08/12/2012 09:16 pm ET Updated Oct 12, 2012

An Inflation Inflection and the Best Trillion We Shouldn't Spend

In the 1960s, Valéry Giscard d'Estaing, then the French Minister of Finance, coined the term "exorbitant privilege" to refer to the special benefits enjoyed by the USA by virtue of the fact that it is the issuer of the world's reserve currency.

Most Americans remain largely unaware of what these short-term benefits are and the long-term fall for which they have set us up.

Pre-1971, it made sense for countries to hold dollars as foreign reserves because the dollars were theoretically backed by gold. Although Nixon nixed that, commodities are still priced and purchased in USD. Therefore for reasons of both history and economic convenience, 60 percent of all of the world's allocated foreign currency reserves are in USD. (The second most held reserve currency is the euro is far behind, representing only 27 percent of all foreign reserves.)

This state of affairs has enabled the U.S. to live well beyond its means for decades, and there is an increasing, even if still faint, awareness throughout the land that at some point the Piper will have to be paid. Many concerned people, and especially those of the "sound money" persuasion, have been expecting inflation for some time, and indeed, the rise in the prices of such commodities as silver, gold and other commodities over the last few years are suggestive.

However, independent analyses have not indicated that the prices of everyday goods have increased significantly -- yet: for example, the excellent "Billion Prices Project," based at MIT, which tracks prices of goods from hundreds of retailers in close to real time is showing inflation at about 1.2 percent per annum since 2008. Wherever the real figure lies, we're certainly not yet at runaway inflation in the United States.

So were the worriers wrong to have been expecting inflation -- or is it really coming? The answer depends largely on an understanding of stocks and flows and sector balances.

Whereas people have in recent years become increasingly concerned about government's ability to print money (conflating here the Federal Reserve and government for ease of explanation), most do not realize that in our modern monetary system -- with its FIAT currency with government as monopolistic issuer -- Uncle Sam actually spends money into existence whenever it buys services or goods from the private sector. Counter-intuitively, when the government's check to Boeing for a warplane or its welfare check to John Doe clears, Boeing's or John's private account gets credited and the money is created in the private sector -- without the creation of an offsetting liability. Since the government is the currency issuer (with the help of the Fed, which handles the mechanics of the process), it does not need to keep a savings account that contains the money it spends. Indeed, when the government collects U.S. dollars -- through taxation or borrowing -- that money is not saved anywhere in the normal sense: it just disappears from the private account of the tax payer or creditor without the appearance of an asset in a government savings account elsewhere. Put simply: If you can create money, why save it?

In a very real sense, then, the very act of government spending is inflationary -- and this fact begs the question: Since the government is only taking in about 57 cents in tax revenue for every dollar it spends (as it is currently doing while running its huge public deficit), why aren't we seeing all that massive inflation as this new government-spending-created money sloshes around the private sector?

Good question. And the answer is telling.

For decades until 2009, all of those government-created dollars were being spent by Americans to buy foreign goods. In other words, Americans sent the government-created dollars out of their own private sector, putting them in the hands of, for example, Chinese exporters in the Chinese private sector. These Chinese businessmen swap the dollars (which they can't spend or use to pay taxes in China) for the Chinese Yuan, which they can spend and pay their taxes with, so the U.S. dollars end up in the hands of the Chinese government (all three trillion of them). Meanwhile, the Chinese, in this case, suffer from inflation through the creation of their own currency that their government creates and swaps for those USD in the hands of private Chinese exporters.

The net effect is that the inflation that would otherwise be created by the U.S government's massive over-spending into the U.S. economy is exported to China (and any other partners who have a trade surplus with us), and so the standard of living of Americans increases at the expense of improvements in the standard of living of Chinese.

The extent of this phenomenon -- the emptying of U.S. dollars from private Americans ultimately to foreign sovereigns -- is measured by the trade deficit, which, like the public sector deficit, has been huge for a long time.

The creation of money by government spending doesn't contribute to inflation as long as foreigners are willing and able to take the American dollars out of American hands... but when they stop being willing or able, the game changes -- as every deficit dollar spent by the U.S. government stays at home, and becomes American inflation.

That started happening in 2009, when the U.S. federal deficit for the first time in decades exceeded the trade deficit, meaning that the government (USG) became a net-emitter of over three times more dollars than the US economy could emit to the rest of the world.

By turning the cash it spends into the private economy into non-spendable Treasuries, the government drains those spendable dollars from the economy, holding off the inflation that could otherwise ensue."

Is it possible, then, that we don't have inflation, but have crossed a Rubicon toward it?

There will come a time -- it may already be upon us -- when all the American recipients of govt-printed dollars don't want to buy Treasuries with them any more. Indeed, if you were a banker (a likely ultimate beneficiary of current excessive government spending), why would you want to buy a piece of paper that can only be redeemed in the future for dollars of reduced value when, alternatively, you can buy real assets at knock-down prices that will hold their value? As more holders of cash wealth make that realization, government will no longer be able to drain the money it has created out of the system; asset prices will move up, and the inflation will take hold for everyone to see.

When that happens, not only the things that we buy as citizens, but also the things that the government buys, become more expensive. That gives our politicians two choices: either spend whatever it takes to buy what they think government needs, causing more inflation, and so on in a spiral out of control as every dollar it spends remains in the U.S. private sector (as has been the case since 2009), or stop the destruction by cutting out all that federal spending that is not offset by revenues (currently 1.3 out of 3.6 trillion or 36 percent).

I suspect they'll stick with the devil they know.

But whether they do or not, with the economic turmoil and consequent social upheaval that this nation would then be facing, the one trillion dollar govt. real budget cut that Ron Paul has proposed to stop the death spiral might, with the benefit of hindsight, look like the best trillion the country shouldn't have spent.