The Real Threat to Future Economic Stability

In yesterday's Market Observation column for Financial Sense, I noted the continuing deterioration in our nation's finances:

The latest results of Washington’s spending-and-borrowing spree are in and, as you might expect, they don’t look pretty. According to the Congressional Budget Office, the U.S. budget deficit hit a record $1.4 trillion in the fiscal year just ended; at 9.9% of gross domestic product, it was the largest such shortfall since 1945. In addition, September’s monthly deficit was the 12th in a row, a losing streak that has not been seen in least four decades.

I also highlighted some recent remarks by an old market hand suggesting the steady accumulation of red ink has reached dangerous proportions:

More ominous, perhaps, is the fact that the FY 2009 deficit turned out to be just over 40% of outlays. According to research highlighted by Hayman Advisors in their October Letter, the fact that such a sizeable share of government spending is being financed with borrowed money has, historically at least, been a harbinger of trouble ahead:

There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.

Given the extremely bad habits Washington has adopted during the past two years, one has to wonder, as Hayman Managing Partner Kyle Bass puts is, whether America has “reached the critical tipping point”?

As it happens, another savvy commentator, Dylan Grice, a member of Societe Generale's Strategy Research team and a colleague of Albert Edwards -- one of those rare individuals who is always worth paying attention to -- has also highlighted the unsettling historical relationship between reckless government spending and runaway inflation in a research piece entitled "Popular Delusions: Inflation Is Always and Everywhere a Fiscal Phenomenon":

Even before the “Great Recession”, unfunded fiscal obligations made government finances an accident waiting to happen. The crisis has merely brought forward the day of reckoning. The question isn’t whether developed governments will “default” on them, with attendant consequences for other asset classes, it’s when and how. Yet long-term inflation is priced at 2% in the US. This could be the biggest pricing anomaly across markets today.

• Believe it or not, the first great inflation occurred in third century AD Rome. The territorial limits of empire had been reached several decades earlier and the huge army, which in former times had financed itself (through the conquest of new, plunderable and taxable lands), was now needed to protect the border from barbarian invaders.
• Just like the baby boomers of today's developed world, that cohort of Roman society which had once been its engine of growth became its unsustainable financial burden, straining imperial finances so thoroughly that the government could only fund itself by debasing the coinage. The silver content of a denarius, which had been 75% in 180AD, was a mere 0.02% by 270AD. Fiscal pressure had caused the first inflation and the Empire would never regain its former greatness.
• And since this early Roman experience the theme has repeated itself again and again. Medieval Europe, Sung China, revolutionary France, America during its civil war, Weimar Germany and arguably even post WW2 Britain and America, all saw inflations in which money was the vehicle, but the root cause was a government unable to pay its way.
• Albert Edwards has always said the Ice Age would end in substantially higher inflation because political desperation to avoid Japan's fate would drive government debt to such extreme levels that default would be inevitable. Driven by an age old dynamic, this is exactly what is playing out now.

From where I sit, those commentators who believe that a bursting credit bubble precludes inflation, or who are focusing on what the Fed will or won't do next, may be discounting the real threat to future economic stability.

Comments

[mthomas]

I think the govt even realizes now that they are at the point of no return. They have created so much debt to stimulate and bail out failed institutions, and they cannot withdraw this money because the entire system would implode. They know that it will still eventually implode, but they hope it will occur after they are out of office so they do not personally have to deal the consequences, at least professionally, although they definitely will on a personal basis.

Thanks for pointing out historical examples of rampant inflation as well, as I think this provides a good context for what could occur in the future.

[michael]

Wow!
Do you know where the debt ratio graph originated from, and is there a version or list for all developed countries?

[Michael Panzner]

Unfortunately, I don't. You might want to try contacting the author of the report directly.

[roger]

The silver content of a Denarius could have been
caused by other factors and not necessarily by
fiscal pressure. Just a thought.

[Marion Shaw]

A very astute German historian, whose name I cannot recall, observed that the
historic German hyperinflation was deliberately engineered by
the bankers; for what purposes, I forget. The result, however, was the destruction of the middle class. upon whose self idenity was based on its
financial well being and comfortable life style. With all that wiped out, the
majority of the German people were open to anything. And anything is what they
got, as did the rest of the world along with them. I wonder who the American
anything will be?

[Dante]

October 9, 2009
Just over a year after economic calamity brought promises of reform from Washington, has Wall Street really changed? Former International Monetary Fund chief economist Simon Johnson and US Rep. Marcy Kaptur (D-OH) report on the state of the economy.


http://www.pbs.org/moyers/journal/10092009/watch.html

[roger]

Dante: EXCELLENT SITE I HIGHLY RECOMMEND IT,
Those who don't get a profound sense of outrage
must be brain dead