A 12-point recommendation list will fix numerous structural problems, create lasting jobs, and reduce the deficit.

Midst of Deflationary Collapse or Brink of Inflationary Disaster? 12 Recommendations

As I've often said, sometimes it is better to just post what someone else has written much more eloquently than I could do so. the following is an article by Mike (Mish) Shedlock. He does an excellent job of not only explaining the state of economic affairs now, but further, he offers concrete ideas on how the U.S. can begin to get our economic house back in order. Additionally, I've often expressed a concern about the foundations of inflation being sown because of the Fed's "crank up the money printing presses" mentality. My thought should always be expressed with a caveat: in order for inflation to get going, it is necessary for banks to lend money. Well, banks aren't to anyone except the BEST of credits.

Credit Cycle Understanding Is Key to Returns

It is very refreshing to see someone else writing about debt deflation and how powerless the Fed is to stop it. Instead, we see article after article by people touting high inflation, even hyperinflation.

Hyperinflation is complete silliness at this point. Were it to come, it would be an act of Congress that would create it, not an act of the Fed, and the Fed would probably have to play along (though I doubt it would). For all its many faults, the Fed does not want to destroy banks. Hyperinflation would do just that.

The Republican-dominated House wants little or nothing to do with more stimulus. Certainly US government debt is going to mount, but it is going to mount in Japan, the eurozone, and the UK as well.

Moreover, eurozone structural issues matter now, while US government debt will matter more in the years to come.

Midst of Deflationary Collapse or Brink of Inflationary Disaster?

Although the Keynesian and Monetarist economists have missed the boat on what is happening and why, Austrian-minded folks who fail to understand the importance of credit and how little the Fed can do to revive it have blown the call as well.

It pains me to see articles like On the Brink of Inflationary Disaster by Austrian economist Robert Murphy.

Clearly we are in the midst of a deflationary collapse as noted in Yes Virginia, U.S. Back in Deflation; Inflation Scare Ends; Hyperinflationists
Wrong Twice Over.

Focus on Money Supply Alone Is Fatally Flawed

Deflation is about credit; it is also about attitudes that govern the demand for credit.

As I have stated many times over the years, and in the Contrary Investor article, there is nothing the Fed can do to force businesses to expand or banks to lend.

That point explains why Austrian economists who focus on money supply alone have failed and will continue to fail.

Until consumer demand returns, businesses would be foolish to expand. Unfortunately, the Fed's misguided easing policies have stimulated commodity speculation, thereby increasing manufacturing costs, while simultaneously clobbering those on fixed incomes and reducing final consumer demand.

I wrote about the plight of those on fixed incomes in Hello Ben Bernanke, Meet "Stephanie" back in January. Please give it a read if you have not yet done so.

The Deflationary Hurricane of Deteriorating Social Mood

One of the best posts recently on social mood and deflation is by Minyanville contributor Peter Atwater.

Please consider The Deflationary Hurricane of Deteriorating Social Mood

This morning, in the aftermath of Fed Chairman Ben Bernanke’s speech on Friday, the editorial page of the Wall Street Journal noted, “Mr. Bernanke also lectured that ‘U.S. fiscal policy must be placed on a sustainable path,’ though not by cutting spending in the short-term. So the Fed chief joins the Keynesian queue of spending St. Augustines – Lord, make us fiscally chaste, but not yet.”

Everything we need to do for long-term economic, if not societal success and stability comes with very severe short-term consequences. And so the response of most policymakers (and not just those responsible for fiscal policy but also regulatory policemen like Mr. Bernanke himself) has been to advocate for short-term expansionary programs and rules, while postponing the real teeth of necessary change until some later date in the future. Basel III, for example, has a phased-in capital-strengthening requirement for the banking system that does not finish until 2019 – again, "chaste, but not yet."

I am sure that what is behind the thinking of policymakers is the notion that if we can just get through this tough “transitory” period, the economy will turn up; and at that point, whether it is fiscal or regulatory policy, our ability to handle constraints will be much, much easier to bear.

After 11 years of declining social mood, the notion that further monetary stimulus has limited use is hardly a surprise. As I have cautioned so many times, when it comes to the consumer it is not the depth of a recession that matters, but rather its length. And while for policymakers and financiers this may feel like a three-year-old recession (and for some even just a three-week-old recession!), for the American consumer this is a decade-old recession that has deteriorated well into a depression. The average American is now financially and emotionally exhausted. And given the news reports out of Washington over the past month, they are also now afraid that they are at risk of losing some or all of their government safety net, too. Like the children of fighting, divorcing parents, they are now fearful of what an increasingly uncertain future holds.

While further fiscal stimulus – particularly job-related initiatives – may slow the pace of deterioration, I am increasingly afraid that further fiscal and monetary policy actions are now impotent agents against our current social mood. Where in 2000, the future was so bright that we’d need shades, in 2011, the future for many Americans is so dark that they can’t see their way forward.

The consequence will be price deflation -- and not just further price deflation across those debt-dependent purchases like homes and automobiles, but across all categories of consumer goods. And for the first time since the 1930s, American businesses will see that lower prices are not always met with greater demand.

Price Deflation on the Way?

My definition of deflation is "a decrease of money supply and credit with credit marked-to-market." Judging by symptoms of deflation and the Fed's efforts at fighting it, the US is back in deflation now by my measure. In my model, falling prices are not a requirement for deflation.

The important point is not definition, but rather the expected conditions. Yet, the conditions I expect -- and indeed the conditions in the US right now (in aggregate) -- match deflationary scenarios, not inflationary ones.

Murphy calls for an "inflationary disaster" while Atwater calls for "price deflation across all categories of consumer goods."

I do not know if we see across-the-board price deflation Atwater calls for given peak oil constraints and an inept US energy policy that also affects food prices.However, I do expect to see falling education costs and medical costs as well as falling prices in a broad array of consumer goods and services, especially if Republicans can get a few sensible deficit measures passed.

Whether that scenario happens or not, the idea "brink of inflationary disaster" is complete silliness unless and until the Fed can revive credit, yet the Fed is powerless to do so.

So, unless Congress goes really haywire, attitudes will change and deleveraging will play out before the US experiences serious inflation. Unfortunately, Fed and Congressional policies have only served to lengthen the deleveraging timeline.

Those looking for hyperinflation or even strong inflation have missed the boat again, and again, and again, and will continue to do so, interrupted by periodic inflation scares until debt-deflation plays out.

Understanding the Deflationary Cycle

To understand what is happening, why businesses are not hiring, why housing is stagnant, and where the economy is headed, one needs a model that takes into consideration five key factors:

1. Mark-to-Market Measures of Bank Credit and Capitalization Ratios
2. Credit Cycle Theory
3. Attitudes of Banks, Businesses, and Consumers
4. Futility and Limits of Keynesian Stimulus
5. Futility of Monetary Stimulus

1. Mark-to-Market Measures of Bank Credit and Capitalization Ratios

Banks cannot and will not lend unless they are not capital-impaired and unless they have credit-worthy customers. Atwater noted Basel III was delayed until 2019. I noted on many occasions banks are still hiding investments off the balance sheets in SIVs, and mark-to-market rules have been suspended several times.

As happened in Europe, delay tactics can only work for so long before the market questions if loans on the balance sheets of banks will ever be repaid. That time is now, not 2019. Thus banks are too capital-impaired to take excessive risks, even if they wanted to. Moreover, too few credit-worthy businesses want to expand in the first place. 2. Credit Cycle Theory

In accordance with long-wave, Kondratieff Cycle (K-Cycle) theory credit expansion and contraction cycles play out over decades. At least 75% of the time, continuously (not on and off), the economy grows in an inflationary manner. When deflation hits, few expect it because all that many have known for their entire lives is inflation.

As long as consumers have ability and willingness to add debt and leverage, the Fed seems to have power to revive the economy via various stimulus efforts. Once a consumer deleveraging cycle starts, the Fed's power ends.

3. Attitudes of Banks, Businesses, and Consumers

The willingness and ability of banks to lend and consumers to borrow and increase leverage is shot. Banks don't want to lend (or are to capital-impaired to lend), and boomers are heading into retirement overleveraged in housing, without enough savings.

Consumers first thought tech stocks would be their retirement, then housing. Both dreams have been shattered. Consumers are now determined to pay down debt (saving), even if by outright default or walking away. Default and walking away impacts banks' willingness and ability to lend.

Think of attitudes like a pendulum. Attitudes can only go so far before they reverse. Housing reversed in 2007 as did the Nasdaq in 2000. Both reversed when the pool of greater fools ran out.

The Nasdaq is still nowhere close to old highs. These cycles last longer than most think. I expect housing will be weak for a decade once it bottoms, and it has not yet bottomed.

Finally, it's not just boomer attitudes that affect credit. Kids see their parents and grandparents arguing over debt, worried about bills, worried about jobs and vow not to repeat their mistakes. This point ties in with K-Cycle theory above.

4. Futility and Limits of Keynesian Stimulus

Keynesian economists always want more, then more, then still more stimulus until the economy heals. Japan with debt-to-GDP ratio over 200% has proven such policies cannot ever work.

Keynesian economists always refuse to discuss the endgame, how the debt can be paid back, and what happens when stimulus stops.

The US has virtually nothing to show for all the make-shift, ready-to-go projects that temporarily put people back to work in 2009 and 2010. Not only did we repave roads that did not need paving, those hired still have debt-overhang and are still underwater on their houses.

All that happened was a delay in the day of reckoning. More Keynesian stimulus will only further delay the day of reckoning while adding to the national debt and interest on the national debt.

Priming-the-pump Keynesian theory will fail every time in a debt-deleveraging cycle. Indeed, it never works; it only appears to work until debt leverage is maxed out.

5. Futility of Monetary Stimulus

As discussed above, monetary stimulus negatively affects the real economy for the temporary benefit of the financial economy and Wall Street. The trade-off was not worth it except through the perverted eyes of Wall Street.

Telling action in bank stocks says the limits of helping Wall Street may have even run out.

Many point to excess reserves as a sign of future inflation. I point to excess reserves as a sign of failed Fed policy. Commentary from Austrian economists shows they fail to understand how credit even works.

The idea that those excess reserves are going to pour into the economy in a 10-1 leveraged fashion is simply wrong. Banks do not lend when they have excess reserves. Banks lend when they have credit-worthy borrowers, provided they are not capital-impaired.

It is time Austrian economists finally wake up to this simple economic truth.

Academic Theory vs. Reality

Economists of all sorts stick to failed models.

• The Monetarist want more monetary stimulus even though it is counterproductive
• The Keynesians simply will not admit end-game constraints
• The Austrians, for the most, part either ignore credit or incorporate failed models of credit expansion into their theories

Each camp points the finger at the others as to why the others are wrong. Ironically, none of the camps seems to understand the combined mechanics of debt deflation, deleveraging, and attitudes.

That said, I side with the Austrians about what to do (essentially, let things play out, while implementing much-needed structural reforms).

Twelve Specific Recommendations

1. Banks and bondholders should take a hit. Banks are not going to lend anyway so bailing them out at the expense of taxpayers is both morally and economically stupid. End the bailouts, all of them, and prosecute fraud -- the higher up, the better.

2. Implement serious bank reform now, not nine years from now. Banks should be banks, not hedge funds. This proposal will necessitate breaking up banks. So be it.

3. Scrap Davis-Bacon and all prevailing wage laws. Such laws drive up costs and have wreaked havoc on many cities and municipalities now bankrupt or on the verge of bankruptcy.

4. Pass national right-to-work laws. Once again, we need to reduce costs on businesses and local governments to spur more hiring and reduce costs.

5. End collective bargaining rights of all public unions. The goal of unions is to provide the least service for the most money. The goal of government should be to provide the most services for the least money.

6. Scrap ethanol policy and end all tariffs.

7. Legalize hemp and tax it. Prison costs will go down, tax revenue will grow, and biofuel and fiber research will expand as hemp produces very soft fibers.

8. Corporate income tax rates should be lower in the US than abroad. Current policy encourages capital flight and jobs flight via lower tax rates on profits overseas than in the United States. This penalizes businesses that work only in the US, especially small businesses that do not have an army of lawyers and lobbyists.

9. Stop the wars and set a plan to bring home all US troops from Iraq, Iran, and 140 or so other countries.The US can no longer afford to be the world's policeman.

10. Implement Paul Ryan's Medicare voucher proposal. It is the only way so far that anyone has proposed that puts much-needed consumer "skin-in-the-game" that will reduce medical costs.

11. Legalize drug imports from Canada.

12. End the Fed and fractional reserve lending. Both have led to boom-bust cycles of ever-increasing amplitude.

Those are the kinds of things we need to do, not throw more money at problems. The latter does nothing but drive up national debt and interest on the nation's debt for short-term gratification.

Notice how counterproductive Fed policy is and how counterproductive Obama's policies are.

The Fed wants positive inflation but businesses have not been able to pass the costs on. Instead, companies outsource to China. Those on fixed incomes get hammered.

Fool's Mission

Obama wants to create jobs via stimulus measures. This is a fool's mission.

Prevailing wages drive up the costs, few are hired, and the cost per job (created or saved) is staggering. Money never goes very far because the US overpays every step of the way.

Stimulus plans that do not fix the structural problems are unproductive. Then when the stimulus dies, which it is guaranteed to do, a mountain of debt remains.

Instead, my 12-point recommendation list will fix numerous structural problems, create lasting jobs, and reduce the deficit.