Originally posted at Monty Pelerin's World blog [16],
The days of reasonable economic forecasting are over. Today, an economic forecast is more like the analysis of a criminal mind than the evaluation of economic data. The dominating role of government overpowers markets intentionally. In the short-term that will continue. Reactions to Federal Reserve minutes referencing continuation, alteration or cessation of quantitative easing cause stock markets to move by over 100 points. Other markets are affected by government interventions, just not so noticeably.
Long term, markets will overpower government. But, to paraphrase Keynes, in the long term many of us will no longer be around. In the meantime, economic forecasting is more political than economic. Dinosaur government affects everything it touches. Markets remain important although government is currently overpowering them. These deliberate distortions may continue for some time.
Markets left alone would reveal the truth about the sorry condition of our country. Government is doing everything it can to hide this condition from the populace. The nature of any government is to make itself look better in the eyes of the people. Big government has the power and means to do so.
Some recent articles generated comments from readers, some pro and some con. Most were very thoughtful. A common theme among the dissenters appeared to be regarding the likelihood of high inflation. There are valid reasons to argue either side of this position. My reason for leaning toward an inflationary outcome is more related to politics. However, all the unused bank reserves in the system is the basis for such a conclusion on economic grounds.
There is no way to definitively predict how this economy ends. Ultimately it ends in another Great Depression. The issue is whether the Depression is preceded by very high inflation, what Ludwig von Mises referred to as the “crack-up boom.” Some readers believe the inflation will not occur. Some seem to think that neither will a Depression. I am going to deal with two views that believe high inflation will not occur. These positions are valid and no better than mine. I will attempt to discuss their positions in a way that seems to reconcile them with my own. My comments are not meant to imply that an inflationary blow-off must happen.
One thoughtful reader argued that the excess reserves in the system are only important if the banks are willing to lend:
Central bank balance sheet expansion transmits into inflation by causing others in the economy to leverage up. But the end of that game comes when everyone is already leveraged to the max. At that point, the central banks can print to their hearts’ content, without generating an explosion of inflation, simply because very few can take on more debt, and there is very little good collateral left that isn’t already leveraged to the max.
In this latest round, most of the new debt has been in the government sector (and student loans, but those are basically government too, aren’t they). But most governments are near or past any sane level of leverage on their projected tax receipts. And even the Fed is starting to realize that they can’t expand their balance sheet to infinity. We may get inflation down the line, but not until after the deflationary collapse of the debt house of cards.
The level of indebtedness is serious and could cause a landslide of defaults and bankruptcies. That would prevent inflation and produce deflation ala The Great Depression. Barring this, however, the fact that banks won’t lend or borrowers won’t borrow does not in and of itself eliminate the concern for inflation. Lack of cooperation in the banking system and private sector only reduces the expected magnification of Fed efforts.
So long as government runs deficits and funds them via the Federal Reserve, inflation is a risk. If the deficits on an annual percentage basis are greater than the rate of growth in the economy, then the money supply is increasing even if banks refuse to lend. That will cause price rises because the money supply is increasing at a faster rate than the supply of goods and services.
Admittedly it would be at a slower rate than if the banking system multiplied the Fed’s efforts by tenfold. Additional money enters the system each year and floats around somewhere. Eventually conditions change and both banks and borrowers become less risk adverse. When that happens, the Fed is helpless as it has no means of withdrawing all this excess liquidity.
A different perspective was provided by another reader. This take was predicated upon deficits decreasing as a result of tax increases:
I think the “crack-up boom” is farther away than you probably do. My prediction is that with the sequester, end of the payroll tax cut, various increases on high earners, and ObamaCare taxes, the deficit for ’13 will be around $800 billion, with it falling to around $600-700 bn for ’14. A deficit of $500 bn would be managable for a long time. Of course another major foreign expedition or domestic terrorist attack would alter this significantly.
Tax increases, using static analysis, always promise more revenue than they deliver because their negative effects on economic activity are assumed to be zero. That assumption is obviously fallacious, contradicting everything we know about human nature. But that does not mean that tax increases cannot increase revenues. Here we get into a Laffer curve type discussion which is moot. Even if it is assumed that higher taxes do not reduce tax revenues, they are a form of blood-letting of the private sector which bleeds resources away from it and into the less productive public sector. Government does not produce growth except in the sense that GDP accounting falsely claims it does.
I think there is even less reason to assume that spending cuts will result from the sequester. This Administration shows no inclination to cut spending. Their every instinct is to increase it, except perhaps in the area of national defense (which is greatly overbloated). Unfortunately they seem to want to reduce waste in this area only to commit these and more to bigger wastes in areas such as solar energy, internal defense (government defense against US citizens) and spending that will make more people dependent upon government.
Republicans are little better than Democrats. They will readily cave on spending-cut demands as soon as they perceive it to be in their own political interest. When the economy weakens. as I suspect it will as a result of the tax increases coming, there is apt to be a tidal wave of additional support for new stimulus programs.
If we indeed reach a “crack-up boom,” it will be as a result of politics. That is what makes our near-term future so difficult to predict. In prior times, markets provided a degree of rationality and limits. Government has overruled them with its Leviathan status and behavior.
It is entirely possible that a massive deflation rather than a massive inflation results. It is all dependent upon the reaction of politicians, a scary and unnerving thought. Markets used to ensure that the economy and country could not get too far off course. Today, it is truly frightening to have our future and the futures of our grandchildren at the mercy of corrupt fools in Washington.
I see few in Washington that even think in these terms. Corruption ultimately kills societies unless reversed. Power-wielders have no incentive to give up their positions or plunder. I don’t believe the US will contradict the rest of recorded history in this regard.
There is no economic recovery in the US or much of the world. Most developed economies are spent welfare states. Politicians have mortgaged their countries’ futures in order to get and stay in office.
Welfare states can no longer maintain their level of spending, services and welfare. However, they dare not stop lest civil unrest and violence break out. The bind they are in has no solution. The welfare concept itself was extended beyond reasonable safety net considerations and morphed into a political vote-buying scheme as well as an attractive alternative life choice.
Governments everywhere are doing anything they can to prevent the inevitable. Social unrest and likely civil strife will result when dependants no longer receive what they feel is theirs. Entitlements worked well for the political class when the resources were available. They represent terrible liabilities when they no longer can be honored.
Governments around the world are doing whatever is necessary to survive. Lying, stealing and outright confiscation will begin in order to support their bankruptcies. Cyprus was a minor precursor of what is coming. Like desperate, cornered and wounded animals they have promised their citizens. There is no solution to this problem other than to default on promises. Debt defaults will also occur in many sovereigns.