One of the main tests of a model is how useful it is for predicting the future.  I believe my model explains events such as the great depression and the collapse of ’08.  I will probably write more about these in the future.  However, without further adieu, I want to get on record using my model to do some predictions so that I can say “I told you so” when they happen (the signs are already popping up so there is no time to waste). 

First a couple of notes about forecasting.  It’s hard and it might be wrong.  Especially when the government is monkeying with things all the time.  I will try to predict what they will do.  In broad terms, they are pretty predictable but who knows what details they wll add.  If they do something different, something else will happen and by the way, this would not be a poor reflection on the model, just on my ability to guess what the government will do.  Second, the timing is tough to pin down.  These things might happen in a year or ten years, it’s hard to say, especially when, again, the government is doing its best to postpone them as long as possible.  Also, other events may intervene. 

We have had artificially low interest rates for a long time and consequently we have built up a lot of potential deflation.  Also, interest rates are already near zero so there is no way to inflate prices any further with monetary policy.  This means we will see deflation in the near future.  The signs are already appearing (try going to and searching for consumer prices falling, the article I was looking for from a few days ago doesn’t even come up but plenty of other evidence does).  In spite of these signals, the thing that will make this apparent to most people will be when the following two things happen (probably in this order but it could go either way).  Asset bubbles including housing (again) will collapse and the stock market will fall dramatically.  This will probably happen before the end of the year (but remember timing is difficult).  Notice that this is what they are trying to stave off by getting the Chinese to inflate their currency and begging European governments to spend more.

Now the political predictions come into play.  The reaction by the government and their Keynesian economists will be to say that monetary policy is not capable of fixing the depression because interest rates are already near zero.  This will be true but they won’t mention that the reason we are in a recession is because of their monetary policy.  Therefore the only solution will be for the government to “stimulate demand” by increasing spending. 

At this point, recall why unexpected deflation is a problem.  It causes everyone to simultaneously default on their loans and all their property to be seized by creditors.  So the Fed will suddenly own much of the real wealth in the economy and nobody will have the money to buy it from them….except the federal government.  So the government will start spending like crazy but there will be nobody to tax so they will have to borrow the money.  But there will be two problems.  First, nobody will have any money to lend because it will have been sucked back in by the Fed and second, those who do have money will become nervous about lending to the government because they will begin to see where it is headed.

Luckily (for them) there will be one place left where they can get the money–the Fed.  The Fed will start buying government debt at a rapid pace.  This will cause dollars to flow into the economy in a different way from when the Fed loans it out in the sense that it will cause real assets to flow out of the economy at the same time (remember they paid farmers to destroy crops to keep prices high while people were starving during the great depression).  This will bid prices up and counteract the deflation but it won’t undo any of the harm caused by the deflation.  In fact it will do more harm because people will still be broke but they won’t even get the benefit of lower prices and the process of adjustment back to efficiency will be disrupted. 

When people notice that prices are rising again, government debt is going through the roof, and the economy is not recovering, they will notice that we are heading full steam ahead toward a sovereign debt default.  If anyone is still holding bonds at this point, they will try to get out.  There will be lots of money floating around and nothing to buy with it and every day there will be more money and less to buy.  This will mean that people will be reluctant to hold cash and they will have few other attractive investments.  They will try to find other ways to store wealth.  The prices of gold and silver will shoot up.  Other asset prices will follow.  This inflation will make people even less willing to hold money and velocity will start to accelerate rapidly leading to very high levels of inflation (possibly Weimar-style inflation).

When it becomes apparent that neither monetary nor fiscal policy are capable of fixing the economy, drastic changes will be called for….. By the way, did you know that in the IS-LM model, if taxes are 100%, output becomes infinitely large?  That would be nice huh?  Then we could all sit around and look at art all day.

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