Continuing Coverage of the Spending Crisis . . . The Spending Crisis May Already Have Begun

For 15 years I have warned of a crisis of spending, debt and deficits, which I call the spending crisis because its root cause is spending. At first, I cautioned about a possible crisis and in recent years, a likely crisis. Once the debt ratio blew past 90%, it became an inevitable crisis. The only remaining questions are when will the crisis begin and how will it unfold. We know the crisis will not be transient and will result in a lost generation. It will end only when all excess debt is purged and taxes and spending are brought into balance, a lengthy and tortuous process that will transform America.

I often wrote that the crisis is likely to start suddenly and unexpectedly. I have used the example of a seemingly innocuous posting on Bloomberg going viral and, by the end of the day, the market for US government debt evaporates. That may still happen, but there is another – perhaps more likely – scenario. The crisis could begin stealthily and only in hindsight will we recognize it was the beginning of the crisis. There is, in fact, a very solid basis to believe that the spending crisis may already have started.

In chaos theory, complex systems like the US economy are inherently unpredictable. Small and seemingly insignificant events can lead to profound and non-linear impacts over time. In chaos theory, the butterfly effect is the sensitive dependence on initial conditions in which a small change in one state of a system results in large differences in later states, i.e. a small change in initial conditions cascades to a cataclysmic event. Thus, the present inflation could cascade into a life-altering crisis.

The true cause of the present inflation may not be monetary policy, but fiscal policy, i.e. spending, debt and deficits. When government debt exceeds what people expect can or will be repaid, they spend in the belief everything will be more expensive in the future. This drives up the price of all goods and services. If our present inflation is indeed being driven by fiscal policy – either entirely or in significant part – it can only be fixed via fiscal policy, i.e. higher taxes and/or draconian spending cuts. Further, that means that our present inflation is indeed signaling the start of the spending crisis

There are two, and only two, possibilities. The first is for the Fed to let inflation go unchecked, either intentionally or (more likely) by taking half-measures, i.e. to raise rates too little and/or too slowly. This will result in long term inflation which is the cruelest tax of all – and leads to social unrest and political extremism. This possibility will bring about the spending crisis. Of course, 100% inflation over say 10 years would cut the deficit in half. However, even halving the deficit would not end the crisis; the US still would be running a humongous fiscal deficit and would be back at square one.

The second possibility is for the Fed to jack up interest rates to counter inflation. To get inflation under control, interest rates must exceed the inflation rate. The last time the US had high inflation, the Federal Reserve had to raise rates to 20% to control 14% inflation. Imagine what would happen now if the Fed raised rates to say 15% to control our present inflation of 10%. That would cause a severe recession that adds many trillions to the debt. Moreover, it would not prevent the spending crisis.

Let’s recap. If the present inflation continues long term, social and political cohesion will disintegrate just as it has in other countries – the Weimar Republic comes to mind. If the Fed takes drastic action to halt inflation, that leads to a crisis as shown supra. Also, remember that if inflation is being caused by fiscal policy – it can only be fixed via fiscal policy. There is no way out of this situation. Either way, it is checkmate.

Following are the Five Main Takeaways

1. If something cannot go on forever, it won’t.
2. To tame inflation, the interest rate must exceed the inflation rate.
3. The crisis ends only after excess debt is purged and the budget is in balance.
4. If inflation is caused by fiscal policy, it can be ended only via fiscal policy.
5. At its heart, it really is a moral crisis; rather than control our spending, we chose to borrow from future generations – and for all the wrong reasons.

There is a solid basis to believe the spending crisis has begun, but we will know for certain only in hindsight. No bells will toll to announce the start of the crisis.