Inflation: The Magic Cure-all?

Chinese leader Wen's remarks put focus on U.S. Treasuries
USA Today – Investors this week may be watching the U.S. Treasury market a bit more closely than usual. Any heightened scrutiny would be thanks to Chinese Premier Wen Jiabao, who said Friday he was "a little bit worried" about the safety of his government's U.S. Investments. "We lent such huge funds to the United States, and of course we're concerned about the security of our assets

They have good reason to worry. Because, you can be sure, the Chinese have boned up on how the US got itself out of a similar mess back in the late 1970's. Back then the US was staggering under the massive debt built up by Lyndon Johnson's and Richard Nixon's “guns and butter” policies. Like George W. Bush, Johnson and Nixon were trying to fund and fight an very unpopular war – Vietnam.

And like George W. Bush the way Johnson & Nixon managed that tricky juggling act was by assuring Americans they would not have to sacrifice, that he could fight a war, not raise their taxes and boost domestic spending too boot.

To pull of such a stunt all three of these Presidents, had no choice but to borrow – and borrow, and borrow.

Much of that borrowing came in the form of the sale of US Treasury Notes (I.O.Us) By the time Jimmy Carter stumbled into office a lot of that debt, some held by US citizens, more held by other governments –  was coming due, and at the worst possible moment.

Two decades of profligate government spending and borrowing finally hit Main Street. Recession had set in, further eroding tax payments driving the national bank account further in the red. The economy was stagnant.

What to do?

What  they did back then was inflate the currency. The Federal Reserve turned on the presses and the money supply exploded. By 1978 gold broke through the $800 and ounce mark – adjusted for inflation, today that would equal $2591 an ounce.

Asset values soared. In California -- where at the time I was selling real estate -- home prices were increasing at a rate of 2% a month... or 24% a year.

There's your first clue.

Today US home values have declined by as much as 50% in some places today. Most of those homes have mortgages and a lot of those mortgages are underwater – meaning more is still owed on those homes than the homes are currently worth.

Which is one big reason so many lenders are in trouble. And home prices continue dropping. Just stopping that decline won't be enough to get lenders out of trouble. To truly fix the banks home values have to get back up as close to where they were before the crash – and get there fast.

To date the Fed has used every trick in it's toolbox without much affect. There's only one tool left that can pull off such a whiplash recovery;  inflate and inflate with a vengeance. Because at this point academic debates over what constitutes “true market value,” and "mark to market accounting, are all very interesting, but way too late in coming. Lectures on good fiscal hygiene are useless now. It's time for steroids.

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