January 21, 2009
Could Obama be remembered as the man who presided over the greatest hyperinflation the world has ever see? At the moment, with unemployment rising, companies going to the wall and prices falling everywhere, the mention of hyperinflation seems ridiculous, that is until you examine what the new president wants to do.
Obama plans to spend a phenomenal amount of money to re-boot the US economy. How does he plan to finance this spending? Where does he think he’ll get the money? What will the US’s latest splurge do to the trust the world has placed, up to now, in the dollar and American assets in general?
Rarely has one man assumed such a burden. It seems that an indebted, beleaguered America is looking to him to come up with the greatest escape act since Harry Houdini. The brilliance of Obama is that he seems unfazed. Watching him yesterday, he has obviously steeled himself for this moment and, as the ‘Financial Times’ stated, “the world needs Obama to succeed”.
However, the hope and expectation shouldn’t blind us to the difficulties. We hope for the best, but must prepare for the worse in order to temper some of today’s effervescence.
Everything in Obama’s programme for government will be predicated on his ability to get the economy going again. At the root of America’s problem, like Ireland’s, is bad housekeeping. The US lost the ability to balance their books and, in an effort to prolong the good times, it borrowed from wherever it could get cash and spent most of the subsequent overdraft on instant gratification. Its banks and its people overextended themselves, fuelled by the hi-octane combination of other people’s money and rapidly rising house prices. In the end, some of its banks went bust, overburdened by an array of financial waste. Now the US must clear up this mess.
Up to now, the Americans have tried throwing as much money as they can at the banks. However, a pattern has emerged over the past few quarters. Every time the government feels it has done enough for a bank by injecting new capital, the bad debts tarnish this new capital and the banks are back at square one. The Nobel prize winner Paul Krugman referred to this approach recently as Voodoo banking, where the state, in an effort to avoid nationalisation, keeps throwing taxpayers’ money at banks, which is essentially a gift to shareholders and, according to Mr Krugman, probably the only thing keeping bank share prices from collapsing totally.
Ben Bernanke is continuing with this policy. Having failed to stop the unravelling of the economy with a monumental interest rate cutting process from 6pc to 1pc, the panicking Bernanke is pushing US rates down to zero. The big problem is that for the US, zero is not low enough. By this I mean that the US needs negative real interest rates (the interest rate minus the inflation rate); in essence, it needs to pay people to borrow. The only way it can do this is to allow inflation to creep up, while keeping interest rates close to zero. This financial conundrum is made all the more tricky by the added fact that Obama is going to preside over a budget deficit of $1 trillion in his first year, using borrowed money.
Who is going to lend the US the money? And at what price, knowing the US will need negative interest rates? Additionally, if so much of the cash is geared at saving insolvent banks, is the US not throwing good money after bad?
Politically, these questions are predicated on the central assumption that the US intends to pay the cash back. What if the US has forgotten that borrowed cash has to be repaid? What does it do next and, more significantly, what becomes of the lenders in such a world? These might seem like outlandish contentions. Surely the US is not considering giving its lenders the two fingers?
Think about it. What country can lend this type of cash to the US? China is the only country in the world with its $1.9tn in foreign reserves. But the Chinese already own $700bn of US treasury bills. It may just be reaching US debt fatigue. Indeed, in November, ‘China Business News’ reported on this dilemma, saying, “the US must pay back its debts, and to do that, it needs to live a more frugal life, instead of others lending it money to maintain its over-consumption”.
If China begins to question the wisdom of putting all its foreign-exchange eggs in one basket, what will Obama do? If the Chinese say no, the market for US debt will collapse. The dollar will also fall like a stone and the US will begin to experience hyperinflation. With no-one to buy its debt, no appetite to reduce public spending and, most crucially, no memory of a time when the world’s financial markets ever rejected the seduction of the dollar, the US will simply start printing paper dollars and covering them with paper IOUs, flooding the market with worthless financial confetti.
All this implies that Obama could quite conceivably preside over a period of hyperinflation. Today this seems impossible but he has inherited such a mess from George Bush and his political need to get the economy going, if he is to deliver on some of his immense promise, might just prove too much. Don’t take my word for it, just look at what is happening to the price of gold — the only real hedge against hyperinflation.
Economic theory would suggest that after a period of hyperinflation, where all old US debts are wiped out and lenders to the America robbed, the dollar revalues as America reindustrialises under the green job agenda talked about by Obama.
History could well look on the end of the first decade as not just a momentous era which produced the first black president, but as a period of dramatic economic change. The debt-fuelled boom of the Noughties, leading to a rapid deflation and failed banking bailouts at the end of the decade, giving way to hyperinflation, which ultimately cleaned up the US’s balance sheet. Sounds fanciful? But then again, so, too, did a black president not so long ago.