.

So what rate of return would entice folks to part with their cash? How about a real rate of return of say, 4%, plus a premium in the event inflation in the U.S. continues rising. So let's say a minimum of 15%.

Another funny thing happens to existing bonds paying 3% when new bonds yield 15%. The old bonds drop hugely in value because one way or the other buyers now expect 15% return. So a $10,000 bond paying 3% will drop to $2,000 in value so that its effective yield is equivalent to the new bond yield of 15%.

Now remember that the U.S. Treasury needs to sell a couple trillion dollars of new debt every year from now until doomsday. (Forget the fantasy that the economy is going to recover and tax revenues will skyrocket.) Not only that, but the Treasury also has to roll over trillions in old debt which comes due. That's a heap of trillions, and guess what--there is no Plan B except to print off a couple trillion dollars and "monetize" the debt by buying it with newly printed dollars.

Nobody knows what will happen if the Federal Reserve and the Treasury try to corner the global market in Treasuries with money created out of thin air, but most guess that will nudge up inflation--the very problem that put us in this pickle, i.e. nobody wants to buy our debt at 4% when inflation is 10% and climbing.

You see the point: the idea that inflation is "good" for the Treasury is purely academic. In the real world in which the Treasury has to sell hundreds of billions of dollars of new bonds every year, inflation means interest rates will have to jump high enough to offer a positive return (above inflation) and that will destroy the existing bonds' value and decapitate the housing market all in one swoop.

We might also anticipate that all our dear friends who foolishly invested their hard-earned cash in Treasuries in years gone by might not be too overjoyed to find that their previous investments are now worth 20% of face value. That lack of joy might motivate them to never buy another T-bill again.

So the idea that the Fed and the Treasury are looking forward to a sharp rise in inflation simply does not make sense in the real world of selling tens of billions of new bonds each and every week.

We can also anticipate that corporations will not be too thrilled at having to pay 15% in order to issue new corporate bonds.

Now let's say your family controls $200 million or so in productive assets.(Nice gig, eh?) Yes, you're one of the rentier-financial Power Elite, a.k.a. the Plutocracy. As inflation ramps up, followed by interest rates, does that make you feel all warm and fuzzy? Probably not, because inflation introduces a great uncertainty in your assets and returns. Tangible assets will go up, of course, but then the high cost of money means financing is nearly impossible to get; and no matter how fast your enterprises raise rents and prices, they're always behind inflation.

Yes, you can play around with hedging the dollar and so on, but since nobody knows whether inflation will stabilize, double, or fall, it's difficult to choose high-yield strategies. Meanwhile, your income is rising and so are your taxes (assuming you pay any, heh.)

Now since you give various high-powered congresspeople a couple hundred thousand each, plus a few million dollars to various parties and PACs, the politicos perk up when you call and tell them this inflation is wreaking havoc on your business.

You see the point: inflation is not all that great for the 1% of the citizenry who own/control 2/3 of the productive wealth of the nation. These folks tend to own a lot of everything, and their bonds are getting wiped out. Maybe their timberland is rising in value, but since costs are rising, too, then it's all a wash. Meanwhile, the property taxes are leaping along with valuations, and there's no guarantee that prices will keep up with costs. The same can be said of rental property and other income-producing assets.

The idea that the super-wealthy and super-influential folks who own the politicos will benefit from inflation does not hold water. And so how much pressure do you reckon the politicos will be feeling "to get a handle on this inflation"? I would reckon a tremendous amount--the sort which causes people to lose elections. And since that is the last thing a politico wants, then they will start calling people and demanding that somebody somewhere get a handle on this inflation thing and shut it down.

(Mever mind what happens to the politicos' cherished pork spending when interest rates jump to 15%. The Federal budget will largely go to paying interest, leaving precious little to toss around the home district come election time.)

It seems abundantly obvious that high inflation is not a "solution" to the Treasury's main problem, selling trillions of dollars in new debt, nor is it some sort of windfall for the Plutocracy. And if it's not helpful to the Treasury or the super-wealthy, then why would either allow it to happen? (After all, it's not exactly a mysterious force from space; it's rather terrestrial in origin.) Maybe the answer is: they won't.

A few classics in case you missed them:

The Long Emergency: Surviving the End of Oil, Climate Change, and Other Converging Catastrophes of the Twenty-First Century James Howard Kunstler

Depletion and Abundance: Life on the New Home Front Sharon Astyk

The Future of Life E.O. Wilson

Globalization and Its Discontents Joseph Stiglitz

On Peak Oil:

Beyond Oil: The View from Hubbert's Peak

The Party's Over: Oil, War and the Fate of Industrial Societies

The End of Oil: On the Edge of a Perilous New World

Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy

On chemical/toxins overload:

Our Stolen Future: How We Are Threatening Our Fertility, Intelligence and Survival

On the demographic time bomb about to explode:

Fewer: How the New Demography of Depopulation Will Shape Our Future

The Coming Generational Storm: What You Need to Know about America's Economic Future

On collapse of advanced civilization:

Collapse: How Societies Choose to Fail or Succeed (Jared Diamond)

The Collapse of Complex Societies

A realistic appraisal of alternative energy:

Sustainable Energy - Without the Hot Air

Our previous lists of hot reading and viewing can be found at Books and Films.

Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle

Of Two Minds reader forum (hosted offsite, reader moderated)

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