By understating inflation, our government has been able to create the illusion of an economic "recovery." In fact, their "positive economic growth" number is created by counting inflation as GDP growth. However, when inflation is measured in the old way (the way it was measured before Clinton's presidency), it becomes clear that the US has experienced no real GDP growth in the 21st century. In other words, in reality we have had a decade of no growth in GDP -- while being told otherwise. And all the while, the "presstitutes' in the media have gone along with the official ruse and deception, and, like the good cheerleaders they are, have proclaimed "recovery."
So why is this a problem?
The government's somewhat rosy forecasts of its budget deficits are based on the aforementioned assumption that an economic recovery is underway. But if in fact there is no recovery, and the economy is about to worsen, then the trillion-dollar-plus deficits, which the government forecasts for as far as the eye can see, will be even larger than they otherwise would be. And since more debt creation will eventually require more in the way of inflationary money creation by the Federal Reserve (which creates all the money the economy needs . . out of thin air), the future purchasing power of the US dollar will eventually be quite dismal, as all that money creation accumulates into an amount that cannot help but be inflationary. (Ever more dollars chasing a fixed amount of goods and services equals inflation.)
The federal government's reckless issuance of debt in order to finance its hegemonic wars, and the Federal Reserve's misuse of its authority to create $16.1 trillion in secret loans to US and European banks (as revealed by the recent GAO audit of the Fed) have created (out of thin air) an enormous number of new dollars. In addition, financial deregulation (the elimination of Glass Steagall) has resulted in banks creating paper claims (derivatives), on real assets, that far exceed the value of the underlying real assets. Obviously this is an untenable situation. See the explanatin that follows.
How is this to be resolved?
Derivatives like Mortgage-Backed Securities greatly exceed the value of the homes they are based upon (and from which they derive). Similarly, credit Default Swaps and other financial innovations (also being derivatives) have resulted in paper claims on assets that once again exceed the value of the underlying real assets from which they derive.
Consider Credit Default Swaps, a form of insurance that will supposedly compensate bond buyers in the event that a borrower (the country that issues or sells the bond) does not pay back this money that it has borrowed by way of selling the bond. Investors -- speculators, really -- do not have to own a Greek government bond or a mortgage-backed security (derivative) in order to purchase a "swap" (a kind of insurance policy) that insures its value. Therefore they are purchased freely in a kind of speculative marketplace or casino. Therefore, the total value of the associated "swaps' (insurance policies) issued on Greek bonds, for example, can far exceed the total value of the bonds themselves. Similarly, the value of swap/insurance issued on mortgage-backed securities can far exceed the total value of the underlying mortgaged real estate! Hence the total value of all derivatives in the world is in the hundreds of trillions of dollars.
Financial institutions such as US banks, which sold 'swap/insurance' on Greek bonds, are gambling that Greece is going to be bailed out and will not default. These financial institutions regard as gravy the super-abundant insurance fees or premiums paid to them for these "guarantees" (insurance policies) -- on which they now cannot possibly make good in the event that Greece does default on the bonds they've sold. (Like AIG during our last financial meltdown, they simply don't have the assets with which to cover all these guarantees, in the event that the underlying bonds (which people and banks bought and therefore invested in) go bad.
Furthermore, no one knows the total extent of the swaps insurance that has been issued on the sovereign debt of countries like Greece, Spain and Italy. However, we do know that the Bank of America alone has sold $2.1 trillion in swaps insurance on this kind of sovereign debt. Once again, keep in mind that these are insurance policies sold to those who purchased the bonds of countries like Greece, Spain, and Italy. So imagine the crisis that would be released upon us if the Bank of America had to try and pay off on all these swaps insurance policies in the event that Greece, Spain and Italy default on the bonds they have sold to investors! BofA and a number of other US banks would have to be bailed out by the Fed, just like AIG was, last time around. Only this time we're talking about a much, much larger bailout. And they know they would be bailed out, so they have no fear as to how many such derivatives they sell.
Therefore, if European sovereign debt blows up (i.e. if these countries default on all the bonds they've sold to investors), the US financial crisis will become much much deeper than it already is.
The recent GAO audit of the Federal Reserve showed that the Fed made secret loans to banks of $16.1 trillion between December 2007 and June 2010. To put that figure in perspective, this amount is larger than the US GDP and larger than the US public debt! This means that it's already taken a tremendous amount of new money to keep our financial system from collapsing. Yet despite this huge sum being pumped into the banking system, to prop it up, the banks are still regarded as weak and troubled. And the corresponding insecurity that bank depositors feel (regarding the money they have on deposit) is reflected in the very low, one basis point (1/100 th of a percent) interest rate on Treasury bill money funds, which most investors now feel provides a safer investment than having one's money deposited in a bank. (Essentially there is no interest and no return being paid by such T-bill money fund 'investments.') In fact, many Americans (and Europeans) are now even willing to receive a negative interest rate -- which means that they are essentially paying a small fee in order to have their money safely stored away.
When the paper claims (derivatives, like swap insurance) on assets exceed the value of the underlying assets, one solution could be slow write-downs (devaluations) of bad paper (bonds, Mortgage-Backed Securities etc.) over time, as the banks' growing profits permit. This would require suspending the mark-to-market rule , permitting the banks to remain "solvent." This would done by counting bad assets as good ones until growing profits permit write-downs (devaluations) of the bonds and MBSs that these banks hold.
This would be a sensible solution if the banks had profitable prospects. But with consumers too indebted and broke to borrow any more than they already have, and the consumer market too impaired to allow good sales prospects for businesses, what profitable prospects do banks have? Answer: No prospects other than those created by the Federal Reserve's support of the "carry trade," i.e. the ability of financial institutions to borrow from the Federal Reserve at essentially zero interest rates and then put this borrowed money into Greek and Italian sovereign debt (i.e. buy their bonds). This is of course a reckless kind of gambling, otherwise known as "casino banking." (Thank the elimination of Glass-Steagall for this.)
So, if the coming financial and economic reality precludes gradual write-downs, all that remains is bankruptcy or inflation. And since the Fed and the US government have ruled out permitting the banks to fail, that means another bailout along with the inflation that will eventually and inevitably follow.
The main legerdemain
Except for a relatively few indexed Treasury bonds, financial instruments are in nominal values. This means that bad debts can be inflated away by driving up the nominal values of the underlying real assets as well as driving up the nominal values of wages and salaries -- which means inflation. In other words, the path that policymakers are taking is to reduce the purchasing power of everyone's money in order to drive up nominal asset values, so that those values once again exceed the claims against them. (No need to cash in on the swap insurance (which the banks could never pay) IF the insured assets have not lost any value but rather have gained in value.)