A while back I wrote about inflation and asked whether or not inflation is inevitable. I actually shopped the post out to a few people I thought may have an informed opinion on the subject and the feedback I got was positive. Positive in that they felt I was grappling in the correct direction, not that inflation is a good thing.

I've also written a number of times about what I've called the "government bubble", the bubble of financial interdependency that is going to burst when the federal and state governments are forced to reduce spending levels. The focus of this blog is on towns and neighborhoods, so understand that my observations on the government bubble deals primarily with municipalities. Our discussions here on the social policies of health care, education, social security, etc... are limited to the notion that a) they are expensive, and b) at the end of the day they are likely to be a higher priority than continued central funding of the local growth Ponzi scheme. Those facts seem self-evident.

I'm in the middle of reading Nouriel Roubini's Crisis Economics: A Crash Course in the Future of Finance and so my mind is channeling various economic theories. As a non-economist, it is fascinating and maddening at the same time. If you ever wondered why economics is known as the "dismal science", you can start by reading this "uplifting" analysis from the UK Telegraph on where we are at in the current crisis.

Let us be honest. The US is still trapped in depression a full 18 months into zero interest rates, quantitative easing (QE), and fiscal stimulus that has pushed the budget deficit above 10pc of GDP.

The share of the US working-age population with jobs in June actually fell from 58.7pc to 58.5pc. This is the real stress indicator. The ratio was 63pc three years ago. Eight million jobs have been lost.

The average time needed to find a job has risen to a record 35.2 weeks. Nothing like this has been seen before in the post-war era.

And we dismally seem to be at a loss as to what to do about our current position from a macro sense. I heard a Democrat this week invoking supply-sider Jack Kemp in calling for stimulus because, in a paraphrase of Kemp's words, "If you fix the economy, the other problems become easier." This seems obvious, but can the economy be fixed?

It seems that the consensus best-case situation is that we slay three beasts on our way to renewed, albeit far more modest, prosperity. That would be (in order):

  1. Deflation,
  2. Default, then
  3. Inflation

There are real legitimate concerns right now that we are in a deflationary spiral. Deflation is where prices fall - a dollar all of a sudden can buy more goods than it could before deflation. 

Look at housing. With rising unemployment, foreclosures increase. The number of bank fire sales has added housing stock to a market that already lacks buyers. This drives prices down. Falling prices put more mortgages underwater and increases the default rate. This begets yet more fire sales combined with fewer and fewer people that can afford to buy a house. Prices continue to deflate in a self-reinforcing cycle. Further investment is stifled and people and businesses hoard cash because there is a very real possibility they may need it, especially if they are leveraged in any significant way.

As reported in the Wall Street Journal,

Two Federal Reserve officials Wednesday gave a dim view of the U.S. economy, saying it isn't yet strong enough to warrant interest rate increases and that credit growth is likely to be restrained for years.

The remarks come amid growing signs that the recovery may be losing steam and serve as a counterweight to more optimistic comments about the recovery made by other U.S. central bank officials earlier this week.

Atlanta Federal Reserve President Dennis Lockhart Wednesday warned the recovery remains so weak that deflation--or a dangerous generalized drop in price levels--is a risk that warrants watching.

Paul Krugman has been arguing for a long time that more federal stimulus is needed to stop this cycle of deflation. The idea is to put money in the market so that people can consume and stop the negative feedback loops before they take everyone down. So why are we not spending more? Krugman explains,

The Fed seems aware of the deflationary risks — but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity — but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments, that austerity is coming anyway, in the form of budget cuts at the state and local levels.

Austerity. Getting real with our financial situation. There is no question we have too much debt and that is at the core of our problems. We are that family wound tight with debt, overspending in the good times in the belief they will never end and overspending in bad times because they are over committed. If we could have those decades and trillions back, I am guessing we would do things differently today. God help us if that is not true.

So we get the economy moving by spending more, which really means borrowing more. This puts us on a tightrope where default - and the significantly higher borrowing costs for everyone that would accompany default - becomes a real concern.

If there is a municipal default - a state or major city - it casts doubt over all municipal debt. Doubt means risk which translates into higher interest rates. Higher interests rates means greater debt payments which increases the likelihood of - you guessed it - default. Another self-reinforcing spiral that we need to find a way to avoid.

From an article in the Financial Times,

“The risk in the second half of the year is that investor attention switches from Europe to the US,” said Robert Parker, senior adviser at Credit Suisse Securities, who singled out parts of California, as well as towns and cities in Illinois, Michigan and New York state as among the most vulnerable.

“You will see investor concern about the viability of those cities and therefore you will see, inevitably, further spread widening in the municipal bond market.”

If these market swings are sustained, they could push up borrowing costs for local governments, which, in turn, could exacerbate the squeeze on local authority finances and place more stress on the federal budget.

The Wall Street Journal had a tremendous article that details the financial dealings of many states and local governments that make them quite prone to default. From the article:

Governments have loaded up on debt, stretched out repayment times, and used slick maneuvers to avoid constitutional borrowing limits. While the country's economic troubles have helped expose some of these practices, a sharp decline in tax revenues has prompted more abuse as politicians use long-term debt to kick short-term fiscal problems down the road.

But state and local governments can't really default, can they? They will just tax people more, but they will make their payments? An article in the Economist suggests that politics, not economics, will govern the ultimate decision:

That New York even tried to force a restructuring on creditors, albeit New York City’s, illustrates that the threat of default is primarily not economic, but political. With revenue plummeting, legislatures and governors are often unable to agree on spending cuts or higher taxes to narrow the gap. California’s dysfunctional politics are a big reason why Moody’s rates California only a few notches above junk. “This is the seventh-largest economy in the world—it’s not an ability-to-pay issue,” says Robert Kurtter of Moody’s.

Believe this really can't happen? Take a look at what is currently going on in Illinois.

Even by the standards of this deficit-ridden state, Illinois’s comptroller, Daniel W. Hynes, faces an ugly balance sheet. Precisely how ugly becomes clear when he beckons you into his office to examine his daily briefing memo.

He picks the papers off his desk and points to a figure in red: $5.01 billion.

“This is what the state owes right now to schools, rehabilitation centers, child care, the state university — and it’s getting worse every single day,” he says in his downtown office.

Mr. Hynes shakes his head. “This is not some esoteric budget issue; we are not paying bills for absolutely essential services,” he says. “That is obscene.”

At the city and town level, there are already examples of cities on the brink about to embark on bankruptcy.

So we avoid the peril of deflation by borrowing and spending. Then we avoid the peril of default by ensuring that we don't borrow too much - just enough to get us moving but not enough to push us over the edge. If we avoid those two minefields and things start moving again, we then face the third peril: inflation.

Inflation is the situation where too much money is chasing too few goods. We could solve the housing deflation crisis right now by giving every family a $500,000 voucher to put towards a house. But what would happen to home prices? They would artificially inflate. You would not now be able to sell your double-wide trailer for $50,000 and buy that half-million dollar house up the road. That half million dollar house would now be worth a million and your trailer, likely around a half million.

So you would have more money, but everything would cost more. With inflation, your purchasing power does not increase, but the value of your money decreases substantially. As I wrote previously, inflation punishes those that save and have invested wisely. It discourages lending. It creates mass instability in the market.

But if we continue to borrow money - stimulate the economy, bail out municipalities - along with the other things we are doing to shore up bank balance sheets like the Fed policy of "quantitative easing", we will inevitably deal with inflation.

In this CNBC clip, Nassim Taleb, one of the thinkers I listen to most closely, talks about the likelihood of inflation and hyper-inflation.

And here is another good CNBC interview with an economist from the UK reacting to Taleb's assertions and the fine line we are walking.

Deflation, default, then inflation. Can we defeat these three beasts in sequence?

Wouldn't it have been better if we didn't have to find out? No matter the outcome of this crisis, our mindset needs to shift to a Strong Towns approach from top to bottom. Resilience needs to replace growth as the goal of our economic policy, from the federal government down to the smallest town.


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