The U.S. Is On The Edge Of A Growing Deflationary Sinkhole

July 16, 2010
by Lorimer Wilson
25 Comments


Unemployment line

The U.S. caused the 1930s deflationary depression and is again the cause of the current contraction. Although similarities exist between the two, the differences between them insure a far more consequential outcome today than in the 1930s. [Indeed, the world] now finds itself on the edge of a growing deflationary sinkhole created by the sequential collapse of two large U.S. bubbles, the dot.com and U.S. real estate bubbles.

Words: 1535

Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com, provides below further reformatted and edited [..] excerpts from Darryl Robert Schoon’s (www.drschoon.com) original article* for the sake of clarity and brevity to ensure a fast and easy read. Schoon goes on to say:

Global demand is again falling as credit contracts, a sign that debt-driven deflation is back but, today, there is an additional danger as well. Since 1971, because of the U.S. default on its gold obligations, money no longer possesses intrinsic value and the consequences will soon become apparent. Deflationary depressions and a collapse in the value of fiat money have happened before but never simultaneously. Soon, they will.

The Day of Reckoning Has Arrived
We are in what Stephen Roach, Chairman of Morgan Stanley Asia, calls the end-game, the resolution of past monetary excesses and imbalances, excesses and imbalances that reached never-before-seen heights in the last decade.

The Problem
Capitalism cannot function unless its constantly compounding debt is serviced and/or paid down. Today, the U.S., the world’s largest debtor, can no longer pay what it owes except by rolling its debt forward and borrowing more [in] what the late economist Hyman Minsky called ponzi-financing, financing common in the final stages of mature capital systems.

The amount of outstanding U.S. debt, according to Martin D. Weiss, www.moneyandmarkets.com, has now reached levels that can never be paid off. The United States government and its agencies have, by far,
- the largest pile-up of interest-bearing debts ($15.6 trillion),
- the largest accumulation of unsecured obligations (over $60 trillion),
- the largest yearly deficit ($1.6 trillion), and
- the greatest indebtedness to the rest of the world ($4.8 trillion).

The unpayable levels of U.S. debt are not just the problem of the U.S. because the U.S. dollar is the lynchpin of today’s fiat money system, U.S. debt is everyone’s problem. The U.S. dollar is the world reserve currency and a default by the U.S. will have far-reaching consequences, especially in China, its largest creditor.

The Solution
Bill Gross, co-founder of PIMCO, the world’s largest bond fund and an expert in matters of debt, wrote in 2006 that the way a reserve currency nation [such as the US] gets out from under the burden of excessive liabilities is to inflate, devalue, and tax.

a) Inflate
Inflation destroys the value/cost of liabilities by eroding the value of money. Debts are paid back with inflated currencies, a process which benefits the debtor and injures the creditor. This is why reserve currency nations usually inflate their way out of debt by printing what they owe.

b) Devalue
Devaluation is another option afforded reserve currency nations. By devaluing the value of their currency, the value of what they owe falls relative to other currencies. Again, the benefit is to the debtor at the expense of the creditor.

c) Tax
Taxation is another option but is no longer available to the U.S., as its liabilities are now too high. It would be like forcing the elderly and morbidly obese to engage in strenuous exercise to regain youth. Of the three, inflating away debt is by far the preferred option but it is one the U.S. can no longer choose.

Why Inflation Won’t Work
It’s tempting to think that the U.S. can inflate its way out of its fiscal problems. A faster, sustained increase in prices would erode the real value of past debt, and higher future inflation would – other things equal – reduce the real resources needed to service and pay back the promises we are making today. However, inflating away U.S. debt won’t work because as Richard Berner points out nearly half of federal outlays are [now] linked to inflation, meaning that increments to debt would [also] rise with inflation.

Inducing monetary inflation would also raise aggregate U.S. debt resulting in a self-defeating cycle of higher prices and higher debt. However, there is also another more fundamental reason why inflating away U.S. debt won’t work, to wit: Inflation is almost impossible to induce during severe deflationary contractions. Fed Chairman Ben Bernanke understands this difficulty quite well. Bernanke’s late mentor, Milton Friedman, theorized the Great Depression could have been prevented by sufficient monetary stimulus and so in 2008, faced with the possibility of another deflationary depression, Bernanke put Friedman’s theory to the test. Unfortunately, when tested, Friedman’s theory didn’t work. Despite Bernanke’s massive monetary expansion, global credit is still contracting and lending is drying up.

Inflating away debt is virtually impossible in the presence of deflation, but if U.S. monetary expansion is sufficiently large, it could result in the hyperinflation of the U.S. money supply, which would destroy both U.S. debt and the U.S. economy as well.

Managing Director and Chief U.S. Economist at Morgan Stanley, Richard Berner, recently discussed the reasons in We Can’t Inflate Our Way Out, February 24, 2010. www.morganstanley.com/views/gef/index.h ... c960980e46

Will Devaluing The U.S. Dollar Work?
Devaluation is the U.S.’ only remaining option but, as pointed out in Comstock Partners’ special report of February 25th, “The Cycle of Deflation, Impediments to Debt Reliefâ€