The Eagle Way

I have been reading a lot about the growing concern over US$1 trillion dollar deficits. Latest, the Stanford professor John Taylor, creator of the famous Taylor rule, argued in a rather alarming op-ed in the Financial Times this week that the risk posed by this debt is systematic and could do more damage to the economy than the recent financial crisis.

From the projected US$1.2 trillion by the Congressional Budget Office in 2019, income tax revenue are expected to be about $2 trillion, so a permanent 60% across the board tax increase would be required to balance the book.

Clearly to any sound mind, this will not and should not happen. The next question is how else can debt service payments be bought down as a share of GDP? Inflation will do that!

To bring the debt-to-GDP ratio down to the same level at the end of 2008 would take a doubling of prices. That 100% increase would make nominal GDP as high and thus cut the debt-to-GDP ratio in half, back to 41% from 82%. I know the math sounds complicated, and in a lay-man terms, I am arguing for a 10% inflation rate for 10 years period in time.

Issue is that we may see return of great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years and a successively higher inflation rate after each recession. While a large tax increase would keep the economy from crisis and collapse, it is not without very serious consequences. It will put a serious crimp in economic growth.

Is Obama give lip service in cutting the deficit in half? I am seeing that this is a very dangerous path and one that bond market seems to be concerned about, as interest rates are rising, even on mortgages that the Federal Reserve is buying in massive quantities in its effort to hold down rates and stimulate the housing market.

Home prices are still free-fall and they are down almost 19% yoy and 32% from their 2006 highs and if we get back to the long-term price growth trend, we could see another average 10% drop, and as prices tend to overshoot on the upside and the downside, in some markets, they could fall even further. While house sales are still quite depressed, what are selling are homes in foreclosure as buyers perceive that there are bargains and they are right! However, on the negative side, the supply of homes available for sale is again rising as more and more foreclosures come onto the market!