MnMark wrote:According to your reasoning, no country would ever inflate in this situation. Because every country has holders of its currency who would be hurt by the inflation, so according to your reasoning, it should be politically impossible for any country to ever inflate. Yet they do, all the time.
I spent some time trying to figure out how to answer this in a way that hasn't already been done here. To do that, I'll have to start with this. Before on this forum, I've stated that no country in the situation of having the world reserve currency has ever been able to inflate their way out of a burst credit bubble despite heroic efforts to do so.
I understand this is not exactly what you are saying here. Basically I will first make the case that, historically, "no country ever could achieve the end result of inflation in this situation" even if they tried, which some did. I really don't know about the political impossibility of past historical situations. It does seem to me that the situation today could prove to be politically impossible, but even if it isn't, historical outcomes are not ultimately on the side of inflation in these instances.
Therefore, the premise is that countries that have been in the same situation as the US is now have historically tried to inflate their way out of a burst credit bubble, but have never been successful.
The 3 best examples that I can think of where a country had both the world reserve currency and a credit bubble are:
1. Britain 1720 (South Sea Bubble)
2. Britain 1825
3. Britain 1873
4. Britain 1772
5. Then of course we all know about 1929.
These are the only 5 I know of that fit this situation.
Number 1 fits our situation the most closely from an overall historical standpoint in my opinion. But in a lot of ways it's different too. One similarity, as John has pointed out many times on the website, is the fact that there was a generational unravelling period where the bubble was blown up even bigger and none of the other situations are similar in that respect, except for 1929. The others fall more into the K-Wave cycle. If I remember right, Britain and France had just been involved in The War of the Spanish Succession which ended around 1707 and both had piled up a lot of debt. This would be similar to the situation where the US and the USSR had been in the Cold War and both had piled up a lot of debt. Both Britain and France blew a bubble to try to work off the debt. I can't for sure remember the exact scheme but it seems like the British packaged the debt up and sold it as some kind of annuity in the South Sea Company, offering shares to the general public. Eventually the Mississippi Scheme blew apart first in France in 1719 and the result was hyperinflation. A year later, the South Sea Bubble collapsed and Britain, which had the world reserve currency, collapsed into deflation with the British stock market losing over 90% of its value in 2 years. In the current situation, the Soviet Union first blew apart and the result was hyperinflation. The US has been able to hold on for quite awhile with some of the new techniques Wall Street and Greenspan used to keep the bubble going but it appears it has finally blown apart.
Greenspan was quoted (if the source is authentic, which it seems to be) years ago saying that he knew K-Winter was coming and he was going to try to defeat it. The Central Bankers are getting better at holding off deflation after having had several go-rounds with it. Whether they will be able to defeat deflation here or not is a judgment everyone is going to have to make for themselves, but there isn't any historical precedent for making a judgment other than these 5 cases that I am aware of. The historical examples all say they ultimately can't inflate their way out.
Number 2 is interesting from the standpoint of some quotes I dug up from a source on the Internet regarding the great lengths that the British Central Bank had taken post 1825 to resurrect the bubble after it burst. They claimed to have tried everything they could come up with, but were unable to stop deflation.
Number 3 was a similar situation. A lot has been written about the post 1873 deflation and it was known as the worst deflation before 1929. I don't recall reading anywhere that inflation was attempted in this case, but it may have been. Again, Britain had the world reserve currency and the most notable thing I remember about the bursting of this bubble was that real estate prices fell every single year(!) for over 2 decades. The only price index I have for this period is for the US. Between 1873 and 1900, prices in the US fell 31% during this period.
Number 4 I haven't read enough about to comment.
Granted, the Central Bankers and governments today are much stronger than they were in the past and have some historical examples to work with. But in my view, their ability to hold off deflation only results in a bigger more unmanageable bubble that they are ultimately unable to resurrect.
Some of the other subjects to be addressed could be:
1. What do the US Treasury Bond holders really want? My guess is that they do not want the Fed to do quantitative easing. Russia hasn't said what they want besides to get the world off of the dollar standard, and I don't see how quantitative easing helps them get that, but a default probably would. More important than that is what China wants and I don't know the answer to that either. Russia has Topol-M SS-27 missiles pointed at Washington that are on hair trigger alert. The Chinese have nukes pointed at us too and have said they will use them. That may trump what the masses here want, which is quantitative easing, unlimited government programs, and so on. I mean, I really don't like making a statement like that, but power is what it comes down to. This situation hasn't existed before in history and seems to put a damper on Central Bank ambitions.
2. The Richard Koo argument that John has been putting forth for quite awhile here says that there will be enough domestic savings to finance the government debt because there is a 1 to 1 correspondence between domestic savings and what the government will need to borrow. I don't think Koo is right on everything, but it has to be considered that he might be substantially correct.
3. If the US needed to borrow money and could not get all the long term debt auctioned that they want to, then they can go down to the short end of the curve and auction it off there instead before going to quantitative easing. Granted, that is not really a solution and probably would not change anything in the long run.
4. Debt default will occur on corporate, municipal, commercial, consumer (credit card, auto, student loan), and prime real estate before it hits the US bond market. Post bubble episodes by definition always result in a widening of credit spreads as the market rushes to the relative safety of government debt. Government debt isn't safer than it was (before these other entities that are going bankrupt or have lost their source of income edge into default), just relatively safer, so that's where the money flows until the process is done. It hasn't been any different this time.
5. Finally, and this is an important subject that almost everyone seems to neglect when discussing this type of thing, is a large and sudden event outside the realm of economics. Pandemics, earthquakes, volcanoes, terrorist attacks, large industrial accidents, power grid lockups (due to solar flares or who knows what), and similar things that tend to occur generally during crisis periods or seem likely in this one tend to lead toward deflation and default because governments are unable to anticipate and instantaneously respond to them. At the beginning of each year, I try to take a fresh look at all of these events and add the probabilities of exceeding different dollar levels of loss according to expert opinions. It's a lot higher than one would think at first glance and seems to be increasing. This situation hasn't existed before in history from the standpoint of losses on the order of a trillion or more that have the potential to occur within a short time. Buffett (being basically an insurance man) pointed out a few years ago that the detonation of a nuclear device in a large American city is an almost certain occurrence within the next 50 years and his insurance policies specifically state that they don't cover it. Is such an event inflationary or would it tend toward default? My guess is almost definitely the latter.
Anyway, that's a start but it's not really complete. It outlines some of my thinking on the subject.