Our Unstable Economy:
Looming Inflation

February 22, 2011

Many people are worried about the possibility of inflation as a result of the trillions (millions of millions) of dollars that have been pumped into the economy by the Federal Reserve (the FED) and the US government. Mainstream economists tell us this is not a problem. They say that the FED can raise interest rates and combat inflation as the economy begins to recover. The problem is that these are the same economists that say "no one" was able to foresee the recent housing crisis that peaked in 2008.

Another branch of economics, known as Austrian Economics, did predict the crash of the housing bubble. They couldn't predict exactly when it would happen, but they did predict how events would unfold. Now Austrian economics tells us to expect massive inflation of the US dollar, perhaps even hyperinflation, and an economic collapse possibly greater than the great depression.

The FED Destroys Market Information

One reason that the FED will not be able to counter inflation is because it can combat unemployment by lowering interest rates, or combat inflation by raising interest rates, but it can't do both. This is the problem that the FED ran into in the 70s when high unemployment and high inflation were occurring at the same time. Unfortunately, our economic condition is much worse now than in the 70s.

Another problem is that the FED's interest rates are always artificial. By not allowing the market to set its own prices, the FED is destroying information the market desperately needs. The FED tries to adjust interest rates to what is appropriate for the market, but it is slow to react. The FED can never act with as much knowledge or act as quickly as the market could on its own. Also, the FED often has a political agenda of its own beyond what is best for the market.

A Looming Dollar Crisis

When the massive amount of currency that has been pumped into the economy begins to cause inflation, the FED will be unable to avoid a crisis. Even IF unemployment has improved enough that the FED can feel comfortable raising interest rates, and even IF the FED could react fast enough, the dollar could not currently handle a rise of interest rates. The reason for this is because of the unprecedented size of the US national debt.

In 1981 the FED fought inflation by raising the federal funds rate to 20%. At that time we were the world's largest creditor nation with a national debt of $909 billion, or 33% of GDP. [1] Today, we are the world's largest debtor nation and our national debt is 15 times larger at $14.1 trillion, or 97% of US GDP.[2] That doesn't include the US coverage of Freddie Mac and Fannie Mae debts and the government's unfunded Social Security and Medicare liabilities.

Today it will be more difficult to fight inflation by raising interest rates because the US will have to deal with rising interest rates on the national debt. In 2010 the US paid $22.48 billion in interest payments on the national debt with an interest rate 2.498%. [1] Three years earlier in 2007, the debt interest rate was almost double - 4.963%. If the interest rate is brought back up to 5% to combat inflation the interest payments on the US national debt will rise above $500 billion, or 23% of projected 2010 tax receipts of $3.455 trillion.[1]

Currently, even if the US raised income tax rates to 100% it would not be able to balance its budget.[1] If the US began to pay 1/4 of its projected tax receipts just to pay interest on its debt, this would be a sign to the world that the dollar is no longer a safe store of value. Russia and China already showed their lack of confidence in the dollar in November, 2001 when they stated they would no longer use the dollar for bilateral trade and would use their own currencies instead.

Precious Metals

During times of high inflation any asset with tangible value is a good storehouse of wealth. However, precious metals have many advantages over other tangible assets. Unlike real estate, precious metals are easily divided, liquidated, and transported. Unlike diamonds, precious metals bullion is fungible, meaning one amount is equally exchangeable with another.

Whether investing in bullion or rare coins, the time has never been better for ownership of physical precious metals. The price of gold and silver is a direct reflection of the value of the dollar. The question is not whether the price of gold and silver will continue to rise, but whether the dollar will continue to fall.

[1] "US Inflation Report" by the National Inflation Association, June, 2010.

[2] http://www.usdebtclock.org

"The first panacea for a misguided nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists."
- Ernest Hemingway

"Bankers know that history is inflationary and that money is the last thing a wise man will hoard."
- Will Durant

The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.
- John Maynard Keynes

Inflation is the one form of taxation that can be imposed without legislation. - Milton Friedman

Inflation is determined by money supply growth. - Roger Bootle