Thursday, January 1, 2009

Crisis: Phase 2

The financial crisis has slipped off the front pages.  That doesn't mean its over.  The US Fed has consistently reacted to the crisis as if it were worse than it appeared.  So far, they've been proven optimistic.  Several weeks ago, they announced a new set of policies.  Its taken awhile for their significance to sink in.  Since WW2 and Bretton Woods, the task of Central Bankers has been to manage inflation.  While monetary stimulous (low interest rates and a larger money supply) has always been tempting in order to goose economic activity, anyone that relied on it too much got hammered by inflation and currency devaluation.  Its a well understood balancing act, though not easy.   Like doctors, central bankers have an oath, "First: cause no inflation".  Not really, but they act like it.

All that makes the US Fed's new policies all the more bizarre.  They appear to be so afraid of deflation that they are deliberately trying to cause inflation in the US economy.  Recall that deflation is fatal for an economy.  Consumers put off purchases because goods will be cheaper tomorrow.  Economic activity crashes.  Even worse, debts have to be paid back from declining incomes.  The last time this happened in the early '30's, US economic activity fell by nearly half.  It took the massive inflationary event of WW2 to correct the situation.

Now, the Fed has announced it will in effect print an extra $2 trillion next year.  Big numbers tend to blur, but its worth putting this one into perspective.  The total US economy is running at about $14 trillion per year.  Only 8 countries in the world have a GDP of more than $2 trillion.  Only 14 have a GDP more than $1 trillion.  Nobody has ever attempted corrective action on such a scale.  Nobody knows what will happen.  In philisophical terms, this is like the Pope announcing that he's become a Satanist.

There are no mechanisms to distribute this volume of debt.  Its a tremendous gamble, because nobody knows if there is a market.  If there isn't a market, the Fed could end up with the worst of both worlds, domestic deflation and a currency crash.  This is bad, bad, bad.  I sure hope they know something we don't.  I hope the current situation is worse than anyone outside the Fed has guessed.  Because otherwise, the Fed has gone crazy.  Either way, it looks like several years of economic turmoil for everyone with a stake in the US economy.