For more than 40 years, the Federal Reserve has fostered, encouraged, and otherwise helped to create the most reckless credit expansion in the nation’s history. Total credit market debt of all varieties — federal, state, local, household, financial and nonfinancial – has ballooned from 330 percent of gross domestic product in 1960 to over 900 percent of gross domestic product in 2021. Adjusting for the size of the economy and for inflation, we now have three times as much credit and debt as we had in 1960.

In many ways, credit can be a wonderful thing. It can enable a worker of meager financial means to acquire a motor vehicle that will allow him to take a job otherwise inaccessible to him via public transportation. It can enable a young married couple to buy a house and to build equity in that house over the 30-year term of the mortgage or deed of trust. Credit can enable an entrepreneur to buy a business and to do a better job of running the business than the previous owner was able to do.

The expansion of credit on a nationwide scale is expansionary in economic terms because virtually no one borrows money to put it under a mattress. People borrow money to spend it, whether on goods and services or on investment assets. The spending of borrowed money on goods and services buoys the real economy, creating demand for a product that would not otherwise exist. It also buoys investments, such as stocks, bonds, and real estate. For example, real estate rises in price because of the availability and price of credit. If you doubt this, ask yourself this question: if it were totally impossible to borrow money to buy a house if you could buy a house only by paying the full purchase price in cash, how much would houses sell for? The answer is obvious, isn’t it? They would sell for far, far less than they sell for today.

Although taking on more debt puts money into a borrower’s pocket, debt service — paying interest and principal — takes money out of that borrower’s pocket. That means less money the borrower has to buy goods and services or invest. Overall economic effects on the nation, though, are determined not on an individual borrower basis but on the basis of all the borrowers and lenders — on a nationwide basis, in other words. As long as credit and debt are expanding on a nationwide basis, expansionary economic policies remain in effect. The economy remains robust, unemployment rates remain low, and for the stock and bond markets it’s “party on, Garth.”

But what happens if, for whatever reason, credit and debt (the mirror side of credit) begin to decline on a nationwide basis? Should that occur, the amount of money flowing into goods and services into the purchase of goods and services would decline, as would the amount of money flowing into investment assets. In economic terms, this is contractionary. Because the amount of credit and debt outstanding is in the trillions, if the magnitude of the contraction in total credit outstanding were sufficiently severe, the resulting economic contraction could quickly turn into an economic depression far exceeding anything this country or any other country has ever experienced. Society would unravel.

The Fed has striven mightily to prevent this from ever occurring. The Fed’s response to economic developments in 1987, 200-2002 and 2007-2009 has been the same: “flood the market with liquidity.” Do whatever needs to be done to keep total credit from contracting, because that will spell disaster. If credit does indeed contract in large amounts, the Fed will be exposed as having run the greatest Ponzi Game in history. The truly massive amount of debt it has created — measured not in the billions but in the tens of trillions — will be the fuel for a giant crash. As Warren Buffet famously said, it’s not until the tide goes out that you learn who has been swimming naked. It’s no accident that Ponzi games such as Enron and Madoff Securities are not exposed until the stock market crashes.

The Fed’s tools to prevent a devastating credit contraction and crash — flooding the market with liquidity — don’t work to curb rising inflation. Flooding the market with liquidity would only make inflation worse. The Fed’s tool to combat inflation is to raise interest rates — to raise debt service requirements. That is where the Fed is now. Consumer price inflation is bubbling along at an 8.5 percent rate (the highest in 40 years). Producer prices are galloping at an even higher rate: more than 11 percent. When inflation was 7.6 percent in 1978, the Fed pushed the federal funds rate to 8.5 percent. And now, with inflation higher than it was in 1978, where is the federal funds rate? At 9 percent? No. At 8 percent? No. At 7 percent? No. It is at 0.33 percent!

The Fed is hugely behind the curve. The most recent rise was a paltry one-quarter of one percent. The Fed is clearly terrified at the prospect of raising interest rates, otherwise, the rate increase would have been at least one full percentage point or more. The Fed is demonstrating by its actions that it is not serious about fighting inflation. It is gambling that inflation will subside of its own accord, with little help from the Fed.

If over the next six months to one year, inflation does indeed subside, with the federal funds rate rising to perhaps 1 percent or 1.5 percent, the Fed will be shown to have made the correct decision. But no one has a crystal ball in that regard.  If the inflation rate keeps advancing, and we have double-digit consumer price inflation six months or one year from now, the Fed’s hand will be forced. Serious interest rate increases will be required. In that scenario, the probability that the Fed will err, either on the upside (raising interest rates too high and creating a market panic and resulting crash) or on the downside (runaway, Weimar-style inflation as a result of tepid interest rate boosting) hugely increases.

The historical precedents here are strongly against the Fed. The market can panic more quickly than the Fed can counter the decline by lowering interest rates and engaging in “quantitative easing.” Note that 2000-2002 was a more serious downturn than 1987 and that 2007-2009 was more serious than 2000-2002. The trend is clear. The next downturn likely will be far worse than 2007-2009 if the Fed errs in the direction of raising interest rates too far or too fast. The reason for this is that declines are generally roughly proportional to the amount of total credit market debt outstanding.

To date, the equities markets have come back after each drubbing, but if a decline goes far enough, that pattern may not necessarily repeat. Instead, we may end up in a Japanese/Nikkei scenario where equity prices in 2050 or 2060 are lower than they are today. Note that the Nikkei is lower now in 2022 than it was 33 years earlier in 1989. In Great Britain, following the disastrous South Sea Bubble, equities went into a more than 50-year bear market.

The historical precedents are not any better if the Fed errs on the downside and allows inflation to really get out of control. Inflation has a way of accelerating, as the Weimar experience shows. (The source of the data that follows is “The Great Disorder” by Professor Gerald D. Feldman, a 900-plus page tome that will tell you more about Weimar Germany than you ever wanted to know). In August 1914, the dollar exchange rate of the paper mark in Berlin was 4.21— one U.S. dollar would buy 4.21 marks. At the time of the Armistice in November 1918, it was 7.43. Things became steadily worse after that. By January 1922, one U.S. dollar would buy 191.81 paper marks. Relatively speaking, though, that had been a walk in the park compared to the complete and utter disaster —- resulting in the total destruction of the mark, and I do mean total —that unfolded beginning in August 1922 and finishing up a mere 16 months later in December 1923.

In August 1922, one dollar bought 1,134.56 paper marks. By June 1923, one dollar was buying 109,966 marks. Was that the end of it? No, things got worse, much, much worse. Two months later, in August 1923, one dollar would buy 4.6 million marks. One month after that, in September 1923, a dollar would get you almost 99 million marks. In October 1923, the exchange rate was 25 billion paper marks for one U.S. dollar. By December 1923, one dollar would get you 4.2 trillion marks.

One conclusion that may be drawn is that it took only about five years for inflation to destroy the mark. Another is that when things really get out of control, as they did for Germany beginning in August 1922, the end is nigh, as little as 16 months away.

In conclusion, the Fed is now sailing between Scylla and Charybdis, between the monster of a stock market crash and resulting depression on one hand and the whirlpool of runaway inflation on the other. Despite an 8.5 percent inflation rate, the U.S. dollar has remained strong. Across the Pacific in Tojo-land (Japan), the Japanese yen has been rapidly depreciating. Japan is even farther along the economic-profligacy scale than the U.S. is. The ratio of debt to GDP is far higher. The Japanese economy has been aptly described as “a bug in search of a windshield.” Keep an eye on Japan: it may provide an important clue of what finally happens when monstrous credit and debt expansion over decades (especially sovereign debt) goes off the high board.