(This is Part 4 of a series. Go back to Part 3.)
Virtually every government in history that has been faced with overwhelming debt has eventually chosen the third option and begun a systematic monetary inflation, which leads after a time lag to a raging price inflation.
Examples include G. Britain in the 1710s, France in the 1790s, the United States in the 1770s, Germany in the 1920s, Hungary in the 1940s, China in the 1950s, Brazil in the 1980s, Argentina in the 1990s and so on.
The thing is, money and credit inflation is a very pleasant phenomenon at first, and particularly for the governments involved. It seems like such a painless solution to the pressing debt problem. No new taxes need be enacted; no serious spending cuts need be made.
In fact, inflation is like a secret tax which is levied upon both consumers and businesses. The tax comes in the form of lowering the purchasing power of the currency used by the populace. Since not one citizen in a thousand understands that inflation is actually a hidden tax, the government can claim to be "holding down taxes".
As its debt becomes monetized the government gets to float yet more debt and spend yet more money that it didn't have before. As new liquidity flows through the system, the economy picks up again. All very pleasant.
The tragic costs come later as the process turns malignant. Prices and interest rates eventually begin a relentless rise, a rise that becomes self-reinforcing as people begin to flee the currency and spend money faster.
Meanwhile the unit of currency becomes increasingly debased (which is simply another way of saying that overall prices are rising). Continued on to its ultimate conclusion, the process ends by destroying the currency and impoverishing the middle class.
The process can be stopped only if the government stops creating new money. However, the effect of this is to immediately precipitate the economy into a recession or worse as artificial stimulation leaves the system. This is politically unpalatable, and so what normally happens is that the government creates yet more liquidity to prop up the system yet again.
We can use the United States as an example. Since 1987 the U.S. Federal Reserve has responded to every hint of an implosion in the economy by flooding the system with more liquidity.
It happened, for instance, in the 1987 stock market crash, the 1989 savings and loan crisis, the 1994 Mexican peso devaluation, the 1997-98 Asian Tiger crisis and the 1998 failure of LTCM.
In each case, because the credit bubble was already of prodigious proportions, the "triggering event" could have precipitated an implosion of the bubble and a recession.
Such a course would have been constructive though painful—a recession/depression allows the economic system to cleanse its distortions, rebalance itself and rebuild on a firm foundation—but it was not to be. In each case, the added liquidity jolted the system forward once again while further increasing the credit bubble.
The magnum opus of this process so far has been the reflation following the 2000-2002 stock market decline. The creation of liquidity this time has truly been on a biblical scale, resulting in a reflation of the stock market and huge increases in the bond and real estate bubbles.
This reflation in money and credit by the U.S. has been mimicked worldwide. The result is that the world has now created—measured as a percentage of world GDP—the largest credit bubble ever conceived.
Naturally, the question now becomes: What will happen when the next "triggering event" occurs?
(This is the end of Part 4. Go to Part 5.)
—jim sloman, 03.06.05
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