Why The Federal Deficit Is In Even Worse Shape Than You Think

If there was any question before that the federal deficit was completely out of control and unsustainable, the successful passing of the "free healthcare for all" plan should completely seal the deal!

As you probably recall, the out-of-control debt spiral faced by our government sparked some interesting conversation at our local Casey phyle meeting about the safety, or lack thereof, of our retirement savings.

That conversation was originally inspired by a fine piece of analysis that Bud Conrad, Casey's Chief Economist, put together for The Casey Report. They've graciously given us permission to republish Bud's piece here, so read on to learn just how bad the federal deficit is. Believe it or not, it's probably worse than you think!

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Battle for the Budget

By Bud Conrad, Editor, The Casey Report

Recently the Congressional Budget Office (CBO) published its scoring of President Obama's budget for the next 10 years. It shows a budget deficit of $9.8 trillion. That is just shy of $4 trillion worse than the CBO’s baseline budget, a budget that includes only the laws as currently enacted, with no estimates of any new programs lawmakers may add that worsen future projections.

That our budget is out of control is no surprise, but the charts I present here should provide some perspective of just how dangerous this set of budget estimates could turn out to be. The first chart below shows the amount of red ink in each year for the two CBO estimates.

To get a visual interpretation of just how big these budget deficits have become, I plotted the long-term history, then tacked on the CBO evaluation of the president's proposal. Knowing the propensity of governments to spend more than they promise makes one question if the large improvement shown in the dotted line will actually occur. Even if nothing changes, however, the results look like they could be very damaging for other aspects of our economy.

One aspect of the CBO projections that is difficult to defend is the expectation that inflation will stay incredibly low. In the next chart, I present the same sort of long-term history, coupled with the projection, for the Consumer Price Index (CPI).

In the next chart, I put together two of the most important measures: the three-month T-bill interest rate and the deficit expressed as a percentage of the gross domestic product (GDP). Both history and projection are shown.

The most important observation is just how disastrous the current deficit is in the historical context, even after rationalizing it by dividing it by the GDP. I overlaid the two series to show that higher deficits in the past tended to occur along with higher interest rates.

As you can see, we now have a significant anomaly, with the budget deficit at its worst in half a century, while interest rates remain near their lows for the period. A closer look at history shows many divergences, to the point that in the short term these two series tend to bounce in opposite directions. That is probably because when the economy shows weakness, the government expands its spending and collects lower taxes, so the deficit becomes worse. Thus, in the short-term cycle of a few years, these two measures often move in opposite directions.

But the situation we face now is much bigger than anything we've seen since the 1950s. The government bailouts and stimulus are at record levels, and the special actions of the Federal Reserve have driven interest rates close to 0%. It is my expectation that both inflation and interest rates will rise dramatically because of these large deficits.

I also think the projected interest rates are much lower than what I expect the deficit would require. As foreigners and others recognize how seriously indebted the U.S. government is becoming, they will expect higher interest rates to compensate for the debasement of the currency.

The budget analysis goes further in calculating the expected growth of the economy, which ranges from 2 to 4% over the years. Those are not large numbers for real GDP, but there is no expectation of another recession during the decade. If the economy didn't grow, tax revenue would be less, and the budget deficit would be worse.

While interest rates are expected to rise as shown in the chart above, the projections expect that they roll over and stop rising at around 5%. That is contrary to my expectations that they will be much higher, and even perhaps closer to 10%, by the end of the decade. If they are, the cost of funding the outstanding government borrowing escalates rapidly because the increased interest has to be added to the debt so that the debt grows even more.

The problem from the onset of this crisis has been the debt, and that continues to be the case.

Leaving aside the above two adjustments that could make the budget deficit worse, it’s helpful to look at the outcome with the given assumptions and see where it leads. Perhaps the most problematic result is that the debt of the federal government held by the public grows from $7.5 trillion in 2009 to $20 trillion by 2020. Such big numbers are hard to understand, though you can get some sense of things by considering that the government is intending on almost tripling the debt in just 11 years. The ratio of this outstanding debt to the GDP gives a flavor of how dangerous the situation has become. As Ken Rogoff and Carmen Reinhart have indicated in their new book, when we approach 90% government debt of GDP, we have serious potential for a currency crisis. As you can see, we are well on our way to those levels, even without assuming the two adjustments above.

How will the deficit be funded?

The question arises who will service the rising levels of debt. Clearly the taxpayers are on the hook for all these projections, with more to come. So the question becomes whether the tax base can grow fast enough to provide support for servicing the debt. The CBO gave us two series for the tax base. One is Domestic Economic Profits, and the other is Wages and Salaries. The basic assumption is that these are the main revenue streams that can be taxed by the government to fund its expenses. I added these two series together and divided by the GDP to determine if the tax base is growing more rapidly than the economy. Unfortunately, but as expected, the orange line in the above graph shows that the tax base only grows about as fast as the economy itself. That's not surprising, but the contrast to the rapid growth in debt will be a serious source of problems, as the only way the debt can be sustained will be through increasing the tax rates, and probably quite dramatically.

The latest set of budget predictions will probably be wrong, and not just because the assumptions are too optimistic, but because there is a relatively high probability that something will go off track to cause a major shift before the 10 years are completed. Unfortunately we are not preparing ourselves for such problems, and so I would interpret the CBO projections as being far too rosy.

Bud Conrad is the chief economist at Casey Research, and crunching numbers like these is his daily bread. It also enables him, together with the rest of the Casey Report team, to accurately forecast what’s in store for the U.S. economy… a skill that subscribers to The Casey Report have come to highly appreciate. Learn more about what the future holds and how to profit by clicking here.

Ed. Note: As you probably know, I am a longtime Casey Research subscriber and affiliate.

Free Special Report - Is the Economy Actually Recovering?

Here's a guest piece by Bud Conrad and David Galland from the Casey team, with an opportunity to check out their free report on the current state of the economy. As always, these two do a bang up job of looking under the hood of rosy government figures and media reports to get the real story.

I love their analysis and completely agree that the economy is a trainwreck, with the ugliest carnage around the corner. I'm not sure if I still agree with their inflation hypothesis...though with gold pushing $1,000, the market may prove them right and me wrong, perhaps sooner rather than later!

Enjoy this piece and free special report. And have a great Labor Day too - if you're short on investment reads, you can check in here - I'm not going anywhere, and my wife is out of town...so when I'm not drinking beer, I'll probably be catching up on reading and cranking out a blog post or two.

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Green Shoots or Greater Depression?

By Bud Conrad/David Galland, Editors, The Casey Report

While we aren’t contrarian for the sake of being contrary, more often than not that is the position in which we find ourselves. Today, with the media falling all over itself to paint a rosy outlook for the economy while simultaneously voicing encouragement to the new administration in its remake of the nation in previously unimaginable ways, it’s hard not to question our conviction that the worst is yet to come.

Could the economy really recover this quickly from the traumatic trifecta of a record real estate bubble, leviathan levels of debt, and a global credit collapse? We don’t see it as remotely possible, but yet… but yet… there for everyone to see are countless happy headlines and breathless exhortations that the worst is behind us.

So, is it Green Shoots or Greater Depression?

Getting the answer right is critical, because from it flow serious consequences to each of us. And not just in our investment portfolios but in how we organize our lives.

Looking for an evidence trail leading to the correct conclusion, Casey Chief Economist Bud Conrad once again put in very long hours digging through the data. Here’s what he uncovered, about the claims of green shoots, and what may actually be in store for the economy moving forward.

David Galland

Rather than accepting the many commentaries that our economy may be improving, let’s focus for a minute on the important forces that will play out over the decade ahead, and the minor improvements – from disastrous levels – that have given commentators such hope that the worst of our problems are behind us.

What Do the “Green Shoots” Really Look Like?

While some individual measures of economic activity appear slightly less dire than previously, it’s important to understand that most improvements are largely attributable to government intervention.

For example, at the onset of this crisis, commercial paper spreads rose to the point that this important source of corporate short-term funding had virtually shut down. Today, those spreads have returned to almost normal levels. But the bulk of this improvement is not due to a return of confidence in the economic system but rather to the Federal Reserve directly intervening in the market with several hundred billions of dollars.

And mortgage interest rates, which briefly dropped into the 4% range, did so not because of a surge in creditworthy borrowers or eager lenders… but rather because the Federal Reserve launched a program of buying $1.25 trillion of mortgage-backed securities. Doing its part, the Treasury has poured billions into Fannie and Freddie and provides guarantees for their mortgages.

In these and many other instances, the "green shoots" that optimists have spotted are really just the visible manifestations of the massive interventions by an increasingly bankrupt government.

Indeed, the massive fiscal stimulus provided by the federal government – and by the Fed, which has slashed interest rates to near zero, purchased mountains of toxic waste, and bought up Treasury debt with billions in freshly printed money – are unprecedented in the history of the U.S.

But even a cursory review of key metrics reveals continuing declines in housing prices, rising unemployment, and slowing consumption as measured by falling retail sales, GDP, and the collapse of world trade. Sure, housing unit sales recovered a little recently, but that’s due mostly to the distress sales of foreclosed homes and houses worth far less than the outstanding mortgage. These are not signs of a strong economy.

The only rational conclusion to be drawn is that the crisis is far from over and that we are not likely to see a strong recovery anytime soon. In fact, things are likely to get much worse before they get better.

The massive debt expansion that played a crucial role in creating the disastrously overleveraged economy is not shrinking. As you can see in the chart here, it’s growing ever bigger.

That debt growth was fostered by U.S. government debt growth, which is now getting out of control.

[Don’t just believe what you hear about “green shoots,” or you could lose some serious money. To find out what’s really going on and where all this is leading, read the rest of Bud’s in-depth article here.]

Why the FDIC Will Soon Require Hundreds of Billions in Bailout Funds...At Least!

Despite the self congratulatory nature of the financial media in the recent weeks and months, I remain highly skeptical that the worst is indeed behind us. Down in the trenches of daily economic life, I can't find any noticable signs of improvement. In fact, the only thing that seems to have changed is a sharp 50% rally in the major US indices, which has buoyed bullishness towards the stock market.

If my suspicions are correct, then one house of cards that's sure to be blown over during the first gust of economic bad news is the FDIC. It's chances of funding it's insurance obligations is laughable to say the least. And because it's not politically palatable to allow the FDIC to default on these obligations, this means more bailouts are on the way - likely to the tune of hundreds of billions of dollars.

To explore this theme in more detail, we'll turn it over to our good friend Bud Conrad from Casey Research. Bud, a frequent guest columnist, cranks out top notch investment analysis that's "too heavy" for mainstream finance from his home in Silicon Valley. I am a subscriber of Bud's, and also am fortunate enough to be a part of the local SV investment group that Casey Research organizes and Bud participates in.

Read on for Bud's insightful piece...

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The FDIC Is in Trouble

By Bud Conrad, Editor, The Casey Report

As we all know, the Federal Deposit Insurance Corporation (FDIC) guarantees depositors that they’ll get their money back if a bank fails, at least up to a certain amount. To fund its operations, the FDIC collects small fees from the banks that are held in reserve for the purpose of taking over troubled banks and paying off depositors.

Since the Great Depression, a period marked by widespread runs on banks, the FDIC has done a good job of fulfilling its mandate. So how are they doing in this crisis?

In a nutshell, they are in trouble.

The FDIC insures 8,246 institutions, with $13.5 trillion in assets. Not all of them are going bankrupt, of course. Yet as of late July, a disturbing 64 banks had gone belly up this year – the most since 1992 – costing the FDIC $12.5 billion. At the end of Q1, the agency was already asking for emergency funding.

And worse, much worse, is likely yet to come. The following chart shows the total assets on the books of the FDIC’s list of 305 troubled banks. The list doesn’t include the biggest banks that are considered too big to fail, as they are being separately supported with bailouts. By contrast, if the banks on this list fail, the FDIC is on the hook to have to step in and take them over and, of course, make depositors whole.

Other measures of how serious the losses at banks are becoming can be seen in the chart below, which shows charge-offs and non-current loans at all banks. You can see that the Net Charge-offs remain stubbornly high, with banks charging off almost $40 billion in bad loans in the last two quarters alone. And the number of non-current loans – loans where payments are not being kept up – is soaring.

Together, these measures indicate the potential for more big failures and more big bailouts coming down the pike.

About Those Reserves…

Into the battle against bank insolvency the Fed brings a level of reserves that can best be described as paper-thin. From almost $60 billion last fall, the FDIC’s reserves have been drawn down to only about $13 billion today, a 16-year low. A quick look at the FDIC’s own data shows us how inadequate those reserves are compared to the deposits they are now insuring.

The chart below says it all:

As you can see, the Federal Deposit Insurance Corporation currently covers each dollar on deposit with a trivial 2/10ths of a penny.

And even that understates the seriousness of the situation: the $4.8 trillion in deposits the FDIC is providing coverage on doesn’t include the expansion that now extends insurance coverage from $100,000 to $250,000 for normal bank accounts. That likely brings the exposure of the FDIC closer to $6 trillion. But that’s pretty inconsequential at this point: using any reasonable accounting method, the FDIC is already bankrupt and will require hundreds of billions of dollars in government bailouts just to keep the doors open.

So, given the dire shape of its finances, what measures is the FDIC taking, you know, to batten down the hatches and all that?

For starters, they are expanding their mandate by guaranteeing bank loans – $350 billion and counting at this point. And the government has tapped the FDIC to play a pivotal role in guaranteeing the loans issued to buy toxic waste through the government’s highly problematic and fraud-prone new Private Public Investment Partnership (PPIP). The FDIC’s commitment to the PPIP is and may become limited based on its resources.

It is hard to draw any other conclusion but that hundreds of billions in new funding will be required to keep the FDIC operating. Given the catastrophic consequences of the FDIC failing, starting with a bank run of biblical proportions, there’s no question it will get whatever funding it needs. By loading the new loan guarantee responsibilities and the PPIP onto the FDIC’s back, the administration will go back to Congress and ask for the next large bailout.

Of course, in the end, all of this falls on the taxpayer, either directly in the form of more taxes or indirectly via the destruction of the dollar’s purchasing power. Another bale of straw on the camel’s back, and another reason to be concerned about holding paper dollars for the long term.

PS: If you still trust the government to take care of you and yours when the feces hits the fan, you’re on the path to financial disaster. But even in times of crisis, there are things you can do to protect yourself – for example, by betting against the insane machinations of the government and Fed. You can’t make them stop, but at least you can profit from them. Read about Bud Conrad’s favorite investment of 2009… by clicking here.

Bud Conrad Likes the Short Play on Interest Rates

Here's a short clip of Bud Conrad, Casey Research's Chief Economist, on CNBC last Thursday. Bud has been pounding the table for investors to buy gold (since much lower prices) and short long bonds for some time.

The buy gold trade has been a good one thus far, and Bud now believes that betting on long term interest rates to rise is THE trade to make right now.

He starts talking around minute 4:20.

TBT and RRPIX are two of the most popular ETF plays on this trade.

If you like what Bud has to say, you may want to check out The Casey Report, where he provides his in-depth analysis each month.

Why Socialized Healthcare Will Sink America

It's ironic that folks who identify themselves as free market proponents lament Obama's plans for socialized healthcare in America. We already have socialized healthcare in the US.

There is very little that's laissez faire about the American healthcare system. The entire market is strangled by red tape, bureaucracy, and stupid rules.

Result: the least efficient healthcare system in the world.

A true representation of a laissez faire industry in America is high technology, which, by no coincidence, is constantly innovating and producing untold amounts of wealth for the US. We are fortunate that most of our elected representatives do not understand technology, and, thus far, have not been able to pass enough red tape laws to kill the industry.

Healthcare is a joke, and could very well be the final straw that bankrupts our government, if we do indeed go the way of national healthcare. For more on the current mess, let's turn to one of our favorite economic minds - Bud Conrad...

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Why Healthcare Is Killing America
by Bud Conrad, Editor, The Casey Report

Healthcare is the biggest segment of our economy. In the debate over who should pay for what or, increasingly, for whom, most people don't stop to understand just how large a portion of our society's money is dedicated to healthcare.

For some perspective, as a share of GDP, the U.S. spends about twice that of other advanced nations. This is an important reason why the U.S. is increasingly uncompetitive in global manufacturing. It is, for instance, the most important factor (besides poor management) that General Motors and Chrysler are going bankrupt.

Going forward, the situation is guaranteed to get worse. The Obama administration is committed to major reform to cover the 40 million people not now covered by insurance. Once everyone has insurance, with many paying nothing at all for coverage, patients won't care what it costs, and the system will quickly spin out of control.

And it's already out of control. I recently spent one day in the hospital due to a broken arm, which cost on the order of $100,000. Remarkably, that eye-opening amount still doesn't include the ambulance, the doctors, the x-rays, the CT scans, or the anesthesiologist. I'm still getting bills. The system is far more broken than is widely understood, unless you have had a recent bad experience.

Projections for healthcare are particularly problematic because of the demographics of so many people born just after World War II. Soon, there will be less than three people in the workforce for each retired person. That will result in huge taxes on the few workers to supply the expensive end-of-life medical care for the retirees (and it is in the latter years where medical expenses really begin to rack up).

This bubble was predicted and a government trust fund was set up. Unfortunately, as is typically the case, the government couldn't keep its hands off the money, and so it has already been spent. The outlook is not good. In fact, in just over 10 years from now – by 2020 – the demands on the government for Social Security and Medicare will get so high that they cannot be met. And it gets worse from there.

It's a safe bet, based on history, that the government will once again try to print its way out of the problem – but all that will do is further destroy the dollar and drive interest rates up even more. Just to be clear, this is not just about a government program gone awry, but as much or even more so a demographic problem – which makes it all the more intractable.

Don’t wait to be saved by the government; take your life – and your asset protection – in your own hands. For example, by playing one of the most obvious and inevitable trends and Bud Conrad’s favorite investment for 2009. Click here to read the full report.

How Bad Will The Financial Crisis Get?

How bad can the current financial crisis get, and how long will it last?  Casey Research's Chief Economist, Bud Conrad, tackles this question, crunching the numbers produced by two leading economists who took a broad sampling of banking crises.  The information is presented in an insightful and informative way as only Bud can.  I hope this helps round out your thought process about the depth of the current crisis.

Bad, Worse, or Worst?

An assessment how serious the current crisis is likely to get

By Bud Conrad, Chief Economist, The Casey Report

It’s time to call the global crisis what it is: the worst financial collapse since 1929. That’s no surprise to subscribers of The Casey Report, who have been amply warned over the last five years. But now even government officials, after trying to ignore the facts on the ground for the last couple of years, are admitting the truth of the matter.

Now that it’s here, we turn our attention to trying to discern, “How bad can it get?” and “How long can it last?”

While such questions can never be answered with anything approaching absolute certainty, there are methods that can be used to assess what may lurk over the horizon. With that goal in mind, this article focuses on – and then expands upon – the recent work of two economists who painstakingly analyzed a substantial number of previous banking and currency crises in an attempt to derive potentially useful lessons. I have then taken their data and applied them to the current circumstances to see where we are, relative to those other experiences.


The Data

The data are from a study called “The Aftermath of Financial Crises” by Carmen M. Reinhart of University of Maryland and Kenneth S. Rogoff of Harvard University. In their study, the authors summarize the results of a broad sampling of banking crises, with between 13 to 22 crises analyzed for each of the variables.

The Reinhart/Rogoff study is based, in turn, on data extracted from an even more comprehensive study of events in 66 countries, titled “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises,” by the same authors.

I’ve summarized the findings from the latest study in the table below:

The economic measures in the left column show how far the U.S. situation has deteriorated so far. The next columns show the average historical deterioration and the worst case of the crisis analyzed.

I then applied these data to calculate the levels that the U.S. could reach if it followed the path of the historical examples. The projected level is based on the measure analyzed, either from the peak prior to the downturn (e.g., the S&P 500) or from the bottom prior to the downturn (e.g., the lows in unemployment). Thus, as you can see in the table here, the S&P 500 has already dropped from its October 2007 peak of 1565 down to 766. If this crisis were to end up being only “average,” then it would drop to 690.

If, however, the worst case of a 90% drop were to occur, as it did in Iceland last year, then the S&P 500 would trade down to the shocking level of 157. For further reference, if the current crisis were to cause the stock market to fall as sharply as in the Great Depression, the S&P would touch 469.

Duration of Crisis

As you can see in the summary table below, it took 3.4 years, on average, for the stock market to fall from the peak to the bottom. In the worst case, it took five years. With the recent peak in the S&P 500 occurring in October 2007 – just one and a half years ago – the crisis is likely to have some time to go before reaching even an average duration. More specifically, if this crisis turns out to be just “average,” we would not expect to see the low before the first quarter of 2011.

Crisis Horizon: Some Conclusions

The global economic situation continues to deteriorate on all fronts (see charts below).

Housing prices are down 28% from their bubble peak in 2006 but still have a ways down to go to get back to their pre-bubble levels. Even an average downturn will mean that housing remains a problem for several more years. Unless, of course, the government steps in to stave off those resets… a “solution” that carries with it a separate set of problems, making things worse. We continue to expect very serious problems in the commercial real estate sector.

The stock market is approaching a 50% decline, the average of what has been observed in past crises. Further slowing in U.S. corporate activities and profits means additional increases in unemployment, establishing a negative feedback loop that pushes corporate profits – and stock prices – even lower.

The only growth trend at this point is in government bailouts, which are in high gear, indicating we’ll experience the serious growth of outstanding debt seen in other crises. The elevated levels of government borrowing required to fund that spending are absorbing all available credit from foreigners, directly competing with business in need of the new financing that will be required to expand the economy. The combination of declining business activity, coupled with declining levels of household income, will result in declining tax revenues, increasing the budget deficit beyond the size of the new bailout programs. State and municipal governments across the nation are already being confronted with large shortfalls in their budgets, shortfalls that will only widen as the crisis worsens.

The combined business slowing and jobs contraction assure that the GDP will decline. Components of GDP having to do with necessities like food and shelter will continue to bump along regardless of the economic conditions, but the lack of growth in GDP could extend for years as it did in Japan and as it did after the 1929 stock crash.

Inflation/Deflation

Given that we are currently in a deflationary phase, it is easy to dismiss the case for inflation – and many do. We think that is a mistake. Even a summary tabulation of the unprecedented increases in government debt at this relatively early stage in the crisis make a compelling case for higher inflation, if for no other reason than that it shows clear intent on the part of the government to spend “whatever it takes” to offset the deflationary forces now stalking the land.

The research paints a dismal story of years of economic stagnation. In our view, the trend is now firmly established for dollar debasement, a debasement that will eventually overwhelm the deflationary pressures from collapsing asset values. Therefore, don’t listen to the happy faces on CNBC spouting off, for the umpteenth time since this crisis began, that now is the time to jump back in and buy stocks. It isn’t.

Be extremely skeptical when you hear some pundit pronouncing that this piece of short-term good news or another is an “all clear” signal. Until we start seeing a systematic improvement in the economic fundamentals – for example, an upward movement in consumer confidence – the only signal the economy will be hearing is that of a runaway train coming straight at it.

The numbers paint a dark picture… but it is in crises like today’s where unusually good opportunities arise for investors. Take our investors, for example, who made money shorting financials over the last year. The Casey Report focuses on recognizing and analyzing market trends way ahead of the investing crowd – a strategy that has already provided its subscribers with up to four-digit returns. The latest edition includes an update on the analysis you’ve read above. Try it risk-free for 3 full months, with our 100% money-back guarantee: click here to learn more.

Also by Bud Conrad:

• Battle of the Flations: Which Will Prevail?

Inflation or Deflation - Which Will Prevail?

Battle of the Flations
By Bud Conrad
Chief Economist, The Casey Report

One of the most hotly debated topics among financial talking heads these days is, “Deflation or inflation, what is it going to be?”

There is no question that we are currently experiencing asset price deflation and economic slowing. But we, the editors of The Casey Report, see this as a transitional phase. In our analysis, the truly extraordinary and historic levels of government spending and bailouts being deployed to keep the economy afloat are certain to lead to inflation in the not-too-distant future.

While our long-term view remains solidly in the inflation camp, over the past four months, the U.S.’s financial problems have caused deflation in many important asset classes. Put another way, a reduction in asset prices amounting to about $14 trillion (in housing, equities, etc.) is bigger than the government’s countervailing actions of around $3 trillion -- the total, so far, arrived at by combining the measures taken by the Fed with the federal government bailouts.

But there are important differences between a sharp collapse in asset prices and the potentially leveraged stimulus packages.

The Fed’s actions, if taken in normal times, would be multiplied throughout the banking system as banks used the new money to increase their lending and, in so doing, leveraged the funds throughout the entire economy. This time around, however, while the Fed has been extremely accommodating to the banks, even going so far as to make direct loans to them, the effect is moderated. That’s because of tighter lending standards, the need to replenish capital, and the demise of many complex structures, which were previously available for securitizing and selling loans on to others.

As a result, the banking system as a whole is not responding to the stimulus. It can be thought of as pushing on a string. Simply, as large as the stimulus has been to date, it has not yet been enough to offset the effects of the economic collapse. The resulting deflationary pressure increases concern over a downward spiral in the economy.

Another way to view this is that consumers and businesses alike are now anticipating deflation, which makes saving and survival the primary goal (in an inflation, spending becomes the primary goal, unloading the money before it can lose value). Of course, a cutback in spending and demand drives down the price of things, at least temporarily.

But the longer-term expectation is that Bernanke’s assertion – an assertion now backed up by action – that the government can and will print new money to any extent needed is the more important force.

As long as there is evidence of serious economic collapse, it can be expected that the bailout programs will be ratcheted up. And, to the extent that the public expects deflation – and so businesses reduce prices to raise cash and reduce inventories – the wave of price inflation experienced in the spring of 2008 will be moderated. But within the seeds of that positive are the very big negatives that the government, seeing that its extraordinary money creation is not being evidenced in rising prices, will be emboldened to go even further.

This is of great importance because, unlike in the 1930s, there is no limitation on what the government can do, because there is no gold standard to enforce monetary discipline. Instead, the world is afloat on a sea of massive new government spending and credit facilities. After a lag, the stimulus will perform the expected actions of reinstating credit and debasing the currency. But never lose sight of the fact that the government is creating money out of thin air. Some call it bailouts, we would call it legal counterfeiting on an epic scale.

In the New Deal, FDR created the FDIC and guaranteed bank deposits, set minimum bank deposit rates, and brought the discount rate to almost 0%. He cut the dollar/gold exchange rate from $20.67 to $35 and confiscated gold; i.e., devalued the dollar by 40%.

While the beginning of the collapse from too much credit was parallel to the previous experience of the depression, the response today is different. The size of the monetary stimulus and the risk to the dollar from foreign holders -- who can also see the implications of the out-of-control deficits -- strongly argue for a return to inflation much sooner.

How much sooner? Impossible to say, but remember: deflationary or inflationary fears are not the independent agent that will determine whether or not we will see inflation (though, in the intervening phase, they will certainly be an important economic driver). The Federal Reserve is throwing everything it can at the financial markets to fight deflation. As you can see in the chart below, the Fed has doubled the size of its balance sheet since September.



On December 16, the Fed cut interest rates to a range of between a quarter of a point and zero. That is lower than ever in the 94 years of their existence. And they promised in the accompanying announcement to provide additional funds to “stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level… the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets.”

At this time individuals and companies alike are sensing deflation and, as a result, are raising cash… in the process deleveraging the extreme debt loads. That is causing downward pressure on asset prices and, soon, a serious contraction in the economy as more and more companies lay off workers and cancel spending. This will not be a happy holiday season. And it will be a long-term recession and maybe even a protracted depression.

But the fact of the extraordinary deficit spending is there for all to see and, over time, more and more will see it. And, more to the point, understand it. In fact, thanks to the Internet and always-there financial media, the shift in sentiment can happen almost on a dime. Slowly at first, and then faster, fears over inflation will return, but this time they will be well founded.

The economic downturn could be protracted, but that does not mean that the deflation will be protracted. Instead, once we are through this phase, we expect to see poor economic conditions, but against a backdrop of rising inflation. Stagflation is a word that remains in our vocabulary.

Inflation or deflation – whatever the current market trend, there is a way to play it. Every crisis contains opportunity as well as danger… and many of those who manage to mitigate the risk and grab the opportunity have made a fortune in times like these.

Making the trend your friend and riding the market “riptides” that can lead to exceptional returns in the double, triple or even quadruple digits is easier than you think… with a little help from experts who have been correctly predicting – and profiting from -- these riptides for years. Learn more here.

Editor's Note: You may also want to check out this article by MarketFolly about investing in inflationary vs. deflationary times.

Bud Conrad Radio Interview on Gold, The Fed, and Oil

Bud Conrad, Chief Economist at Casey Research, voices his opinion on Gold, the Fed using borrowed money from the Treasury, and Oil as a limited resource.

"There's not enough gold for everybody."

http://www.bizradio.org/wp-content/uploads/podcasts/december/wss-dec11c.mp3

http://www.bizradio.org/wp-content/uploads/podcasts/december/wss-dec11d.mp3