Inflation occurs when there is either an economically inept government (as there is now in Venezuela, Iran and Here) or a massive deterioration in the terms of trade for the country concerned. Inflation, by eroding the value of incomes and savings, allows the adjustment to much lower living standards to occur with less disruption than if the burden was borne entirely by soaring unemployment and bankruptcies. UNFORTUNATELY We are now in the worst of all worlds.
The period of inflationary recession, STAGFLATION, will thus resemble neither the 1930s, in which those who kept their jobs found their savings and their living standards greatly improved, nor the 1970s, where lack of competition allowed powerful unions to extract rents for their members. Job holders will find themselves receiving little or nothing in pay increases because the labor market will be slack, while unions that attempt to keep up their members’ living standards by going on strike will find their employers locking them out to avoid bankruptcy (their bargaining position being greatly improved by the large pool of available unemployed labor). As for the public sector, we are already seeing a massive political backlash against automatic public sector pay and pension increases, which is likely to intensify as inflation increases and government revenues decline.
Meanwhile the FED will keep interest rates far too low because of the recession, allowing inflation to soar and shrinking the real value of the US capital base, while mammoth public sector deficits crowd out private sector investment. In that case, apart from the very real possibility of a US Treasury default, the US downturn will intensify, as its capital endowment is hollowed out by inflation and public borrowing, while its competitiveness is reduced by a bloated public sector. We might then see a downturn lasting a decade or two and a reduction of 30% or even 40% in real US wages. The US will most likely, be in a period like the early 80′s, a prelude to hyperinflation.
The prospect ahead is thus uniquely gloomy. Part of the gloom is caused by a natural and unavoidable change in the terms of trade, making a reduction in US living standards inevitable. However, most of it can be ascribed to wrong-headed policies pursued by the four horsemen of the Financial Apocalypse, Obama, Greenspan, Geitner and Bernanke. Meanwhile, the next recession and bear market are already baked into the cake. And we should expect a test of the March 2009 lows in the not too distant future.
The Stock Market Has Become Fatally Expensive
Stock market history holds another insight for us. The market moves in long-term cycles from undervaluation to overvaluation and back again. After the bubble burst in 2000, the market never reached levels historically associated with undervaluation. Not at the depths in 2002 – not in March 2009; therefore, I fully expect the secular bear market that began with the bursting of the stock market bubble in 2000 to push valuations down to historically undervalued levels. That is single-digit P/E ratios and dividend yields around 6% or more as was the case in 1974. And all this could happen within the next 12 to 24 months, driving the indexes significantly below their March 2009 lows.
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