Editor’s Note: The Prickly Pear published a related article last week on January 3 entitled The Price of Easy Money Now Coming Due. We recommend reading both articles together to understand current economic conditions and our readers’ concerns about personal financial situations.

When it comes to the economy, nearly the entire populace is of the same mind.  Almost all of us like economic expansions and booms and almost all of us dislike recessions and depressions.  For decades the federal government and the Federal Reserve have accommodated these desires.  A few interruptions have occurred, namely, the 1987 crash, the bursting of the tech bubble in 2000-2002, and the mortgage-backed securities meltdown in 2007-2008.  But by and large, it’s been onward and upward from, say, 1982 to approximately the middle of 2021.

The Fed has fueled the expansion and booms by fostering the expansion of credit and debt, by creating money out of thin air through open market purchases of U.S. Treasury obligations, and by keeping interest rates significantly below the levels that would prevail but for the two aforementioned policies.  Congress has done its part by running enormous budget deficits almost every year since the onset of the Great Depression.

An expansion of total credit and debt on a nationwide basis creates an economic expansion because virtually no one borrows money to put it under a mattress.  It is borrowed to be spent, either by buying consumer goods and services or by investing in assets such as stocks,  bonds, real estate, etc.  Individual and corporate debtors occasionally end up bankrupt, but as long as the overall amount of credit and debt is growing nationally, the expansion continues.

Note, though, that this is a two-way street.  Should the total amount of credit and debt contract on a nationwide basis, the economy will contract as well.  Money paid to a creditor where the creditor does not re-loan the money to someone else is money that the debtor no longer possesses to buy consumer goods and services or to invest.

A somewhat similar force is at work in the stock and bond markets.  If the price of stocks and bonds is rising, the investor holding the stocks and bonds becomes wealthier and is in a better position to both buy consumer goods or invest in financial assets (including real estate).  This also is a two-way street.  A decline in stock and bond prices diminishes wealth and, generally speaking, may make it more difficult for the investor to purchase consumer goods or more stocks and bonds.

The Fed and the U.S. government have striven mightily to keep the economic expansions going and to ensure that stock and bond prices rise in the long run.  One of the enduring mysteries is how —until recently — the government has been able to print vast quantities of money out of thin air without causing rip-roaring consumer price inflation.  This mystery can be solved by focusing on the different ways in which the wealthier and the poorer elements of the population spend money.

Imagine you have one billion dollars and are given a choice:  either give the entire one billion dollars to a tech billionaire or, alternatively, give $1,000 apiece to one million U.S. citizens chosen at random.  What are the differences in how the money is spent?  Will the billionaire use part of his new one billion dollars to buy a big-screen TV?  Probably not.  He likely already has as many big-screen TVs as he cares to own.  The tech billionaire is more apt to invest his new billion in some fashion.  Now, some of that money will go into the real (as opposed to the financial) economy (building a new factory and hiring workers, for example), but the fact remains that more of the billionaires new billion is likely to go into the financial economy than the collective billion of the million average Americans who receive $1,000 apiece.  The average American is more likely to use their windfall to spend on consumer goods and services, to take vacations, etc. as opposed to investing in stocks and bonds.

The upshot is that it’s possible to print gigantic quantities of money without creating consumer price inflation as long as policies are put into place to keep the wages and salaries of America’s middle and working classes stagnant and low.  And this is precisely what’s been happening since around 1982.  Keep the average guy broke, and you can print vast quantities of money without creating a lot of consumer price inflation.  Among those policies are the following:  exporting good manufacturing jobs to other countries; bringing in hordes of immigrants to keep wages low under the ironclad law of supply and demand; creating vast amounts of student loans to turn the newly-minted graduates into a form of indentured servants once they enter the workforce; and that old reliable, union-busting.  In the January 5, 2023 edition of the New York Times, there was an article on the op-ed page by Peter Coy entitled “The Fed Doesn’t Want Your Pay to Catch Up to High Inflation.”  Of course not — keep those wages and salaries of average Americans low so that Congress can continue to run huge budget deficits and the Fed can continue to print vast quantities of money without creating much in the way of consumer price inflation.

And where does a great deal of that printed money go?  It goes into financial assets (including real estate).  Hence we have a Dow Jones Industrial Average that has risen from approximately 900 in 1982 to over 30,000 today.

These policies have been greatly aided by technological advances.  It’s now possible to pay bottom-basement wages without creating widespread starvation in the working classes.  We live in a society where even many of the destitute are obese.

For decades it looked like the U.S. government and the Fed had a perpetual motion machine.  The economy kept booming and the prices of stocks and bonds continued marching upward (except for the aforementioned retreats in 1987, 2002, and 2008).

And then came the Covid pandemic and the re-emergence of significant consumer price inflation.

What happened during the pandemic, in a nutshell, was that (1) production of goods and services was greatly reduced, and (2) large amounts of cash were passed out to the nation’s average Americans.  It was the perfect formula for consumer price inflation, and that is what we got.   Average Americans began spending that new money in the real (as opposed to the financial) economy in an environment where the supply of goods and services had been curtailed.  Higher demand and lower supply imply higher prices.

The initial response of the Fed and politicians was to pooh-pooh the CPI increases as “transitory,” but after that dog didn’t hunt anymore the Fed was forced to finally raise interest rates in a semi-serious manner.

We haven’t had a stock market crash yet, but individual issues have in fact seen stock prices reduced to crash-like levels.  As of this writing, Tesla’s 52-week high was 390.11; it’s now at 113.46; Google, 152.10, now 88.58; Apple, 180.17, now 127.03; Netflix, 592.84, then down to 162.71 and now back at 305.92.  Trillions of dollars of value in the equities market have evaporated.  Losses in the bond market have also been enormous (in the trillions) as interest rates advanced.

It’s beginning to look like the perpetual motion machine engineered by the Fed and the Treasury over the past 40 years is starting to go in reverse.

As the price of stocks and bonds retreats, the buying power of those who hold those stocks and bonds is diminishing.  As the late Richard Russell may have said, the ammo boxes of the investing classes are starting to empty.  It’s been a slow burn — trillions have been lost, but the volatility index (the VIX) remains relatively low.  There’s no panic yet.  Paradoxically, this is a very bad sign indeed for the equity and bond markets.  Another aphorism from Mr. Russell is apt here:  “The Bear likes a full elevator when he presses the down button.”  The Bear certainly has that now.  Stocks and bonds may be of great value at some time in the future, but prices can’t rise very much if there’s little or no buying power when that time finally arrives.

The other big part of the equation is credit and debt.  The gigantic amount of credit and debt that the Fed and the federal government have nurtured into existence is the fuel for a giant deflationary crash.  There are only three things that can happen to debt:  it can be repaid, it can be re-financed, or it can default.  The rising interest rates engineered by the Fed have increased the pressure on borrowers, and one wonders whether there is a tipping point when large portions of that credit come crashing down (notice: thereby reducing the buying power of creditors), creating an environment where repayment and re-finance of debt become rarer and rarer and default more common.

The all-important moment may be the moment when the Fed is put to a choice:  either (1) continue raising interest rates (or maintain them at their then-current level) for the purpose of reining in inflation even though the effect of that is to cause the stock market, the bond market and the economy to crash, or (2) lower interest rates to save stocks, bonds, and the economy, even though the cost of that is galloping inflation, where inflation rises from 7 or 8 percent per annum to 18 or 20 percent or more per annum. 

I will hazard a guess here and predict that in this situation, the Fed will opt for galloping inflation over a catastrophic crash and a new Great Depression.  If we see the Fed lowering interest rates after a major retreat in the stock market even though consumer price inflation remains high, we will likely know that the Fed has made its choice.

Will that all-important moment arrive in 2023 or sometime thereafter?  It’s difficult to say at the present time.  Perhaps the Fed will be able to engineer a soft landing, where inflation subsides, interest rates can come down, and recession is avoided.  An interested observer can continue to monitor monthly changes in the CPI, monthly changes in unemployment, and other economic statistics and make his or her own educated guess.

If there is one important market to keep a close eye on, it’s the gold market.  Major and persistent increases in the price of gold over $2,500 or $3,000 per troy ounce almost certainly will signal that the market believes the Fed is throwing in the towel in terms of fighting inflation and is doing whatever is necessary to prevent a crash and a new great depression.  If the economy remains troubled with inflation remaining high and there is suddenly a major upward surge in the price of gold, it can be inferred that the elite donor class knows the Fed has made its choice and which way things will be headed.   

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Mark Wallace is a long-time student of financial markets and a former Federal Bankruptcy Judge.