Quite a few of the mainstream media have started using the phrase 'depression era' to describe the current turmoil in the US. Most continue to view the economic environment as being 'deflationary.' This view is bolstered by the continuing declines in the value of all asset classes (equities, real estate and commodities). But the current decline in prices, especially in commodities, is an ephemeral event and what lies ahead is perhaps an unprecedented era of rising prices.

As the Austrian school explains, an inflationary boom such as the one that we have witnessed in the US over the last two decades, is inevitably followed by a deflationary bust. But the deflation happens in terms of real money (ie. gold) rather than the fiat currency (US dollar) system that we have in place today. So almost all assets would lose value over the next decade when measured in terms of gold and that is the nature of the deflation that lies ahead.

What happens to prices in terms of US dollars is just a function of how hard US Federal Reserve Chairman Bernanke is going to crank up his printing press. If he continues to run them 24x7, as he has been doing over the last few weeks, then the US dollar would most certainly follow the route of the Continental. In fact, historically all bouts of hyperinflation have always been caused by governments trying to ward off a deflationary bust and that is exactly what is happening to the US economy today. So the ultimate demise of the US economy and the dollar is going to be caused not by the disease (ie. bursting of the housing bubble or even the more fundamental imbalances as outlined in the previous issue), but by the cure that the US government has proposed.

Why the bail-outs will lead to hyperinflation…

To understand why the bail-outs would lead to hyperinflation, we have to start from the basics. For starters, inflation is an expansion in the supply of money and credit within the system. One of the effects of inflation is that prices increase because money loses value due to its excess supply. Deflation, by definition, is a contraction in the supply of money.
So an economic environment when people default on their loans thereby destroying money as is happening in the US today is inherently deflationary. But when the US Fed replaces this capital by conjuring money from thin air, all that it tries to do is prevent the market forces from clearing the mal-investments. But the new money rarely flows into the 'previous bubble.' For example, when the ex-Fed Chairman Alan Greenspan created massive amounts of inflation as a response to the bursting of the Nasdaq bubble, all of the new money was directed by the market participants towards real estate. So all that Greenspan ended achieving was that he replaced the stock market bubble with the housing bubble.

Deflation, the right medicine…

So it is essentially this deflationary force which happens to be the rightful medicine for Greenspan's inflation that the current administration is trying to avoid. But why the US Congress and the citizens at large continue to believe in Bernanke and Treasury Secretary Paulson is baffling. After taking the power for the never-to-be-used bazooka, Paulson uses it at the first available opportunity and while claiming that $700 billion plan was to buyout distressed assets, Paulson uses the same to re-liquefy consumer lending. Not that the original intent of Paulson was correct to start with, but the essential point is that the only viable solution has to be a liquidation of bad assets through the free market. Any interference in this process would have unintended consequences as Paulson is beginning to realize.

With Bernanke stating that more needs to be done to protect troubled home-owners and US President elect Obama promising more deficit spending to prop up the economy, the US Fed needs to create massive inflation to meet these ends. The effect of these bail-out plans and other innovative schemes launched over the last few months on the US Fed's balance sheet is going to be disastrous.

Well before Obama's term ends four years down the line, it's very likely that the Fed's balance sheet becomes completely toxic.