By Doug Noland
May 22 - Bloomberg (Dakin Campbell and Mark Crumpton): "Bill Gross, the co-chief investment officer of Pimco... said the U.S. 'eventually' will lose its AAA rating, but not any time soon. Both the U.K. and the U.S. have prospective deficits of 10% annually as far as the eye can see... At some point over the next several years' the debt of each 'may approach 100% of GDP, which is a level at which country downgrades tend to occur,' he said... Gross's comments today come two months after he said the U.S. government will need to spend as much as $4 trillion in additional capital to cushion a slowing economy. The Federal Reserve said March 19 that it would purchase $1.8 trillion in Treasuries and housing-related debt to lower borrowing costs. 'We need more than that,' Gross said at the time. The Fed's balance sheet 'will probably have to grow to about $5 trillion or $6 trillion,' he said."
May 19 - Bloomberg (Rich Miller): "What the U.S. economy may need is a dose of good old-fashioned inflation. So say economists including Gregory Mankiw, former White House adviser, and Kenneth Rogoff, who was chief economist at the IMF. They argue that a looser rein on inflation would make it easier for debt-strapped consumers and governments to meet their obligations. It might also help the economy by encouraging Americans to spend now rather than later when prices go up. 'I'm advocating 6% inflation for at least a couple of years,' says Rogoff...who's now a professor at Harvard... 'It would ameliorate the debt bomb and help us work through the deleveraging process.' ...Given the Fed's inability to cut rates further, Mankiw says the central bank should pledge to produce 'significant' inflation... That would put the real, inflation-adjusted interest rate...deep into negative territory, even though the nominal rate would still be zero. If Americans were convinced of the Fed's commitment, they'd buy and borrow more now, he says... In advocating that the Fed commit itself to generating some inflation, Mankiw... likens such a step to the U.S. decision to abandon the gold standard in 1933, which freed policy makers to fight the Depression... Inflationary increases in wages -- and the higher income taxes they generate -- would make it easier to pay off debt at all levels. 'There's trillions of dollars of debt, in mortgage debt, consumer debt, government debt,' says Rogoff... 'It's a question of how do you achieve the deleveraging. Do you go through a long period of slow growth, high savings and many legal problems or do you accept higher inflation?'
S&P's move this week to lower the outlook for Britain's Credit rating brought the spotlight on the even more disastrous U.S. debt situation. And it doesn't help the situation that the dollar has found itself under renewed pressure of late, with even the British pound gaining about 5% this week against our currency. Rather ironically, two of our nation's prominent economists called this week for the Federal Reserve to move even more aggressively to spur Credit expansion and stoke inflation. It is difficult to comprehend how - with lessons that should have been learned about Credit and inflation by this stage in the cycle - inflationism remains so ingrained in economic orthodoxy. Yet the long and sordid history of inflation should have had us on guard. Inevitably, the typical policy response to the hardship wrought from an inflationary Credit boom is the hope for some positive impact from one "final" bout of inflation.
I'll commence this week's discussion making the point that the issue is not whether the U.S. "inevitably" loses its AAA rating. Rather, the focal point of the current economic debate should be on whether our well-intended policymakers (fiscal and monetary) have charted a course that risks bankrupting the entire economy. I'll continue to argue that the paramount policy priority should be avoiding such an outcome. And I will add that there is ample confirmation these days of the inherent propensity for inflationary developments to proceed toward the worst-case scenario.
Dr. Rogoff, advocating 6% (consumer price) inflation, believes a rapidly rising price level would "ameliorate the debt bomb and help us work through the deleveraging process." I disagree on both counts. Trillions of government debt issuance only worsen potential "debt bomb" consequences. There is a school of thought that holds that policymaking is today lessening the debt service burden. This may be somewhat true for the household and financial sectors. I would argue, however, that the benefits to American households are actually far outweighed by the systemic risks associated with the redistribution of multi-Trillions of debt and assorted risks to the Federal government (inclusive of the Federal Reserve). And this is an especially inopportune time to aggregate escalating systemic risk in Washington.
This aspect of the "debt bomb" - or, in my nomenclature, Credit Bubble Dynamics - is not readily discernable today. While federal debt will likely expand an astounding 13% of GDP this year, the optimists take comfort that total federal debt as a ratio of GDP is not yet at a problematic level (and much less than Japan!). Yields are rising, but Washington has no problem selling its paper today. Nonetheless, a crisis of confidence in the Treasury market would be catastrophic. The consensus view believes that Fed-induced low mortgage rates (and resulting refinance boom!) are spurring system repair. I would argue that the associated massive redistribution of mortgage risk (Credit, interest rate and liquidity), especially to the failed GSEs, is a real time bomb.
Dr. Rogoff and others believe policymakers are these days "ameliorating" the deleveraging process. My analytical framework takes a contrasting view. The critical "deleveraging" process at this point would amount to weaning the U.S. Bubble Economy off of its currently required $2.0 Trillion or so of annual Credit growth. The issue is at its heart embedded deep within the economic structure and will not be cured through additional credit inflation. Current policymaking is shifting the debt burden from the private sector to the federal government sector - and, in the process, increasing the total system (non-productive) debt burden by another $2.0 Trillion or so annually. Moreover, I would argue that this momentous government (Fed and Treasury) intervention in the pricing of finance further corrodes our system's process of allocating financial and real resources. The "debt bomb" is not being diffused. Rather, the fuse is being somewhat lengthened as the bomb enlarges.
Professor Mankiw believes that if U.S. consumers understood that prices were going to rise they would borrow more and accelerate purchases - and this would better our economic plight. But our economy doesn't produce enough of what they would likely want to buy, so our current account deficit would rapidly reflate. The dollar is already weakening, which means upward pricing pressure for imports (not to the benefit of the household sector or for system stability more generally). Besides, I would argue that rising inflation expectations lead quickly to purchases of foreign stocks, bonds, gold, energy, commodities and other "undollar" assets. As we've witnessed in the markets over the past few weeks, the latent (weak dollar-induced) inflationary bias in non-dollar asset-classes can emerge and quickly feed on itself.
At the end of the day, it is our maladjusted economic structure in concert with speculative market dynamics that will likely dictate future inflationary characteristics. The notion that there is a system price level easily manipulated by our monetary authorities to produce a desired response is an urban myth. During the 2000-2004 reflation, I would often note that "liquidity loves inflation." The salient point was that the Fed could indeed create/inflate system liquidity. It was, however, quite another story when it came to directing stimulus to a particular liquidity-challenged sector. Almost inherently it would flow instead to where liquidity -and resulting inflationary biases - were already prevalent.
If the dollar bear has resumed, the global inflation/Monetary Disorder issue could quickly reemerge. Federal Reserve efforts to reliquefy our system would be expected to prove self-defeating in a backdrop of significant dollar and Treasury market weakness. Such a scenario would expose what I believe is a major flaw in the conventional economic view that there is a trade-off available between the difficulties inherent to a long economic workout and the acceptance of a higher level of inflation. I fear the current policy path ensures an especially arduous and protracted adjustment period - along with myriad problems associated with an unwieldy inflation backdrop.
I also want to take exception with Professor Mankiw's likening of a Fed push toward higher inflation to the decision to abandon the Gold standard in 1933. This gets back to the disagreement I've had with the "inflationists" for years now: In the name of Keynesian economics, inflation proponents have repeatedly called for massive stimulus in response to the bursting of THE Bubble, while in reality this activist policymaking was instrumental in only extending and worsening a systemic Credit Bubble. This was especially the case after the bursting of the technology Bubble and is again true today following the bursting of the Wall Street finance/mortgage finance Bubble. Now, more than ever before, "Keynesian" inflationism is THE Bubble. When it eventually bursts Washington policymakers will have little left to offer.
Doug Noland The Credit Bubble Bulletin PrudentBear.com
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