‘Inflate or Die’

March 3, 2008 – “Inflate or die.” I’m not sure when Richard Russell, the editor of Dow Theory Letters (ww2.dowtheoryletters.com), first penned those words. It might have been a couple of decades ago or even more, but regardless, those words are as true today as they have ever been.

The dollar became a fiat currency in 1971 when its formal link to gold was broken. Each new dollar created today is not backed by a tangible asset, i.e., gold. It is instead backed by someone’s IOU. In other words, the US economy and the dollar monetary system are built upon debt. And it is worrisome that it is taking an ever greater amount of debt to fuel economic growth, as measured by Gross Domestic Product.

The problem with debt is that it brings uncertainty into the economy. What’s worse, it also brings uncertainty into the monetary system because instead of being based on gold, the dollar today is based on debt. The uncertainty arises of course because not all debts are repaid. Banks take losses because some loans go bad and never get repaid.

As long as those losses are small, there is little reason to worry. But monetary history clearly shows that unfortunately, bankers make mistakes.

They inevitably extend too much credit. That newly created debt increases the quantity of dollars in circulation. The pace of economic activity quickens, but because money is easy to come by from the banks, it gets readily borrowed, with much of it going into bad investments.

A good example of this principle is the condo market in Miami, which has become overbuilt on the back of easy bank credit. But after every boom there is a bust, which is now rapidly unfolding. Sales of Miami condos both in terms of prices and volumes are well below what was expected. They have become an inferior use of capital. The builders of those condos, the buyers of those condos, and the banks who financed them are taking losses.

This boom-bust cycle explains in a nutshell the Great Depression. Banks recklessly extended credit in the 1920s creating a boom – what I prefer to call the ‘illusions of prosperity’. The bust in the 1930s was a direct result as bank debt extended in the good times to finance what proved to be uneconomic activity could not be repaid, which is what is happening now in Miami.

These problems are not yet pervasive, as they eventually became in the 1930s. But clearly, the economic and monetary outlook gets worse by the day. There are dozens of ‘Miamis’ wrecking havoc on the banks, and that reality is becoming widely recognized. However, few people recognize the more important point, namely, that the system is broken.

We have already entered the early stages of what Ludwig von Mises, the greatest economist of the 20^th century, called the “crack-up boom”. At the end of a seemingly endless inflation, people begin to question the quality of the currency. As they become ever more doubtful that the purchasing power of their money will be preserved in view of the growing inflation, they increasingly spend their money to buy goods of real value, like commodities. In other words, people feel safer owning a million dollars of soybeans or crude oil or gold than having a million dollars on deposit in a bank. In other words, we are now witnessing the complete breakdown of the monetary system.

This reality is the underlying message in the accompanying cartoon. The economic and monetary system is broken. But the above cartoon also conveys another important message.

Rather than accepting the reality that the system is broken, the kingpins in the Wall Street-Washington D.C. axis that created the fiat dollar in the first place are hell-bent on keeping it in place. They are taking all sorts of actions to try keeping the system from falling over, which is the point of this missive.

The props being placed under the monetary system – just like those in the cartoon above – are a harbinger of more to come. As the economy and the dollar spin out of control, we are rapidly approaching the moment when the federal government ‘flicks the switch’ by implementing the various provisions of the Patriot Act and imposes capital controls.

Controls of any sort are never a good thing. It is individual freedom to pursue their own goals, and not control and government central planning that has enabled the US to reach the standard of living it has attained. But the federal government nevertheless is moving in entirely the opposite direction. Intervention in the free market process has become the norm.

As the Bush administration draws to a close, I assume that they are focusing on one goal. Their administration has already been a disaster in so many ways, their increasing intervention in the market process may be their feeble attempt to keep economic activity and the monetary system from collapsing before Bush leaves the White House.

I’m not sure that they will achieve that goal. Even a cursory reading of monetary history makes clear that all fiat currency systems are doomed to collapse. That outcome is inevitable for one very important reason.

There must be discipline on the money creation process. The gold standard completed that task commendably. The Federal Reserve on the other hand is creating dollars without limit to feed the federal government’s insatiable demand for money. So rather than imposing discipline, the Bush administration is instead opting for intervention. That’s a recipe for disaster, and we’ll see in the weeks and months immediately ahead how bad that disaster proves to be. I expect that it won’t be pretty.