Britain Becomes the First to Choose Deflation

[Over the last three years, the Federal Reserve has conjured up trillions of dollars of funny money in an attempt to breathe some inflation back into the economy. The attempt has clearly failed. Now, it would appear, Britain has become the first country to throw in the towel on fiscal and monetary black magic. In effect, the country has decided to let deflation take its course, allowing the chips to fall where they may. In the essay below, "Cameroni," a frequent contributor to the Rick’s Picks forum, takes a close look at the decision and what it will mean not only for Britain, but the world. He concludes with a list that spells out what to expect, and the kind of pain we will experience as the world’s financial system comes very slowly back into balance in the years ahead. If his predictions are borne out, the standard of living is about to fall sharply for billions of people around the world RA]

David Cameron’s new Government in Britain announced Tuesday that it will introduce austerity measures to begin paying down the estimated one trillion (U.S. value) in debts held by the British Government. Lets let that sink in for a moment, for it is a stunning announcement. Now repeat it:  Britain will introduce austerity measures in order to eliminate the deficit and begin paying down the national debt. And that being said, we have just received the signal to an end to global stimulus measures — one that puts a nail in the coffin of the debate on whether or not Britain would “print” her way out of the debt crisis. That would have virtually guaranteed an eventual hyperinflation that would have spread to all Western nations, destroying the U.S. dollar as the world’s reserve currency in the process and ending several hundred years of Western economic dominance.

This is actually a celebratory moment although it will not feel like it for most. But wait. The U.S. did not say it would pay down its debts. And anyway, everyone knows that debt pile is too large to ever be repaid. They are wrong. And the U.S. does not need to send any particular message at this time anyway. The U.S. has been in a deflationary spiral since 2006, having discovered that nothing, not even oil flooding the Gulf, a nuclear North Korea threatening war, campaigns in Afghanistan and Iraq, nor threats that Israel might one day bomb Iran and shut down the oil pipe, can pump up energy prices enough to drive future inflation or save the economy the old-fashioned way. Not nearly enough to escape the gravity of the housing and asset collapse anyway.

‘Time to Rejoice’

We have run out of the ammo of cynicism and old-style politics. Debts will have to be paid. Creditor arrangements will be made, concessions granted, standards of living will decline and countries will be sent to the table to bargain in a cooperative effort to resolve credit imbalances. There will be horse-trades, payments out of key commodities and access granted where previously it has been denied. There will be recovery eventually and it is a better future than what a hyperinflation would bring us all. And yes, the bills will be settled. Time to rejoice.

To my way of thinking, the U.S. will not, cannot, resort to regular debt monetization, printing press economics or the eventual and guaranteed destruction of their currency, economy and way of life before attempting first to harness what appear to be insurmountable debts and obligations. That is particularly so if European nations and Britain (first among them) begin taking serious steps toward fiscal discipline and enacting measures of restraint. Many will argue against my theory. They will all be wrong.  And so the English have opted to go with the devil they know. They have chosen a path that means their economy will contract, perhaps significantly.  Unemployment will surge as public sector layoffs and the elimination of programs are required to harness the debt bomb are enacted, and all spending is carefully scrutinized, fleshed away, even eliminated.

Minimal Safety Net

Everything could conceivably be on the chopping block short of core government services, social service spending, basic medical services, pensions and the safety net itself. The debt is just so big that nothing less than all the efforts of Government and the cooperation of the majority of the public in accepting restraint will allow it to work. What does it mean in the wider picture when one of the leading members of the G8 has deliberately chosen the path that signals a deflationary trend — possibly even bringing on a global depression as an outcome of that choice?

As I said, the English have chosen the devil they know, and that is economic contraction. The last serious bout they experienced on that front was of course during the 1930s and again following the Second World War, but over the years, Britain has seen many recessions. Some were deep, and folks may recall the Maggie Thatcher days of fiscal restraint, elimination of public programs and a sell-off to the private sector of everything from coal mines to railways and airlines.

Hyperinflation ‘Devil’

The devil the British does not know is hyperinflation — not up-front, ugly and in their faces, anyway, but only anecdotally from the experience of others. No major modern economy in the West has ever hyperinflated. The exception, Germany, did so only under duress brought on by destructive and debilitating reparations following the First World War. Nobody wants a repeat of that. So this is actually a relatively safe move from that standpoint.

Those other nasty outcomes are already too well-known from readings of the history of the Weimar Republic: a complete destruction of the currency there resulted from ill-conceived “fixes” followed by a total failure of the financial, investment, banking and insurance systems. Printing press solutions led to widespread public misery and hunger. Bond and debt defaults were manifest and eventually the worst insult was when the country was saddled by an inability to borrow and rebuild following its confidence crisis. Last came radicalism and political instability as the people demanded solutions to all their problems.

Social Collapse Possible

We know too that hyperinflation can lead to chaos and social disorder. Nor is social collapse out of the question under that scenario — particularly with so many people dependent on our existing system, and as the population ages and becomes more dependent on fewer folks of working age. No Brit wants that either. No Brit Government could survive it. The debt must be paid and the burden of that pain will be shared by all. It is the right decision. But at a high cost.

I think it is worth it. The likes of Russia, India, Brazil and China have been working in concert to develop an alternative world reserve currency, buying up gold in earnest, ostensibly to back their claim with real wealth under IMF auspices and the terms of Special Drawing Rights (SDRs).  Success will give them the kind of collective bargaining power that until now has gone automatically to the U.S. because of the dollar’s status as the world’s reserve currency.

So, will we just sit back, punish our creditors through an inflationary default and thus hand them the power and influence to control a new and developing reserve currency; or will we defend our position, pay off our debts fairly (or by concessions) and retain the rights we hold dear? Let’s first ask ourselves the following question: Why must hyper-inflation be the only alternative to deflation?  Answer:  Because governments all over the globe have already tried stimulating their way out of the recent credit crisis and recession to little avail. They have attempted fruitlessly to generate even mild inflation despite huge stimulus efforts and pointless spending.  All they have to show for it is massive additional debt and an unfolding currency time-bomb.

No Buying Our Way Out

Clearly, we cannot buy our way out our debt burden. It is that simple. It has been tried and it does not work. We cannot dig our way out of a hole either. So instead, consumption, the driver of our Western economies, remains sluggish at best, real estate is badly overpriced almost everywhere, and personal indebtedness is strangling the middle classes as unemployment continues to rise along with the tax burden.  It is an unsustainable exercise that will not end well.  We now know it will not work, cannot work and won’t likely be tried again in any significant way except by insane self-serving governments and those that have just run out of creative solutions. It is time to just pony up and pay the piper. This is simply the better (and only reasonable) solution compared to all the alternatives. But it will mean a long, slow and deliberate winding down until solvency is within reach. It will mean cities, states and counties will go bankrupt and not be rescued.

And it will be painful. Public spending will be cut. Consumption could decline precipitously. Unemployment may skyrocket and bankruptcies will stun readers of daily blogs like this one. It will put the brakes on growth around the world. Oil prices will fall along with the prices of most other commodities. Gold could soar while food costs rise as a relative percentage of daily expenditures. The Dow will crash and there will be ripple effects across the European union – and eventually the globe. Hardest hit will be major exporting nations like China and India who depend on Europe and the Americas for their bread-and-butter income. Aid programs to the Third world will be gutted, and I cannot yet imagine the consequences that will bring to the poorest people on earth.

Announcement ‘No Coincidence’

The significance of the decision announced Tuesday will impact every nation on earth. And this is not happening in a vacuum, nor is the timing of the announcement just weeks prior to the G8 and G20 meetings coincidental. The statements made Tuesday are designed to lead, and they will.  The EU is also attempting to bring spending and fiscal controls to its member states. Greece is only the first to face the specter of a declining standard of living, much higher taxes and interest rates, controls imposed from outside its borders, and seriously reduced government spending. But the idea proposed now by the Cameron government has real traction and will gain momentum. Britain is signing on voluntarily and has done so before, its back is to the wall and no good options other than strategic default. I applaud them.

The idea will spread, but with a twist this time: Instead of protectionist stances between governments, there will be more free-trade arrangements. Access to markets will open, not close. Canada itself is in the process of concluding a major trade agreement with the European Union that would include among other things greater labor mobility and freedom from past employment barriers between the partners. Structural change is in the air too. It will be in the interests of all nations to cooperate and not enter into conflicts or trade wars.

This Is the Big One

Anyone who thinks that the massive debts piled up by governments can be discharged easily while we go through a mild recession is flat-out wrong. This is the big one. Markets may respond positively at first, but then that sinking feeling will bring on some very bearish sentiments. This could well occur over the next few weeks. A major global economic contraction will undoubtedly sap the world’s stock markets as reality begins to set in. This is the expected outcome. It will come as a big surprise, though, to all who were certain that uncontrolled spending, stimulus and debt monetization would be the solution chosen by governments to satisfy the electorate. While spoiled and self absorbed, the electorate is not stupid. They will get on board with a solid plan if it is presented in a way that assures them their core interests are protected and offers hope and a better future.

A major reckoning is now a foregone conclusion. The word “reset” comes to mind — and then a long, slow grind from the depths of debt insanity, followed perhaps by an agonizing return to prosperity and economic health. A decade may well be too optimistic a time frame to bring balance back to the old world and economies of the West. Let’s get used to it. We are all in this one together.

So deflation it is. It will come to Canada eventually, too, so let’s start having a real debate about what that will look like and get familiar with the idea. We have already experienced stark restraint in this country in a program that was masterfully crafted by Jean Chretien and Paul Martin in the 1990’s. Sanity was restored after three hard years of belt tightening.  But this next phase will be a much more bitter pill to swallow. We need to look to our leadership to guide us through the crisis as it unfolds. The inflationist camp can now leave the room because none of us can stand to hear their anguished cries, angry foot-stomping and teary, selfish objections. How pathetic!

What to Expect

Here is a very short list of what can be expected — and trust me, this is a much more palatable list than the ones I have analyzed involving an unthinkable and devastating hyperinflation. So put away the placards and protest signs. We all need to get on board with paying down debt like any responsible citizen debtor would do. We owe big-time, and this is but a taste of how it may cost us:

• Major employment reductions in the public-service sector
• Rationing of health care services, fewer nurses, health practitioners and support staff
• Larger class-size in schools, and large reductions in the number of teachers
• Reduced public pensions and benefits, including social service payments
• Interest rates that will gradually rise and eventually settle at around six percent
• Strikes, labor unrest and supply chain breakdowns
• Widespread unemployment affecting virtually every sector of the economy. No one will be spared
• An expansion of public works programs and green initiatives
• Civil disobedience, arrests, targeting of threatening movements by security agencies and government
• Increasing taxation, particularly on the wealthy and buoyant businesses
• Shortages of all kinds and the loss of variety on store shelves
• An erosion in the standard of living for most, but particularly for those who are in debt
• Cutbacks in military spending, defense, coastal patrols and overseas engagements
• Cherished programs that governments usually support will be eliminated
• Larger police forces, prison expansions and a judiciary that is strained to the breaking point
• Cities, states and counties will be denied bailouts, forcing them into bankruptcy
• Services that protect the environment, animal rights and special interests will be reduced
• Universities will close

The list could stretch on and on, but you get the picture. It will be a very difficult and long-lasting correction that will purge waste and inefficiency from the system. Few will be happy, but the alternative is just too distressing to consider. The only thing that will give you true immunity in the mean time is a fat blanket of cash. Be sure to have some. Be liquid. Pay off debts. Rejoice in your good decisions. And live free.

(If you’d like to have Rick’s Picks commentary delivered free each day to your e-mail box, click here.)