Tuesday, July 26, 2011

Inflation, Recession, or Both

Something bad is going to happen in the economy.  The Fed has more than tripled the monetary base since the fall of 2008.  Meanwhile, the federal government is running deficits of $1.5 trillion per year with the national debt now exceeding $14 trillion.  The government is trying its Keynesian tricks of spending its way out of a crisis.

Not only did the government not allow the full correction to take place from the recession that started a few years ago, but it is continuing to make things worse.  With all of the money creation and huge government spending, it is only distorting the market and misallocating resources.  The more this happens, the worse the future recession/ depression will be.

Something will have to give eventually.  The Fed may go to QE3 (more digital money printing) in which case we are more likely to get rising prices.  The big excess reserves held by banks have helped keep price inflation low.  The low velocity (high demand for money) has also helped counteract the inflationary policies of the Fed.  But if the Fed creates enough new money out of thin air, it will eventually send prices soaring to the sky.

If the Fed slows down or stops its money creation, we are more likely to get another recession (if the previous one ever actually ended).  If the government does not try hard to stop it, this will be a deep recession.  It will be worse than 1981/ 1982 because there has been far more damage done this time around.  This scenario is actually our best case scenario in realistic terms.

The other possibility is a repeat of stagflation of the 1970's, although I would expect this time around would be even worse.  The previous malinvestment is huge and it all needs to be flushed out.  We could see this scenario where the Fed creates new money, although at a much slower pace than we have seen in the last few years.  It would be enough to raise prices significantly but it would not be enough to send the economy into a boom phase.  We would see price inflation over 10%, while economic growth would be very low or even negative.

If the inflation scenario plays out, then there will eventually be a crash anyway, so that is the worst case scenario.  The absolute worst case would be if the Fed did not stop and we went into hyperinflation.  That could be a very dangerous scenario given our high division of labor society that uses U.S. dollars as money.

There is one final scenario that is possible, but highly unlikely.  We could see some huge technological breakthrough that makes our lives significantly better and easier.  It would have to be really big to overcome the massive malinvestment that has previously occurred.  In this case, it is technically possible to have a correction but still have positive growth due to the explosiveness of the free market.  But again, I give this a very low probability because it would have to be a huge breakthrough to overcome the massive government spending and distortion that has already taken place.

In conclusion, this economy will suffer some hard times ahead.  I am optimistic that we will eventually turn towards liberty and less government.  When this happens, we will see what happens when 21st century technology meets a truly free market.  Things will change very quickly at that point and it will be mostly for the better.

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