Inflation, Politics and Mob Rule

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Published on Thursday, 27 October 2011 07:00

Written by Justice Litle, Editor, Inside Investing Daily

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In the battle of inflation vs. deflation, "mob rule" could tip the scales.

"Inflation or deflation?" It's a key question of our times. Which one wins out in the end?

There are powerful forces pushing in both directions. Those who argue for inflation, or even hyperinflation, point to the history of paper currencies and huge mountains of debt weighing on Western economies. They also point to spiraling food and energy costs (deliberately ignored by the powers that be).

Those who see deflation, on the other hand, point to wage and austerity pressures. It's hard to get rip-roaring inflation when wages are flat or falling. As economic activity contracts, households spend less. This keeps a lid on inflation.

Austerity programs -- cutting back on spending and paying down debt -- are also deflationary. On the national level, there is a growing voter backlash against government programs. On the local level, states, counties and cities are forced to cut services as budgets run dry.

So far, the government bond market has said "deflation." Uncle Sam has become the largest binge debtor in the world, damaging his credit rating in the process... and yet investors still flock to Treasury bonds.

Those who see inflation have long predicted a collapse in the government bond market. But the chart of T-bond futures above, dating back to 2007, shows there has been no collapse. In fact the opposite has happened. T-bonds have risen in value on "flight to safety" buying from all over the world.

If things continue this way, deflation will be the champ... winner by technical knockout. As Japan showed us, rising government bond markets and rock-bottom interest rates are harbingers of deflation. In this scenario, the United States becomes like Japan, stuck in slow-growth or no-growth mud for years to come.

There is a big difference between the U.S. and Japan, though: Japan never saw mass protests as a form of economic backlash. (You don't hear much about "Occupy Tokyo.")

Japanese culture places an emphasis on unity and social harmony. There is even a Japanese word, "gaman," that roughly translates as "enduring the unbearable with patience and dignity." These traits helped Japan "endure" tough economic conditions for decades without serious civil unrest.

In the West, however, those suffering the effects of flat wages, deflation and deleveraging are not in a mood to endure with dignity. They are getting angry. That is why the Occupy Wall Street movement is gaining traction -- transforming from a minor disturbance into something bigger.

Ray Dalio is the founder of Bridgewater Associates, one of the largest and most successful hedge funds in the world. Bridgewater and Dalio are known for their accurate market forecasts (and huge profits) in recent years.

Now Dalio believes that the onset of deflation and deleveraging -- a forced process of cutting back and paying down debt -- threatens the rise of "mob rule" in the West.

"We are in the midst of a deleveraging, we are nearly out of ammunition and we are at each other's throats," Dalio says. "Being in a deleveraging and nearly out of ammunition is a very difficult position to be in. But, being at each other's throats is our biggest problem."

In a Financial Times op-ed, Dalio goes on to explain how harsh economic conditions can lead to a "self-reinforcing downward spiral" and the advent of mob rule. He points out how frustration and desperation can lead to extremely bad choices... like the rise of Hitler in 1933.

If we can't work together properly, Dalio warns, "we may experience an economic, social and political collapse."

Getting back to inflation: The desperate need to head off an economic collapse and the pressures of mob rule are precisely what could turn the current picture upside down. If the people get angry enough, they will demand drastic action... and politicians will listen.

Then, when austerity measures have failed as a political management tool, fiscal restraint could be thrown out the window too. The new spending -- and government meddling -- would ramp up in earnest.

For example: The average annual income for Americans over 65 is $18,500 a year, according to the AARP (with most of that coming from Social Security). There is not a lot of breathing room there.

Social Security payments are tied to official inflation statistics. But the government's statistics are skewed. If we continue to see food and energy price hikes eating into wallets, strapped seniors will not stay quiet. They will get behind the political platform that addresses their pain directly -- with increased payments, increased subsidies or both.

Add to this the growing ire of the unemployed and underemployed (whether they pick up an "Occupy" sign or not)... the increasingly desperate plight of state and local pension funds (fatally short of cash)... and the growing ability of angry factions to "organize" and use social media to express their discontent... and the odds of major political backlash are all but guaranteed.

It all adds up to this: An environment of relentless deflation and deleveraging fuels anger, resentment and increasingly frustrated calls to "do something." At some point, the righteous tide is caught by fearful politicians... and unleashes a new tidal wave of spending.

Besides: As the saying goes, "We ain't seen nothin' yet," in a distorted enough environment, all sorts of Nixon-like options could be on the table: Price controls, wage floors, blanket subsidies, you name it.

That's a scenario where inflation -- and the fear of paper money meltdown -- comes roaring back for the win.