Friday, July 9, 2010

Exponential growth anyone?

After recent Extrema post called "Inflation or Deflation" my friend Dr. David Mieczkowski has suggested that despite some correct points, my analysis of the threat of global inflation may be off-target, because of the push toward global austerity. He suggested that Japan's scenario of low growth, low inflation is more likely. My response (in the comments to that post) was that this view is missing the unprescedented fiscal crisis looming for many of the world's developed countries.
Here is one interesting tidbit of information. US debt grew by $166 bln in a single day on June 30. Surely, this figure is a bit artificial and US debt does not grow at such speed everyday (though it may start to). However, the sheer number is staggering and is worth pondering for a while. Add to this the potential impact of unfunded liabilities, which could be anywhere between $30 TRLN and $50 TRLN and you get the picture. How is it possible to get out of this hole? It is not clear to me how it can be done without inflation.
The history is clearly on the side of my forecast. It their excellent book "This time is different" Carmen Reinhart and Ken Rogoff examined hundreds of financial crises and showed that sovereign debt crises quite frequently followed banking crises. It is not hard to see why. The idea that financial sector is a completely free enterprise that may be allowed to fail has been cooked up by ivory-tower ideologues ignorant of reality. Financial sector has always been and will always have to be rescued in order to avoid depressions, thus putting pressure on government balance sheet. This time is not different in anything except scale.
I would be happy to amend my forecast if someone showed a workable way to fix this debt problem. I looked hard for such an explanation, but have not found one. This debt problem is so huge, it becomes, unusually for financial forecasts, a question of simple math. This math suggests that there are really only three choices:
1. Outright sovereign default.
2. Default by inflation
3. Cutting spending by 50 % or more.

Outright default is not going to happen, because US debt is in dollars and there is no reason to create an event that can become a calamity, if the same can be achieved by inflation (not hyperinflation which is a completely different animal). Cutting spending by 50% is practically impossible, not only because discretionary spending part of the US budget is around 38%, but also because it the cost of potential social instability is simply unacceptable for anyone with a sane mind. This leaves inflation. Very rarely can one have such clear arguments in economic matters, but I believe that we are in one of those rare periods in history when we can.


Daniel Milstein said...

That is so true. As an author and business man, I can relate to how you said "The idea that financial sector is a completely free enterprise that may be allowed to fail has been cooked up by ivory-tower ideologues ignorant of reality". I hope more people discover your blog because you really know what you're talking about. Can't wait to read more from you!

Extrema Risk said...

Hi Daniel,
Thank you for your kind comments. It just so happened that we are repoening this blog as part of the site. Hope that our commentary will be of use to you!