In the sound-money community you hear a lot about “the crossroad.” That's the point at which an overindebted country suddenly realizes that it has to choose between two (and only two) very different paths. One leads to deflation, with excess debt being purged from the system through mass-bankruptcy and falling prices. The other leads to inflation, with the debt being eliminated by lowering the value of the currency in which it’s paid off. It’s been clear for years that the U.S. was approaching this fork in the road. And last week, with the Fed chopping half a point from short term rates and promising more action as needed, we may have arrived. Whether inflating away this much debt is even possible remains to be seen, but that we’ll try looks certain. 

Now the mainstream press is climbing aboard the metaphor. Today’s Wall Street Journal has a story featuring a nifty drawing of a rollercoaster with track that branches toward two equally forbidding tunnels. One is labeled inflation, the other deflation:

Which Way Is Scarier? The Federal Reserve cut interest rates last week in order to address a pressing concern: the risk of recession and of a breakdown in credit markets. By lowering rates before it really wanted to, however, the central bank has revived another fear that had been dying down: inflation. That has left the Fed and the investment world in a tight spot. If the Fed gets it just right, the economy will slip through this crisis and keep expanding with only modest inflation, making investors happy. If the Fed's rate cuts are too little, too late, recession fears will return, sending another cold wind through credit markets and the stock market. If the Fed cuts rates too much, inflation could loom. What was troubling some investors after the Fed rate cut last week, a reduction in short-term rates by half a percentage point, to 4.75%, was the latter risk -- the risk of inflation. Until the credit crisis struck, the Fed had signaled no intention of cutting rates so soon. Lower rates typically stimulate the economy by making it easier for companies, consumers and investors to borrow. If the Fed continues cutting rates before inflationary pressures have been stifled, it risks pushing inflation higher. The Fed has acknowledged the concern, noting in the statement announcing last week's rate cut that "some inflation risks remain." Inflation could come from the still-booming global economy and from the lower rates themselves, which push more money into the economy, making it easier to raise prices.

Note that the Journal still holds out the hope of some kind of middle way (maybe a bike trail running alongside the coaster?) in which our  omnicompetent central bankers guide the economy to another decade of non-inflationary growth. As usual, this misses the underlying dynamic, which is that the past two decades of low inflation and steady expansion have been purchased with ever-greater amounts of debt. In the 1960s it took about a buck-fifty of new debt to produce a new dollar of GDP. Today it takes about six bucks. And that’s assuming the GDP numbers are accurate (they aren’t) and that reported debt is all the debt we’re creating (it isn’t). If you include the unfunded liabilities of U.S. entitlement programs and over-the-counter derivatives, both of which are growing exponentially, the trend in societal productivity looks even worse. 

As for what the conventional wisdom now considers normal and good,  the latest Fed Z-1 report reveals that in the second quarter (prior to the start of the credit-sector meltdown) U.S. households increased their borrowing at a seasonally-adjusted annual rate of about a trillion dollars. Businesses increased their borrowing at a 10.6% rate and state and local governments 11.9%. Total debt in the U.S. economy grew at a seasonally-adjusted annual rate of $3.7 trillion, and now stands at $46 trillion, up from $29 trillion in 2001.

The pace of debt creation has no doubt slowed a bit since the second quarter—hence the panic in the financial markets and the Fed’s dramatic rate cut. So here’s the dilemma: To engineer another decade of moderate growth and low inflation, the Fed will have to convince us not just to keep borrowing but to step up the pace, despite falling home prices, soaring foreclosures and surging prices for gas, food and healthcare. And it will have to convince foreign investors to keep accepting dollars at close to the current exchange rate even though it’s been declining in value for years. Neither will be an easy sell. And even if the Fed succeeds for a little while longer, all it will have accomplished is to spread another layer of toxic debt across the top of the financial landfill.

Sorry, but this time the crossroad has just two forks. And we’ve made our choice.