Inflation Countdown in Final Stages

12/13/2012 9:15 am EST


Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

What it will take to get through the current mess will mean that once it's sorted, we'll have to deal with the oncoming train of inflation, argues Richard Lehmann of Income Securities Investor.

Our financial problems today are the result of decades of abuse of a political system, democracy, which is conceptually flawed. The flaw is that it elects to office those who promise the greatest number of voters the most, irrespective of whether such promises are sustainable over time.

Greece is currently the most egregious example of a country which has spent itself into bankruptcy. Coincidentally, it was also the first example of a failed democracy, around 300 BC.

The fact is, our problems cannot be fixed by normal means-they are too big. It's not just the $16 trillion in national debt, it's the $86 trillion in unfunded government mandates. That doesn't count the trillions in similarly unfunded state obligations.

The seeds to our economic future, however, have already been sown. The agent of change is the Federal Reserve.

It is they, the unelected arbiters of our economic growth, who will manage the solution of our dual burdens of trillions of dollars in national debt and unfunded, un-payable mandates. Mandates are spending commitments for pensions, health care, and other social programs imbedded in current legislation.

The Fed's solution, in a nutshell, is inflation. Inflation grows government revenue without having to raise tax rates. It diminishes the burden of the national debt and of the unfunded mandates.

Even homeowners who currently are under water on their mortgages can feel they are on the road to recovery and will continue to make their mortgage payments when housing prices rise. Inflation is the hidden tax that needs no political approval. All politicians disapprove...just as they are against a weak dollar, government waste, and special interests.

The Fed solution is a burdensome one which must be conducted in an environment of high public visibility. Hence, a great deal of deception is assured. The Fed has always been good at working in the dark.

Being able to do so without political accountability is essential because their solutions, if fully understood, would not keep them in office. So far, the Fed has been singularly unsuccessful in creating inflation despite creating trillions in monetary reserves. This is because the de-leveraging of our economy puts deflationary pressures on the economy.

In short, all their currency creation has only prevented a deflationary economic spiral, a la Japan. But the Fed toolbox has a few more hammers. They have dropped interest rates to unprecedented lows, even for long-term borrowings.

This has the happy effect of reducing the budget deficit by billions of dollars of annual interest expense to finance the national debt. On the other hand, it has the unhappy effect of denying those with wealth a reasonable return on their savings, or even a return that will preserve those savings, a de facto wealth tax.

Don't think government is going to wait until you die before taxing your estate. The death tax, by the way, is slated to go up to 55% from 35%. Since returns are so low and with a death tax higher than the income tax rate, shouldn't many consider giving away parts of their wealth early? How about that for a way to stimulate the economy!

Low interest rates also have unintended consequences that we have still to discover. History tells us these are almost always bad. Remember 2004-2006, when too-low interest rates lead to a housing bubble? It can happen again, but this time, the value increase will be driven by inflation, not inept policies or greed. Well, maybe a little greed.

Inflation is a self-feeding economic phenomenon, so the Fed will have to act slowly so they don't kill this golden goose. It means they will have to raise interest rates and thereby slow growth, but not so much that it throws the economy into a recession as Paul Volcker did in the 1980s to stop a runaway inflation rate. Back then, though, inflation was still viewed as a problem rather than a solution.

Inflation, of course, is a problem. It rewards debtors at the expense of creditors. However, we live today in a world were creditors are demonized as greedy, and debtors are the embattled middle class fighting to recover from debts foisted on them by ruthless lenders.

Indebting oneself today is viewed as an entitlement, and doing so to excess as a noble striving to better oneself. With luck, this attitude may change, but meanwhile inflation is needed to give government and the profligate a new start.

Inflation also punishes those not as economically well off, mainly the wage earners. They will always be playing catch-up as the cost of goods rises faster than their wages.

But then, no one said straightening out our economy wouldn't be painful. It's just that few realize that everyone-everyone-will share the pain. You think the last four years were hard times? Get ready for round two.

No one can put a timetable to when serious inflation will begin or what will trigger it. Suffice to say, it will happen before President Obama leaves office.

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