The Fed recently announced it will buy up $300 billion in long-term Treasury bonds and spend $750 billion more buying sub-prime mortgages from big banks. Given the $3.6 trillion budget President Obama plans, the $1.8 trillion in deficits he will run and the trillions the Fed is pumping into the economy, there is real risk we will have an inflationary spike in the future.
It is important to understand that what the Federal Reserve is currently doing does not involve literally printing money but extending credit, and that credit can eventually be withdrawn. If at some point the Federal Reserve reduces the money supply by withdrawing that credit or raising interest rates, and if they do that with opportune timing, inflation would be contained. But if they do not handle this delicate assignment correctly, we will not be able to save ourselves from inflation's devastating effects.
Inflation, described as too much money chasing too few goods, edaciously consumes capital and erodes the value of cash, savings, stocks and bonds. By eating away at the value of a currency, inflation punishes savers and creditors and rewards debtors. It is a de facto tax.
But it is a far more devastating tax than anything enacted by Congress, because it does not need approval from legislators. A man with a 5% saving account is going to be in exactly the same financial position if he pays 100% tax on his interest income with zero inflation, as if he pays no income taxes with 5% inflation. A tax rate of 100% on interest income will drive people to violent protests and be considered outrageous, but people would usually not complain about 5% inflation. Yet the truth is, either way they are taxed in a way that leaves them no real income.
Indeed, debasing the currency is the best way to destroy a capitalist system. Unfortunately, as the world's biggest debtor, the US has plenty of incentive to debase its currency and pay off the debts in cheaper dollars. Gold prices more than tripled over the last decade. This is already telling us the market thinks the dollar has been abandoned by the Fed.
It is no wonder therefore, that the Chinese are worried about the Dollar as the world's reserve currency. Rather than endure the pain and accept the sacrifices to cure us of our addiction to leverage and excess spending, we are going back to the same infernal behavior that brought us to the precipice of this financial crisis.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at firstname.lastname@example.org.
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