Which Comes First: The Cart or the Horse?

THE CREDIT CRUNCH THAT WE ARE EXPERIENCING right now seems to be in the front of everyone’s mind. Questions abound and solutions that actually stand a chance of working are hard to come by. A reader recently e-mailed me this question: “What prevents the Fed from sending every household $100,000?”

Just five things:

  1. Lack of authority.
  2. People would use it to pay off debt.
  3. Banks do not want to be paid back with money that is worthless.
  4. The Fed will act to bail out banks, not consumers.
  5. Hyperinflation ends the game. The Fed is simply not in the business of destroying itself.

Rest assured the Fed is going to do almost everything under the sun to encourage more borrowing. That includes slashing the discount rate and the fed funds rate, loosening rules on collateral, etc. Some of those we have already seen. This is likely the first inning.

But the one thing the Fed is not going to do is send everyone $100,000 or $10,000 or even $5,000. If for some reason I am mistaken and the Fed starts sending out checks or depositing money into people’s checking accounts to a significant degree, then I am willing to eat my deflation hat. Just so we are clear on this, another piddly $300 from Congress is not enough.

The Cart and the Horse

Many people in government and the media misunderstand the causes of inflation. In an attempt to answer some of the questions people have, Peter Schiff wrote this in an editorial article on Gold-Eagle.com:

“Inflation has only one cause, and that is the Federal Reserve itself. In the United States, the supply of money and credit is regulated by the Fed. Since inflation is by definition an increase in the supply of money and credit, only the Fed can create it.

“If the money supply were held constant, increases in some prices would be offset by decreases in others. The result would be no overall inflation. In fact, without government-created expansions of the money supply, the natural tendency of prices would be to decline as technology allowed for more efficient production of goods and services. So while most regard the Fed as the primary inflation fighter, in reality, it is the sole inflation creator.”

That is a near-perfect explanation. Certainly, Schiff’s definition of inflation is perfect: “Inflation is by definition an increase in the supply of money and credit.”

Schiff did make an error, however. That error is in the phrase “only the Fed can create it.” When it comes to credit, the statement is simply wrong. Money, in the form of credit, is borrowed into existence every day. This is a systemic problem, and the Fed is clearly not in control of it.

Money as Debt

There is an educational five-part YouTube series on money and debt. It covers in nice cartoon animation what has happened to money over time, fractional reserve lending, how money is created today, why interest rates are so low, why we get unsolicited credit offers, and why debt is exploding.

The video concludes that it is taking exponential increases in debt (money) to stave off a collapse of the entire banking system, and that this cannot go on forever.

Click here to see this five-part series on debt.

I agree with the video that there are practical limits on how high debt can get. Unfortunately, the video’s conclusion is a bunch of socialist nonsense: Eliminate interest, let governments — and only governments — create money, and supposedly, government will then use that money wisely to build roads and bridges that will add value to society.

However, the video does a reasonable job of pointing out many of the problems with the current system of debt creation in a very entertaining and (for the most part) educational way. On that basis, I recommend watching all five parts.

Ability to Take on Debt Is Not Infinite

At the top of this article, I outline five reasons the Fed is not going to give money away. If one believes that rationale, then one must logically accept there is a practical limit to debt, at least at the consumer level.

Proof of concept is easy enough to find. Massively rising delinquencies, foreclosures, and bankruptcies should be proof enough. At the state level, it’s easy to see what is going to happen. Unlike the federal government, states are required to have balanced budgets. That means one of three things:

  • Raising taxes
  • Cutting spending
  • Floating bonds to postpone the problem.

Raising taxes headed into a consumer-led recession will not work. Cutting spending is absolutely needed, but will throw people out of work at the worst time. Postponing the problem is not solving the problem. Postponement only makes things worse.

This is yet another version of “Economic Zugzwang,” wherein there are no winning answers (at least as far as politicians are concerned).

The proper solution is to let free market forces work. If that means banks fail, then banks fail. If that means the stock market collapses, the stock market collapses.

Letting (encouraging) the dollar fall to zero is not a solution, for the simple reason it does not create any jobs where they are needed, which is right here, right now.

Given the amount of credit in the system versus actual cash and global wage arbitrage and slower consumer spending, it would take a mammoth effort from Congress and the Fed to forestall the inevitable once again.

A Sure Thing?

Right now, the surest bet in the world is that when the dollar drops, the U.S. stock markets rise. How long that remains so is anyone’s guess.

There is going to come a time when borrowing dollars to invest in equities is going to blow up. Of course, the carry trade may blow up first (sinking everything in its wake). Perhaps a massive derivatives unwind sinks everything first. Then again, perhaps the trigger is something from way left field that no one is watching.

What I am certain of is this: The fuse is now lit. The structural imbalances worldwide have never been greater, and the fuel at the end of the fuse is enormous. In addition, the amount at risk increases every day.

The interesting thing is that no one knows how long the fuse is. For some inexplicable reason, everyone acts as if they can get out before the stick ignites. It’s simply not possible.


October 30, 2007