Federal Reserve Driven Inflation Hurts Savers

Obama's proposals to increase taxes on private capital gains, dividends, and entrepreneurs reveal a bias against private capital.

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James Rickards is a hedge fund manager in New York City and the author of Currency Wars: The Making of the Next Global Crisis from Portfolio/Penguin. Follow him on Twitter: @JamesGRickards.

Better late than never, some honesty has crept into the debate on Federal Reserve interest rate policy. Unfortunately the honesty consists of a candid warning by the Fed that savers will be victimized for the greater good of propping up asset values in housing and the stock market. The victimization takes the form of targeted inflation engineered by the Fed through zero interest rates and money printing. This is needed to bail out the banks, brokers, and builders who bet wildly and now need a more or less permanent rescue.

To understand why, begin with a world plagued with massive unpayable debt at the individual, corporate, and government levels. There are only three solutions to this much debt—default, inflation, and growth. Default is easy to understand—we're seeing it in Greece today. The borrower simply does not pay in full and the losses fall upon creditors, mostly banks, and institutional investors. This can work for a small entity like Greece or Harrisburg, Pa.

[Read the U.S. News debate on whether the Fed has overstepped its mandate.]

Default is not a solution for large debtors such as Italy or the United States because the creditors themselves would fail and the entire system would collapse. For large sovereign debtors, the preferred solution is inflation. By printing money, the debt owed is worth less because the money is worth less. Eventually the debt is repaid in debased dollars or euros. This is why the United States will never default on its debt to China. It can simply print the dollars needed and hand the freshly printed dollars to the Chinese. If the dollars aren't worth enough to meet China's other obligations, well, that's China's problem.

The Fed is doing everything possible to promote this inflationary outcome including holding rates artificially low, printing money, buying up bonds, and cheapening the dollar in foreign exchange markets. Of course, the Chinese will not be the only victims of this policy. Anyone relying on a stable dollar will suffer also. This includes savers, pensioners, and those holding insurance policies and annuities among others.

This is where the Fed's new openness comes in. Chairman Ben Bernanke and mainstream economists have lately taken to warning Americans about this outcome and all but imploring them to buy risky assets such as real estate and stocks to protect their wealth. In effect, the Fed and its cheerleaders are saying to Americans that if you are dumb enough to leave your money in the bank then you deserve to lose the value of your savings. In America today, prudence does not pay.

[Learn about the many faces of Ben Bernanke.]

What about the third way out of debt—growth? Here the discussion is anything but transparent. The neo-Keynesians at the Fed and in academia discuss the shortfall in individual consumption and make the case for government spending as a growth substitute despite clear evidence that government spending destroys wealth. The so-called "multiplier" effect is a myth. But what happens when even government spending hits a wall, as it has recently?

There is another contributor to growth in addition to consumption and government spending—investment. Investing in a new factory or transportation hub contributes to growth as surely as buying more cars or flat-screen TVs. In fact, investment is a "two-fer" because it contributes to growth immediately and contributes again through improved productivity in later years. With Americans more inclined to save than spend these days and with ample bank reserves parked at the Fed, why is the Obama administration encouraging new asset bubbles in housing and stocks instead of encouraging investment?

The answer is ideology. Obama prefers a Chinese model of "state capitalism" where government directs investment to favored pet projects, political cronies, and union dominated sectors. He disfavors the robust private capital model where entrepreneurs compete for funds to promote innovative and disruptive technology that creates real jobs and real wealth. Obama's proposals to increase taxes on private capital gains, dividends, and successful entrepreneurs while throwing government money at non-economic failures such solar panels, windmills, electric cars, and unwanted mass transit systems, reveal this deep-seated bias against private capital.

[Check out a roundup of editorial cartoons on the economy.]

Investment can pick up the slack in consumption and power the U.S. economy to great heights. This can be a win-win for savers who can get higher yields on their savings accounts. The key is to fix the broken conveyor belt that moves safe savings into productive investment. This was the classic function of bankers before they became leveraged speculators infested with greed while regulators did nothing to stop them.

Obama has taken the failures of bankers and regulators as a green light to substitute government spending for both consumption and private investment. It is embarrassing but instructive for Americans to see how Germany has successfully embraced a business-friendly investment driven model while America clings to a statist, Chinese-style government spending model. It is not too late for America to shift gears and return to its roots as an entrepreneurial dynamo, but it will take lower taxes, less government spending, and improved regulation to get there. This is not the preferred policy of a second Obama administration. Yet, by 2016 it will almost surely be too late.

  • See an opinion slide show of 10 wasteful stimulus projects.
  • See a collection of political cartoons on the European debt crisis.
  • See pictures of Greeks protesting against austerity.