Martin Hutchinson's Bear's Lair newsletter is always worth a read, but last week's was particularly good. Just as the housing bubble of the 2000s brought down the world economy, a government bubble is now growing and approaching bursting point. Artificially cheap credit, which led to massive malinvestment in the housing sector, is allowing profligate governments to spend far beyond their means:
In the government bubble, central banks have played the exacerbating role that Fannie Mae and Freddie Mac played in the mortgage bubble. The Bernanke Fed’s repeated purchases of government bonds, a practice believed devoutly to be thoroughly unsound before 2008, mirrors Fannie and Freddie’s massive portfolio of mortgage bonds and their determination not to be left behind in market share however “subprime” the mortgage market became. Similarly the European Central Bank’s $600 billion 3-year 1% bank funding in December 2011, and its promise to repeat the operation in February, have provided a massive subsidy to the government bubble in the same way as Fannie and Freddie’s recklessly awarded guarantees, their dumbing down of approval criteria and their bloating of maximum mortgage limits subsidized the subprime mortgage bubble.
We printed our way into the "boom" of the 2000s; now we're trying to print our way into a recovery. What's the likely outcome?
The solution in both cases is a recession that writes down the malinvestment and begins the redeployment of resources to more economically viable areas. In the case of housing, that process is nearly finished – there are strong signs that house prices are nearing a bottom, having returned in most areas to below-average multiples of incomes. The next few years will see two further downdrafts, however, one caused by the inevitable (if artificially delayed) foreclosures and the other caused by a rise in real interest rates to historically appropriate levels. It may thus be 2018-2020 before the housing market is truly restored to health, in terms of new home building, etc.
In the government case, the first solution attempted will inevitably be a burst of inflation, with interest rates being kept artificially below the inflation rate, inflation statistics being falsified, and the Fed attempting to depress the real value of the government’s obligations. This will not work, but the temptations to the Fed and the authorities are likely to be such that no Paul Volcker will appear as in 1979 while inflation is at the relatively benign 10-12% level. Instead, sloppy money will be perpetuated until hyperinflation of 100% per year or more has entered the American experience for the first time.
It's a chilling thought. Quantitative easing was once described by the now-Chancellor George Osborne as "the last resort of desperate governments". He was right. QE is becoming an increasingly normalized tool of government policy throughout the world. It may be endless; carried again and again to keep the government bubble inflated until Hutchinson's nightmare scenario is realized.
As the government bubble bursts, Hutchinson himself predicts that after some political turmoil governments will be forced into acting responsibly, with a return to the gold standard and constitutional amendments requiring balanced budgets. History tells a different story about the aftermath of hyperinflations. Let's hope Hutchinson is right.