In the 1970s Fed Chairman Arthur F. Burns had lauded inflation as “priming the pump,” wrongly believing that inflation was a sign of a healthy economy.
As a result, there was significant inflation during Burns’ tenure at the Fed (1970 -1978), which Nixon tried to manage through wage and price controls while the Fed under Burns maintained an expansive monetary policy.
After the 1972 election, due in part to oil shocks from the 1973 oil crisis, price controls began to fail and by 1974, the inflation rate was 12.3 percent.
Burns believed that the American people weren’t willing to accept rates of unemployment in the range of six percent as a means of quelling inflation. From the Board of Governors meeting minutes of November 1970, Burns believed that:
“...prospects were dim for any easing of the cost-push inflation generated by union demands. However, the Federal Reserve could not do anything about those influences except to impose monetary restraint, and he did not believe the country was willing to accept for any long period an unemployment rate in the area of 6 percent. Therefore, he believed that the Federal Reserve should not take on the responsibility for attempting to accomplish by itself, under its existing powers, a reduction in the rate of inflation to, say, 2 percent... he did not believe that the Federal Reserve should be expected to cope with inflation single-handedly. The only effective answer, in his opinion, lay in some form of incomes policy (wage and price controls).”
What many then and today fail to realize is that for the government, inflation has some VERY positive effects, for one thing, it allows one to pay a fixed debt made years before in today’s cheaper dollars. In other words, one MILLION U.S. dollars borrowed at point A, at 5% APR (about $50,000/year in interest payments) is “cheap” when being paid back at point B (after a bout of inflation) when point B’s USD’s are worth, say, 50% of the value of the point A U.S. dollar.
In reality, inflation is VERY BAD, even lethal for people who are on “fixed incomes,” and it’s very damaging to the rest of us who earn incomes, as rises in incomes never keep pace with inflation.
In 2003, three years before he became Fed Chairman, Ben Bernanke visited Japan, which was going through a deflationary period and said, "One might argue that the legal objective of price stability should require not only a commitment to stabilize prices in the future but also a policy of actively reflating the economy, in order to restore the price level that prevailed prior to the prolonged period of deflation."
It’s apparent from that statement that Ben Bernanke doesn’t distinguish between prices that fall on account of a banking or credit crisis and those that fall due to advances in productive technology or improvements in economic organization. It’s all the same to him, and all bad.
That is, quite simply, an inflationary mindset, exactly what America DOES NOT need right now.
Why?
Because we’re drowning in debt and about to get socked with a very damaging and inflationary hit that we won’t be able to moneterize (tweak interest rates) out of.
America’s foreign debt-holders are seriously considering dropping America’s AAA rating, which will significantly INCREASE the cost of servicing our debt.
With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.
In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.
The potential for rapidly escalating interest payouts is just one of the wrenching challenges facing the United States after decades of living beyond its means.
The surge in borrowing over the last year or two is widely judged to have been a necessary response to the financial crisis and the deep recession, and there is still a raging debate over how aggressively to bring down deficits over the next few years. But there is little doubt that the United States’ long-term budget crisis is becoming too big to postpone.
Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode.
“The government is on teaser rates,” said Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that advocates lower deficits. “We’re taking out a huge mortgage right now, but we won’t feel the pain until later.”
The competing demands could deepen political battles over the size and role of the government, the trade-offs between taxes and spending, the choices between helping older generations versus younger ones, and the bottom-line questions about who should ultimately shoulder the burden.
The problem, many analysts say, is that these record government deficits have arrived at the very same time as the long-feared explosion begins in spending on benefits under Medicare and Social Security. The nation’s oldest baby boomers are approaching 65, setting off what experts have warned for years will be a fiscal nightmare for the government.
William H. Gross, managing director of the Pimco Group, the giant bond-management firm has said, “What a good country or a good squirrel should be doing is stashing away nuts for the winter, the United States is not only not saving nuts, it’s eating the ones left over from the last winter.”
Making maters even worse, is that the United States will not be the only government competing to refinance huge debt.
Japan, Germany, Britain and other industrialized countries have even higher government debt loads, measured as a share of their gross domestic product, and they too borrowed heavily to combat the financial crisis and economic downturn. As the global economy recovers and businesses raise capital to finance their growth, all that new government debt is likely to put more upward pressure on interest rates.
Even a small increase in interest rates has a big impact. An increase of one percentage point in the Treasury’s average cost of borrowing would cost American taxpayers an extra $80 billion this year — about equal to the combined budgets of the Department of Energy and the Department of Education.
But that would seem like an overly optimistic outlook, as the cost of our debt servicing is expected to rise much higher. Alan Levenson, chief economist at T. Rowe Price, estimated that the Treasury’s tab for debt service this year would have been $221 billion higher if it had faced the same interest rates as it did last year.
And the White House estimates that the government will have to borrow about $3.5 trillion more over the next three years. On top of that, the Treasury has to refinance, or roll over, a huge amount of short-term debt that was issued during the financial crisis. Treasury officials estimate that about 36 percent of the government’s marketable debt — about $1.6 trillion — is coming due in the months ahead.
“Inflation, higher interest rate and rollover risk should be the primary concerns,” declared the Treasury Borrowing Advisory Committee, a group of market experts that provide guidance to the government, on Nov. 4.
But with a Fed Chairman focused on deflation and with a strong sense in government’s role in “reflating” the economy, those do not seem to be this group’s primary concerns at all.
I’ve said since late 2008 that “the worst is yet to come,” and “this time groups that aren’t traditionally hit by such economic downturns (ie. government workers) are going to be hit and hit hard,” and all that seems to be on our horizon.
We COULD easily see a return to STAGFLATION by mid to late 2010, depending on how quickly and how high the cost of our debt servicing rises. A higher debt servicing will push interest rates higher, as government borrows so much, there’s little left over for private sector borrowing, and that credit crunch, coupled with rising tax rates (especially if healthcare reform and Cap and Trade pass) will pressure inflation rates much higher very quickly.
Worse still, is with government’s interest payments higher, the Fed will not be able to tamp down inflation with lower interest rates.
That portends a tsunami of high interest, inflation and yes, even higher unemployment rates not far down the road.
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