The unprecedented amounts of “stimulus spending” which the Obama administration has requested and the Pelosi-Reid Congress has authorized, are expected to eventually lead to higher inflation and increased tax burdens for years to come.

However, this need not be so.

The Congress may reverse course on spending or give the Federal Reserve extraordinary powers to control inflation.

Basically, it comes down to politics — and these are times in which the course of government may change rapidly and unexpectedly — creating great uncertainty.

This heightened uncertainty is bound to be reflected in erratic behavior of the stock and bond markets.

Classic cures for monetary inflation

The type of inflation being ginned up by the Obama administration will be the result of the money supply increasing much faster than the supply of goods and services.

Note: Even this is uncertain, since with a global economy, in a sense, the supply of goods and services relative to a specific country is much greater than within restricted national borders. As long as the dollar remains the world reserve currency, the US may avoid the worst effects of inflation. However, a profligate US administration is already endangering the dollar’s reputation as a safe haven. Without a strong dollar, the benefits which Americans have seen for the last three generations may fade away.

When people have more money relative to the amount of available goods and services, prices rise and inflation gets underway.

If the amount of money continues to rise faster than the supply of goods and services, inflation becomes endemic.

The cure of inflation is either to increase the supply of goods and services faster than the supply of money, or to reduce the volume of money relative to the supply of goods and services.

When the government has approved government spending on an order of magnitude far greater than any conceivable increase in the supply of goods and services (as in the case of the Obama Administration), the only way to avoid inflation would seem to be to reduce the supply of money.

There are three ways to do this (which can be done in any combination):

1. Increase taxes.
2. Remove money from circulation by selling government bonds.
3. Increase bank reserve requirements.

The last item I call the “Nuclear Option”.

How government spending creates inflation

When the Pelosi-Reid Congress approved government spending in amounts greater than government income through taxation, the foundation was laid for increased inflation.

The steps to inflation are easy to understand:

1. Congress approves the disbursement of funds for some purpose (war expense, help for homeless children, a “shovel-ready” spending project, etc. — the “worthiness” of the project is irrelevant);
2. Based on Congressional approval, the Treasury Department makes a disbursement of funds by sending a check to the beneficiary (say, the contractor on a “shovel-ready” project);
3. The recipient of the government check (or it could be a money transfer), deposits the funds in a bank account;

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4. The bank clears the check, which goes to the Federal Reserve, creating funds in the bank’s account with the Federal Reserve (Federal Funds);
5. The money supply has now been increased by the amount of the payment made by the Treasury. However, as the beneficiary withdraws funds from the bank account to pay others, who in turn deposit the same funds in their bank accounts, and as the new money circulates throughout the economy, and as these banks, in turn, make loans based on these deposits, eventually there are more bank account balances than the original payment made by the Treasury. (The Multiplier Effect).

Brain surgery with a blunt instrument

The cures for inflation all involve removing money from circulation.

However, the three most likely options are difficult to calibrate.

If too much money is removed, deflation will result; if not enough, inflation will persist. Each option also has unpleasant political and economic side-effects.

Take taxes, for example.

In the United States, only about half of the population pays income taxes. Those that create jobs are among that portion of the population that pay most taxes. Consequently, to increase taxes not only fails to remove money from those who don’t pay taxes, but tends to discourage those that create jobs — thereby increasing unemployment.

The result is stagflation.

The possibility of removing money from circulation by selling government bonds is limited by the number of investors that actually have money available for such a purpose.

If government spending is sufficiently excessive (as in the case of the Obama administration), the potential for inflation reduces the appeal of investment in government bonds (fear of inflation), while the shortage of funds available for this purpose, leads to higher and higher interest rates, which, in turn, acts as a brake on business expansion.

Again, the result may be stagflation

The Nuclear Option: Increasing bank reserve requirements

Finally, we have the Nuclear Option — increasing bank reserve requirements — which is essentially a way to limit banks’ ability to earn money on bank deposits, decreasing bank profits while impacting the availability of credit.

The Federal Reserve has the power to require banks and depositary institutions to increase or decrease the percent of various classifications of liabilities that must be deposited as cash with the Federal Reserve in a non-interest-bearing account.

(Recently, the Fed was given power to pay interest on such accounts).

Congress has the power to increase or decrease the limits for reserve requirements that may be set by the Federal Reserve, and also to re-define the institutions that may be required to maintain reserves with the central bank.

(For example, Congress could pass a law requiring money market funds to maintain deposits with the Federal Reserve Bank.)

Prior governments that had economic policies similar to those of the Obama administration — the Roosevelt government of the Great Depression and the Jimmy Carter Presidency — both took measures allowing higher bank reserve requirements.

In both the administrations of Jimmy Carter and Franklin Roosevelt, bank reserve requirements were modified during economic hard times.

In the case of Jimmy Carter, the country passed through a period of stagflation.

In the case of FDR,bank reserve requirements were increased during the Great Depression, resulting in deflation and a prolongation of hard times long after the rest of the world had recovered.

See: Reserve Requirements: History, Current Practices, and Potential Reform.

Undoubtedly, if bank reserve requirements were set high enough and applied to enough institutions (banks, broker-dealers, money market funds, foreign bank branches, etc.), it might be possible not only to stop inflation dead in its tracks, but also to eliminate interest costs that future generations might have to bear for Congressional profligacy.

Political limits on fighting inflation

The best defense against inflation is for Congress not to spend too much in the first place.

Once excessive spending has been authorized and inflation gains the upper hand, governments often fall.

It often takes a change of government to stop bad behavior — however, this usually occurs only when economic conditions read the nadir — and the US is not there yet.

In the United States, Congress has greater control of the economy than the Federal Reserve.

Only Congress can authorize excessive spending or grant the Federal Reserve sufficient powers to control inflation once the economy gets out of hand.

Chairman Bernanke doesn’t have a Wizard Hat that will allow him to wave a wand and cure the economic sickness caused by a bad Congress.

It would be unusual for the same Congress that had approved spending that led to inflation to change course and either cancel appropriations already authorized or to give sufficient powers to the Federal Reserve to risk cutting off recovery, in order to control inflation.

Under current legislation, the Fed’s powers to exercise the Nuclear Option (increasing reserve requirements) are limited by the fact that money is able to flow into non-bank lending institutions, such as money market funds, that are not subject to bank reserve requirements.

Inflation seems the most likely outcome

Although the popularity of President Obama has been falling, the decline has not been fast or steep enough to reasonably expect that the Democrats might lose control of Congress in 2010 or that President Obama might not be reelected in 2012.

Without a change in government in the near term,it seems highly unlikely that the United States will be able escape the logical inflationary consequences of profligate Pelosi-Reid Congress and the Obama administration.

The worst period of inflation can be expected to start soon after funds appropriated under the various stimulus packages begin to result in large bills actually being paid by the US Treasury Department, the logical consequence of current appropriations.

As of this writing, the term “stagpression” gathers only 145 hits on Google. However, as time goes by, we may be seeing more and more of this term.

Although Jimmy Carter did not invent “stagflation”, he certainly introduced the term into the world financial vocabulary. I was living in Brazil at the time and found it rather surprising that so many US economists seemed to think that recession and inflation were somehow incompatible. This, of course, is not true.

Often, inflation is simply the rapid devaluation of the currency, which can occur whenever the government issues more money than it should — usually to cover excessive spending. Recession and depression are terms referring to periods of slow or negative economic growth with higher than normal unemployment.

The difference between recession and depression is simply a matter of degree and duration — or as one wit put it, whether it is you or your neighbor who is unemployed.

President Obama attacks capitalism

After 100 days in office, it is becoming increasingly evident that President Obama is no friend of capitalism — at least that form of capitalism that creates jobs.

Now, I myself am no friend of many who evoke the term “capitalism” but who, in fact, are simply thieves and usurpers of the property of others. In this category, I would place the grossly overpaid employees that sit at the apex of publicly-owned corporations, claiming to be “capitalists” although they are not owners of the businesses they manage for others and who ignore their fiduciary duties and role as agent of the real owners, using stock-options and buybacks to defraud naive, long-term investors by purloining their life savings.

The real capitalists, the ones that create almost all new jobs in the United States, are the little guys and gals that run small stores, restaurants, dry-cleaners, tiny factories, auto-repair shops, and other enterprises in which they have invested and risked their own money and who intend to pay back the bank any amounts that they may borrow.

Now, many of these “little guys” are millionaires (it’s not such a big deal to be a millionaire today):

A business that returns $250,000 a year in net profits is probably worth more than a million dollars — and the owner of this small business is considered a “fat cat” by President Obama — someone who deserves to be heavily taxed, not only on current income, but on the value of the business he or she has built up over the years, hoping to pass on to sons or daughters as a way to make a living. President Obama would like you to believe that it is the “patriotic duty” of these little guys to pay more taxes so that he can hire more non-capitalist, unionized school teachers and support a union-owned General Motors.

President Obama has already indicated that he does not support property rights, as defined in the Constitution of the United States. He has indicated that he objects strongly to the position of Justice Clarence Thomas on strict interpretation of the Constitution. With the retirement of Justice David Souter, he has indicated that he will place a successor on the Supreme Court who will be very squishy on the issue of property rights.

But property rights. after all, are one of the elements that separate socialists and communists from capitalists. Today’s Wall Street Journal carried an article saying that the Obama administration intended to press for a law that will impair the property rights of investors in the United States from offshore financial centers. Obama’s agents have already pressed Chrysler into bankruptcy under terms that give more favorable treatment to claims of the unions than to investors, under the rule of law.

Hardly a day goes by now, that President Obama does not indicate some new plan to raise taxes on the “rich” — in this case, the small businessmen and women that create jobs. Therefore, the foundation is being laid not only for inflation (excess spending), but prolonged unemployment and falling GDP (depression).

The really rich are often smarter than President Obama

The problem with taxing the rich is that they have greater mobility and flexibility than government bureaucrats or members of Congress that draft the laws.

The only tax of the rich that really works is to storm their homes, throw them in jail, and put their children up for ransom until they surrender the hidden family jewels. Then, rip out the gold fillings from their teeth before sending them off to the gas chamber.

President Obama has not quite reached that stage yet. So, the rich will simply fade away to more favorable climes, pushing their assets through the inevitable loopholes present in any tax code, no matter how cleverly written, and hide out at posh hotels in foreign countries, waiting for the storm to pass.

In the meantime, the capital that the rich might have employed, creating jobs in the United States, will go elsewhere. After all, there are many places on earth that welcome investment. Why waste time where you are not appreciated and loved?

This is precisely what occurred in the Great Depression in the United States. Roosevelt attacked the rich as “malefactors of great wealth” and they, in turn, proceeded to sit on their wallets and wait until “that man in the Whitehouse” went away.

Of course, this is not how President Obama interprets history. Apparently he has never read Amity Shlaes book, The Forgotten Man: A New History of the Great Depression. He actually seems to think that FDR saved America by government spending.

Deflation or Inflation?

Franklin Roosevelt, although spending government money on many stupid projects during the Great Depression (like hiring people to bang tin cans to scare birds out of the trees in Washington), did not actually spend that much until World War II.

FDR’s spending, prior to Pearl Harbor, was only a fraction of the spending that Barack Obama has already authorized in his “spending is stimulus” bill. Most of the rest of the world had emerged from the Great Depression, while the United States still suffered under Roosevelt’s rule.

When government spending really exploded during World War II, it went into factory production, to buy tanks, airplanes, and ships, creating the world’s greatest industrial economy. Inflation was controlled by rationing. People were patriotic and bought War Bonds.

This is not what is happening now. President Obama is spending at unprecedented levels, claiming to “stimulate the economy” by transferring wealth from the rich to the poor, by giving “free health care” to all (without increasing the number of doctors and nurses), by nationalizing the big banks and the US automobile industry to save the unions, by increasing the number of public employees and jobs dependent upon government payments, and by ordering the country to shift from a carbon based economy to wind and solar power, whatever it may cost.

Meanwhile, the rest of the world is smarter. China and India are not about to tax the use of energy. In fact, while President Obama is pushing the United States towards socialism, it seems that the fastest growing economies are going in the opposite direction

So what this seems to suggest is a prolonged period of economic stagnation and unemployment in the United States, accompanies by inflation — a stagpression, so to speak.

Of course, no one can see the future. Some dramatic event may change everything tomorrow and it will be a whole new ball game. But until then, the odds are increasing for stagpression. (Or perhaps I should say, stagflation-pression.)

Massive government spending appropriations with looming multi-trillion dollar fiscal deficits, combined with the Federal Reserve Bank’s determination to blow up the money supply by issuing a trillion dollars in the repurchase of government bonds and mortgages, presents a somber picture for those hoping for signs of economic prudence.

There are indications that the Obama administration is becoming much less popular — not entirely, not yet, but alarmingly so for a President who should be in his “honeymoon” phase. This casts doubt on the President’s ability to follow through for long on his New Deal policies of populist spending and taxes on capitalists and entrepreneurs — policies which, as with FDR in the Great Depression, are likely to be deflationary.

A poll in March 2009 indicated that for the first time in years, the majority of Americans said they would vote for a Republican for Congress. Congress has turned into a populist mob, fearing the elections of 2010, forgetting the spirit of the Constitution and voting what was almost a Bill of Attainder to mask their complicity in the AIG bonus scandal.

Time magazine, for the first time, put out an issue distinctly critical of President Obama’s competence.

More and more Americans are having “buyers remorse”, now realizing that the charismatic figure they had put in the White House has no executive experience. It seems increasingly unlikely that Obama will to be able to charm the masses for much longer — there are too many educated people in the country and almost half the population voted against him just last November.

The President seems anxious to get far away from the toils of executive duty and decision making, preferring what he knows best — inciting chanting crowds in carefully chosen “town hall” settings and appearing on late night comedy shows.

Meanwhile, President Obama, having joined the outcry in calling for action against “Wall Street Greed”, has compared his Secretary of Treasury to Alexander Hamilton — perhaps confident that many of those who voted for him don’t know anything about Alexander Hamilton, much less Secretary Geithner (whose betting odds of staying in office are rapidly deteriorating).

So, as Obama’s popularity wanes, so does the outlook for his deflationary measures over the longer term, leaving the country exposed to the now seemingly inevitable inflationary results of extraordinary wasteful government spending and a trillion dollar pumping up of the money supply.

Time to buy real estate and get a mortgage

The worse effects of inflation fall on those who don’t understand how it works or on those who, even if they see what is coming, can’t get out of the way.

In the long span of history, the Brazilians have lived through inflation for many, many years — usually never less than 20%, including the fifteen years of the “Brazilian Miracle” — an outstanding period of rapid industrialization and economic good times. The Brazilians survived inflation of 1000% during the populist governments of the 1980s and 1990s. The lesson is that people can put up with a lot, if they know what to expect and have time to be prepared.

Prolonged, high rates of inflation usually produce predictable effects:

• long-term life insurance becomes worthless.
• long-term bonds, without the protection of monetary correction or a link to gold, disappear from circulation.
• fixed annuities or pension plans fail to provide economic support for the elderly
• debtors gain a huge windfall by being able to pay off debts in devalued currency
• the price of real estate (like everything else) goes up
• wage earners whose salaries are not adjusted frequently, suffer a decline in living standards
• the self-employed (who are able to raise prices daily and who factor inflation into their business plans) can do well
• short-term interest rates rise to match or exceed inflation, so that creditors who roll over short-term obligations can survive.
• governments that depend upon current sales taxes, rather than backward-looking real estate and income taxes, can survive, while government employees without monthly salary adjustments, have a hard time.
• governments lie more the usual about the rate of inflation and cost of living.
• price-earning ratios, reflecting high short-term interest rates, fall sharply. However, stocks, once adjusted downwards for inflation, and once business learns to live with the new reality, can be a reasonable investment, although not a safe as real estate.

Most Americans today work for a salary or fixed wage or depend upon social security that is adjusted for inflation only yearly. American society is not set up to withstand inflation at rates of 20% a year or more. Brazilians during the decades of high inflation, were able to get by because defenses against inflation had been built into the system, based on long experience.

The first casualty of high inflation in the United States will be the political party and the politicians who are in office at the time. This looks like it will be the Democrats. This is what brought down Jimmy Carter.

Inflationary economies still have business cycles

The business cycle doesn’t go away with inflation. Sales and production still rise and fall. There are good years and bad years. Monetary values are just adjusted daily and, if this goes on long enough, people get used to it.

The main reason that inflation is difficult to stop once it gets started is that it is based upon government spending that is endemic — baked into the political cake. There are just too many government employees, too many entitlements, too many special programs and no politician has the guts or ability to do anything about it. It is easier to adjust to inflation, that to stop it.

I lived in Brazil during the sixties and seventies, years of high inflation, never less than 20%. I was able to successfully run various businesses and raise a family, without ever feeling that inflation was really that much of a problem. Certain things didn’t exist, like life insurance, but you adjusted to it and soon forget about it. Almost everyone had government employees in their family. Some of my staff also had government “jobs” on the side, alhough they never had to show up other than to collect a paycheck.

The Obama administration is laying the groundwork for a rate of inflation that the American public is not prepared to accept. Some future administration will have to clean up the mess.

Meanwhile, if you can get a thirty-year fixed mortgage at 4.5%, even if your home is “under water” today, the odds seem very favorable that, in the long run, you’ll be a winner.

If inflation is indeed coming, its time to be prepared. Run your own business, hold real estate, borrow long-term at low fixed rates of interest in amounts you can afford to pay. Once inflation hits, sources of attractive long term loans will dry up.