A “Deer In The Headlights” Policy Freeze?

Posted August 4, 2011

The agreement reached to raise the US government debt ceiling may mark the beginning of the kind of “deer in the headlights” policy freeze described in the last chapter of The Dollar Crisis. If that agreement is fully implemented, this depression is going to become considerably worse. The excerpts below are taken from The Dollar Crisis, Chapter 20: Bernankeism. They were written in December 2004.

It is almost certain that policymakers will respond to the approaching crisis by applying the two great economic policy tools of the last century: Keynesianism and Monetarism. The abuse of those tools will prolong and exacerbate the death throes of the Dollar Standard.

The first recourse will be to employ more fiscal stimulus. With prices falling and in light of the extraordinary amount of paper money that has been created in recent years, interest rates will be very low and there will be little difficulty in paying interest on a much larger amount of government debt. It would not be surprising to see the US budget deficit surpass $1 trillion by 2007 or 2008 if the US current account deficit has come down significantly by that time.

If, at that point, the US current account deficit has been reduced, foreign central banks would not have a sufficient inflow of dollars to finance such a large deterioration in the US budget deficit, even assuming that Fannie and Freddie have ceased issuing any new, competing, debt of their own.

The Fed, however, as Governor Bernanke explained, has already put considerable thought into how to deal with such a contingency and stands ready, in Bernanke’s opinion, to support “a broad-based tax cut” through “a program of open-market purchases to alleviate any tendency for interest rates to rise”.

How long could such “cooperation between the monetary and fiscal authorities” underpin the global economy? For quite a number of years most probably. Economic trends play themselves out over very long periods of time. Moreover, US policymakers will use every last tool at their disposal to prevent, or, at least, delay a global depression. An economic system underpinned by large-scale fiscal stimulus financed by central bank monetization of government debt could hardly be described as capitalism (perhaps the term Bernankeism would be appropriate) but, with any luck, it could stave off disaster for a considerable length of time.

Nevertheless, despite the best efforts of policymakers to keep the Dollar Standard alive and to stave off the depression that would most probably follow its collapse, ultimately, one of the following scenarios is likely to overwhelm even Bernankeism.

1. A protectionist backlash against free trade, resulting in a trade war similar to that which occurred during the Great Depression.

2. A US asset price bubble (as interest rates fall toward zero), that drives property prices so high that they can’t be financed even at very low interest rates. This is similar to what occurred in Japan at the end of the 1980s.

3. A meltdown of the under-regulated $200 trillion derivatives market. $200 trillion is roughly six times global GDP.

4. The loss of nerve on the part of policy makers that deters them from undertaking ever more unorthodox economic policies, resulting in a “deer in the headlights” kind of policy freeze.

5. A decline in interest rates to 0% or very near 0% as in Japan at present.

Any one of the first four scenarios could undermine the Dollar Standard, but the final scenario, where interest rates fall very near 0%, would certainly deal it a fatal blow. From that point, the only option left to stimulate aggregate demand would be to drop paper money from helicopters. That too would fail, however, for who would accept paper dropped from helicopters in exchange for real goods and services? Hyperinflation would quickly set in. Economic transactions would then be conducted through barter rather than via the medium of a debased script. Eventually, a gold standard would re-emerge.

Exactly how these events will unfold is impossible to forecast; nevertheless, the eventual outcome is within sight. The Dollar Standard is inherently flawed and increasingly unstable. Its demise is imminent. The only question is will it be death by fire—hyperinflation—or death by ice—deflation? Fortunes will be made and lost depending on the answer to that question.