WHY HASN’T THE FEDERAL SPENDING TRIGGER INFLATION?

According to the economic theories, when the government expands the spending, hot money will flood the Main Street, triggering more money chasing after relatively fewer products and services. The result was inflation. Now, the Obama government is waging unprecedented spending. The national debt has topped $13 trillion, which is 90.3% of GDP and $117,975 per taxpayer. However, there is no inflation. Why?

This is an interesting question, posted to me by a client. The answer is of critical importance to everyone as inflation impacts everything. For instance, if one can accurately predict the inflation, he could buy real-estate prior to its hitting, as inflation will become the most effective discount of the price that he pays. That is why inflation is known as borrowers stealing from savers, a bias that hurts the economy.

There are two ways that Obama gets the money to spend. First, he can borrow money from the market, i.e., bank, the Chinese government, private investors, etc., by issuing debt. Second, when nobody wants to lend to Obama, he can essentially print more money and keep on spending. The cost of first type of deficit spending is strangling private enterprises (because private enterprises will always lose in the competition as the government can always bit up the interest rate until it wins). The cost of the second type of deficit spending is inflation. Incidentally, the foreign entity’s purchase of the U.S. debt also has the inflationary effect.

Now, the heavy government borrowing coincides with the enormous tightening of the lending by the financial institutions after a financial crisis as they face an unpredictable financial reform bill. In other words, for now, the government spending is compensated by the financial institute’s tightening to the private enterprises, especially small business. The net effect is that, instead of the small business uses the money to create jobs, the government is using the same money to support its spending. The difference on Main Street is that people, when living on government benefit, are losing the skills that they have been relied upon to earn a good living. Obama’s bet is to build up people’s reliance on government welfare so he and the Democratic Party would build a stronger voting basis by creating a stratum of poor people.

A few weeks ago, Fed reported that the credit card lending standard continue to tighten after so many years. That makes the 11th quarter of continuous tightening. Over the past three months, 29% of banks reduced credit card limits, 27% raised interest rates, and 12% raised the minimum credit scores required for a credit card. Many truly small companies, such as small construction companies, heavily rely on their credit cards, typically with credit limit of $20,000, to run their business. They buy their materials on the credit cards and pay their workers and credit card company when they are paid. Now, people with that business model must figure out another way of doing business. Driving them out of market will force people to hire bigger, more unionized and more expensive companies. That is precisely another objective of Obama.

That is part of the reason that the current recovery is so much weaker than the normal recovery in history. Business, seeing opportunities, cannot undertake those opportunities because the finance is not there.

Let’s come back to the topic of deficit. The current government spending is unsustainable. The U.S. government debt as a percentage of GDP increased phenomenally under Obama. The administration’s hands will be forced to increase the middle class tax (because “soaking the rich” would not actually increase the government revenue). Since direct increase of income tax to the middle class is politically impossible. Some form of hidden tax, such as VAT (value-added tax, which is buried in the price of all products), is inevitable. The net effect of that is to take the money away from the middle class and pay for government bureaucracy, an undertaking that is not far better from simply borrow the money from the market.

Government is a monster. Once it gets money, it will build up vested interests, which will use the government, i.e., tax-payers, money to protect its interests. It is next to impossible for the unorganized “people” to defeat the concentrated and determined vested interests. That is the reason that the most basic educational reform is so difficult. That is also the reason that Fanny and Freddie become such monsters and still gobbling billions of dollars of the taxpayer’s money each month with no end in sight, as they pour some of those billions back to politicians to force their hands.

The critical moment is the people’s ability to vote in a government that will limit the spending and allow the banks to lend to individuals and businesses, rather than competing against the small business for the same money. There are enough laws on the book, e.g., the anti-monopoly law and the insurance law, for the government to break up the too-big-to-fail institutes, even when such too-big-to-fail is produced by CDS, conducted by AIG. Now, politicians are using the people’s frustration to build into the law, more ways for them to get the political donations from vested interests.

Before the high inflation hits an economy, typically there is a period of stagnation, where the investors’ confidence is low and the money is tight. With tight money, there would be no inflation. However, the mechanism of that is like a dam. Once the water burst out, nothing can stop it. That is the problem today. Greenspan used to make his influence behind the close doors to stop things from getting out of hand. Since Bernake took over, we have seen all kinds of problems in the financial system. All of them can be stopped by some phone calls.

The current path is obviously sustainable (just like a few years ago when the banks trying to loan money out regardless of the borrowers’ ability to pay, while few people seems to ask questions). If the government, including the White House, Congress, and the Federal Reserve, cannot make the change early next year, Greece today would be our tomorrow.

The breakout “moment” depends the moment that the water breaks out of the dam. That is always an impossible event to predict. However, the fact that breakout is going to take place, if we continue this path, is inevitable.