Inflation, Deflation and the Stimulus.

With all the debate about the stimulus and inflation vs deflation lets take a look at all this.

SOME BACKGROUND

We have lost 1.5 million jobs in 3 months. Companies and Banks are failing at an unbelievable rate and GDP shrunk at an annualized rate of over 15.2% in December. January jobs will probably be worse and the first quarter GDP will be at least as bad if not worse. The stock market has lost close to half its value and pension and retirement funds have been decimated losing anywhere from 30-60% of their value. The downward spiral has begun and a stimulus package has been introduced to try and jump start an economy in freefall. There is some wrangling going on but I have a feeling something will be passed eventually…but what will that do for us? Let’s look at a couple of issues facing the stimulus, the budget and our own personal lives over the next couple of months.

DEFICITS AND INTEREST

As tax revenues implode states are having a tough time keeping up with their obligations, everything from Police and Fire to welfare and Medicaid. California has a record budget deficit of 42 billion dollars and 46 of 50 states will have budget shortfalls this year. The stimulus package aims to shore up the budgets of the states by borrowing money via deficit spending. It’s important to realize how the government borrows money and what deficit spending means. When the Federal Government (Treasury) needs money they ask the Federal Reserve (Fed) to issue debt via a bond auction. Groups of people and institutions can buy the bonds issued by the Federal Reserve often referred to as Treasury Bonds. The Fed then loans the money it raises to the Treasury and the Treasury in turn deposits that in a commercial bank (say JP Morgan Chase). For a quick and dirty example of how this works…say you buy a $1000 2 year Treasury note and receive at an interest rate of 1%. That means you give the Federal Reserve $1000 and they agree to pay you interest on that money of 1% for 24 months. Then at the end of 2 years the government has to repay you the full $1000 back plus interest. They “borrowed” the money for two years. That’s 1000 + 240 (interest paid out monthly).

The problem is twofold, as tax revenues plummet debt service payments are set to skyrocket. IE, you lose your job and have to take on more and more debt to sustain your lifestyle your minimum monthly payment is going up on your credit cards. Now add in interest and that can become quite of bit of money you owe in a very short amount of time. The US government obligations are growing at a very fast pace and instead of paying back the principle ($1000) we are instead piling on more debt. As more and more money is borrowed more and more money will need to be diverted to make payments on that debt. If this continues long enough the interest will surpass the ability of the borrower (US) to service the debt (make minimum monthly payments). This opens the possibility that the US could default on its debt…but wait! Luckily the US government has a printing press and can just create more money and debt out of thin air to continue to service the old debt. They can just say hey…we owe this much per month here is an extra 1 Trillion no questions asked. They just tack on the additional interest. That’s how more and more money gets in the system. Instead of paying back the debt they just borrow more to both cover the interest and buy stuff like bridges and roads and shore up state budgets via a stimulus package.

The problem. Some so called experts and government officials will say that deficit spending is OK, however If you never pay back the debt, the money created by the debt stays in circulation. The more debt we take on the more money is being put into and KEPT in circulation. If the real economy stays the same, the number of widgets sold is the same, BUT the amount of money buying widgets goes up what happens? The price of the widgets will go up and we call that inflation (rising prices due to increased money supply). Now, let’s say for example that we have a recession and the production of widgets falls along with other items like food? That could accelerate inflation and potentially turn it into hyperinflation (inflation exceeding 15% in my definition.) When you here people shocked about a “doubling of the money supply” by the Fed because of these bailouts etc and you wonder why people care here is an example.

Question: 8 people have 10 dollars (80 total). There are 8 cans of chicken. What is the price of the chicken?
Answer: The total price of chicken cannot exceed 80 dollars. That’s all the money in existence and averages out to 8 bucks for a can of chicken.

Now….
Question: Say we double the money supply and the number of cans of chicken stays stable at 8. What is the new price of chicken? 8 people, 20 dollars (160 total) – 8 cans of chicken.
Answer: The total price of chicken now cannot exceed 160 or $20 per can of chicken.

What if there is a recession?
Question: Say we double the money supply but the production of chicken cans Is only 4. What is the new price of chicken?
Answer: 8 people, 160 dollars, 4 cans of chicken. Price is a minimum of $40, and inflation rate of 400%. Not only that but someone is going hungry.

The next logical question is will the price of everything suddenly double after the Fed doubled the money supply? The answer is a little more complicated but no, it takes awhile for money to work its way into the system and some will be held back, but can we expect the price of things to begin climbing? Yes. Will the price of food keep going up? The answer is yes and it has been at a rapid clip (see link at end on rising worldwide food prices). Food production is falling worldwide as the credit crunch affects everything even farming. That is why this stimulus needs to spend the money as wisely as possible to prepare the US for some other very important milestones in human history. Peak Oil is here and we are not ready. The IEA has made the statement that we will need a 360 billion dollar a year investment in infrastructure to maintain a 6.4% DECLINE in production of oil until it’s gone. You need to let that sink in. Peak oil is here. We are going to have production declines FOREVER going forward.

PEAK OIL

What does “peak oil” mean? In the 1970’s the US experienced a 5% supply disruption due to an OPEC embargo. This caused the price of oil to skyrocket 400%. Knowing that the entire world is now in decline and we could see over 6% supply disruptions every year going forward this indicates much higher fossil fuel prices in the future. We could see $200 a barrel oil as soon as next year if not earlier. We have very little renewable infrastructure in place and the current technology’s return on energy invested comes nowhere near fossil fuels.

POLITICS

The current actions of the President with his silly stimulus that pays for STD prevention will certainly lead the US down a path of complete destruction. As food and fuel prices surge and the money supply continually doubled to bail out our collapsed financial system our dollar will be worthless and hyperinflation will be upon us, IN THE THINGS THAT MATTER (food and energy). That can of chicken costing $20 or $40 is not that far off, maybe six months to a year depending on how big the stimulus is and how much production of food and energy fall. The statement by Obama that “Deficits don’t’ matter” is insane. He has put the world on notice that holding US dollars will not be a good investment for “years to come”.

There are many arguments about Inflation vs. Deflation as asset prices implode. The debate rages but misses the point. In the stuff that matters the most to mankind the supply is dwindling. It takes 10 calories of fossil fuels to create 1 calorie of food. If we have hit peak oil then without some changes we certainly have hit "peak food". The increase in money supply will only accelerate this problem. The prices of these very limited commodities could skyrocket as supplies diminish. We currently have 60 million working poor in the US and if we tack on an additional 15% food tax or more that will certainly create a lot of hungry people. Desperate people do desperate things and the civil unrest breaking out across the world cannot be ignored and must be looked at as a symptom of things much worse to come. The United States of America is now a net importer of food. We cannot feed ourselves and we rely heavily on fossil fuel imports from countries that don’t like us to sustain our current production. This is a recipe for disaster.

As prices skyrocket look for hunger, resource wars and other blights on human history to soon be here and with a vengeance. Every other country on earth is in our predicament, the race to secure the last of the fossil fuel supplies is on. Unless our leadership gets really serious and really honest with us REALLY REALLY fast the meltdown could be fatal. The side effects of the credit crisis and the breakdown of society are much more concerning than the DOW.

Even if the prices of houses, cars, TV's and stocks continue to collapse governments will be forced to subsidize two basic things in the end. Energy and Food, and both have a very limited supply as documented by the IEA and others including Dick Cheney who gave a speech on the subject of peak oil in 1999. I could care less about asset prices dropping or deflation in stocks and bonds. Yes the price of a plasma is collapsing but so what? Yes my stock portfolio is gone. But my debt remains and the price to eat only goes up. Show me the price of food, water and energy. That is the only inflation debate that matters.

CONCLUSION

In a country up to its eyeballs in debt and losing jobs faster than one can say "jobs". Inflation in Food and Energy will create such social unrest that the country may tear itself apart. Recently HR 645 was introduced and is in committee. This tells me that the government knows there is no solution and is preparing for the worst and you should too.