In the first two parts of this series, we identified fundamental economic weaknesses that running a Keynesian based economy have brought us.  So the next question is figuring out when the critical point will be, and what it will look like.  In short, we’re looking at it as we speak.

Let’s start with the ‘when’ of the equation.  To put it in its simplest form, the critical point our Keynesian economy will be when the U.S. completely lacks the ability to sell any of its debt, and consumers are unable to take on any more debt.

Using the three farmer analysis in reference to foreign holdings of U.S. treasuries; Remember that when $100 left the farmers economy, there was only $200 to repay $330 worth of debt.  This situation is unfolding as we speak, but a day will come when the answer to the above equation (treasury sales – capital outflow) will be negative by a very drastic amount.  That will be the melting point.

So what will this situation look like?  First off, remember that in the Vietnam era, there was a glut of savings.  This allowed for banks to continue making loans even if some went bad.  With that in mind, things are much different today.  With not just some, but a large number of loans going bad, banks just don’t have the capital to make loans like they used to.  Compile that with a negative savings rate and the only other solution is to increase the monetary base in order to keep the train rolling

I’m sure some of you have noticed a fundamental flaw in the above mentioned reasoning.  Well, maybe ‘flaw’ isn’t the best word here.

This argument refers to the question we hear about on a daily basis.  It is the question whether we will experience inflation or deflation here in the U.S.

Now back to the question of the flaw mentioned.  If the equation is based on treasury sales, what happens if the government creates the treasuries and the Federal Reserve prints the money to buy them (monetization)?  The answer is hyperinflation, and that is most likely the course that the Federal Reserve will take.  This is the last step before the edge of a cliff in a Keynesian economy, and the Fed will do everything in their power to avoid a collapse in their economy.

Going back to the very beginning of the solutions to how the third farmer is going to pay, you have either more loans or more money.  We are seeing this at a level that is unique to our history.  This is the equivalent to a chicken running around with its head cut off before it finally keels over to die.  Have a look at these charts.

The whole goal is to save the Keynesian economy.  The ironic thing is that this was doomed from the start.  Really the two solutions that keep the farmers running are the two paths to the inevitable end.  That end is the collapse in faith of the U.S. dollar and its banking system. 

Aftermath of Keynesian Meltdown

The signs of the boiling point have reared their ugly head.  Those signs come in the form of negative net sales of U.S. treasuries by foreigners, credit crunch making new loans more and more unavailable, and the deflation seen in financial markets.  The U.S. government and Federal Reserve will fight this with every tool they have resulting in a end game of hyperinflation.  This process has began, but it will get more extreme

First let’s look at the question of ‘does this predicament have a remedy?’  The answer is not really.  If a Paul Volcker stepped onto the scene today and raised rates to 20%, we might see another ‘save’ of the banking system, but there is absolutely no one that would be allowed in office today with such a policy.  Even if this was the desired goal, and I’m not saying it is or it isn’t, this would result in deflation that would dwarf that seen in the Great Depression.

Remembering the there is a very significant difference between the Vietnam era and the economy today: savings.  When Volcker came into office Americans actually had savings.  Even though his actions caused a tremendous amount of bankruptcies and financial turmoil, the situation was remediable because of the savings rates.

That is not the case today.  Americans have had a negative savings rate for some period of time now, and a gigantic rise in interest rates would put have this economy with negative double digit economic numbers for years to come.  Anyone holding adjustable rate lending instruments, or anyone who requires access to short term lending facilities (that’s includes ALL of corporate America) would be simply done for.

So you’ve heard me mention a collapse in the U.S. dollar as well as the U.S. banking system.  Am I being a little extreme?  Absolutely not; I call it how I see it, and for the above mentioned reasons; do you really think that there will be any faith in the dollar or the banking system?

Some people look at me as a guy who sees the cup half empty.  That’s not the case at all.  I’m a “that same cup is going to cost you a $1000 before this is all said and done, and that’s if the store clerk is still accepting U.S. dollars” kind of guy.

This economy is simply the result of over 70 years of Keynesian economic theory beginning to exhaust itself.  These are not only the theories practiced by our economic leaders, but these are the theories taught in the economics courses offered by our college courses…the same college courses I took.  We had a near implosion as a result of these theories in the early 1980’s, but it is my firm belief that we won’t be so lucky this time.

Nicholas Jones
Analyst, Oxbury Research

Disclosure: none