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The Back-to-the-Future Recession, Part 2

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Financial innovation's dangerous round trip.

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Editor's Note: This article, which is part 2 of a 2-part series, builds on themes discussed in Stability Trend Only a Fair-Weather Friend. Part 1 can be found here.

The Fed at the Crossroads

As I wrote in Part 1, the key item to watch now is the budget debates. Are we going to build in $2 trillion deficits, or show some fiscal restraint?

And, are we going to try and do this when unemployment is at 10% or more? The Fed is going to come to a crossroads at some point. They can allow inflation, like in the '70s. (And some of us are old enough to have lived through that, though I really didn't notice much. I actually made money on inflation during the '70s. I was in the printing business before I went into the investment publishing business. I'd buy traincar loads of paper on credit and put it on warehouse floors; and because I was the only guy who could get paper and had it at a good price, I got a lot of business.)

We figure out how to Muddle Through, even during periods like the '70s. So the Fed can bring that back -- which they all swear they won't do -- or they can withdraw liquidity. What happens if they do the latter? It slows the economy down because we're pulling money out of the system. Just as higher interest rates begin to take a toll on the economy, they'll have to start pulling money out of the system to avoid higher inflation.

By the way: If rates are rising, that means the interest payments on the federal debt are rising because we have a lot of short-term federal debt. Frankly, as a government, we should be buying all the 30-year bonds we can possibly buy. But we're not, because that would increase the pressure on the current debt. We have the long-term forecasting ability of a mongoose.

We're in the middle of a Great Experiment -- the one truly great experiment of this time -- so the economists are fascinated. We have Keynes versus von Mises versus Irving Fisher versus Friedman, and they all have theories about what you should do after depressions and what works. Someone commenting on Keynes said:

"In a world organized in accordance with Keynesian specifications there would be a constant race between the printing press and the business agents of the trade unions. With the problem of unemployment largely solved, the printing press could maintain a constant lead."

Printing money. That's what the current Fed is doing. Just as aside, here's a great quote I came across. It really doesn't have anything to do with anything, but it's fun. John Ehrlichman told us about a conversation between Richard Nixon and Arthur Burns, who was Nixon's nomination to be Chairman.

Nixon said, "I know there is the myth of the autonomous Fed [short laugh]. When you go up for confirmation some Senator may ask you about your friendship with the President. Appearances are going to be important, so you can call Ehrlichman to get messages to me, and he'll call you." I'm sure that's not done today.

Seriously, the independence of the Fed is critical, Nixon notwithstanding. Given the recent revelations about Bernanke and Paulson supposedly telling Ken Lewis at Bank of America (BAC) not to tell the public about how bad the Merrill situation was, there just might be some pressure on Bernanke. His term is up early next year. It's quite possible we get a Fed chairman who would be more accommodative of a left-wing agenda than Bernanke - who I believe will pull back from allowing inflation to get too high.
No positions in stocks mentioned.

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