In the Keynesian heydays of the 1950s and 1960s, most economists and policy makers believed in the Phillips Curve, which was the (alleged) tradeoff between unemployment and price inflation. The idea was that the Federal Reserve could cure a recession by printing money, or that the Fed could cure runaway inflation by jacking up interest rates. Each of these moves had its downside, of course, but the point was that the Fed could choose one poison or the other.

This Keynesian orthodoxy was shattered in the 1970s when the United States suffered through stagflation, which was high unemployment and high inflation. This outcome was not supposed to be possible, according to the popular macroeconomics models, and it left policy makers with no clear choice. If the Fed raised rates to stem the inflation, it would hurt the economy even more, but if the Fed cut rates (through printing more money) the inflation problem would worsen. The vacuum created by this crisis in both theory and policy was filled by the Reagan Revolution and supply-side economics.

At this stage nothing is certain, but the country is currently headed straight into a period of very rapid price hikes and a very bad recession. It would not surprise me at all if the national unemployment rate and the annualized rate of consumer price inflation both broke through into double digits by the end of 2009. Moreover, regardless of when it actually starts, I predict that things will get much worse before they get better, and that the United States will be mired in a malfunctioning economy for at least a decade, with price inflation in the double-digits (possibly higher) the entire time. We can call this condition hyper-depression.

As with stagflation during the 1970s, hyper-depression will blow up the prevailing cutting edge models of the macroeconomy. Back when he was an academic, Fed Chair Ben Bernanke was actually an expert on the Great Depression. Bernanke adheres to the (alleged) lesson taught by Milton Friedman and Anna Schwartz in their classic A Monetary History of the United States. F&S argued that Fed officials bore a large share of the blame for the Great Depression, because they did not pump in enough liquidity. The quantity of money actually declined by about a third from 1929—1933, as panicked customers withdrew cash from the banks. (In a fractional reserve banking system, when people withdraw deposits, the banks have to shrink their outstanding checking balances because of reserve requirements.)

As the following chart illustrates, Bernanke has taken Friedman’s warning to heart: The Fed has more than doubled its balance sheet since the financial crisis began, leading to an unprecedented jump in the monetary base:

Thus far, this enormous injection of new reserves into the banking system hasn’t caused the CPI to explode, but that is because (a) the banks are mostly sitting on the new reserves because they are all terrified, and (b) the public’s demand for cash balances has risen sharply. But using very back-of-the-envelope calculations, there is now enough slack in the system so that if banks calmed down and lent out the maximum amount of reserves, the public’s total money stock could increase by a factor of 10. There is no way that the public will simply add that new money to its checking accounts or home safes without increasing their spending. Eventually, prices quoted in U.S. dollars will start shooting upward.

All of the financial analysts are aware of this threat, but they foolishly reassure us, Bernanke will unwind the Fed’s holdings once the economy improves. But this commits the same mistake as the Keynesians during the 1970s: What happens when the CPI begins rising several percentage points per month, and unemployment is still in the double digits? What would Bernanke do at that point? Expecting the Fed chief to relinquish his new role of buying hundreds of billions in assets at whim, in the midst of a severe recession, would be akin to hoping that a dictator would end his declaration of emergency martial law in the middle of a civil war.

There are even many free market economists who are predicting that the Fed’s massive money-pumping will fix the economy, at least for a while, but at the cost of high price inflation. Yet these analysts don’t realize that they are buying into — what we all thought was — the discredited Phillips Curve. The 1970s proved that the Fed cannot fix structural problems with the economy by showering it with new money. Hyper-depression is simply stagflation squared.

People need to stop wondering, When will the market find its bottom? This month? Next? The federal government has already done an incalculable amount of damage to the American financial sector, and the insults keep growing. Think of it: Besides the unpredictable sometimes we seize you, sometimes we take billions of bad assets off your books, sometimes we let you fail strategy with respect to major financial institutions, the government has also done childish things such as ban short-selling of financial stocks. No one knows what the rules will be next week in these markets. Only a fool would expose new capital to the American financial sector at this point — and the politicians have the gall to wonder, Why are the laissez-faire credit markets frozen?

Market interest rates are prices and as such they communicate important information about real, underlying scarcity. When the central banks of the world decided to drive interest rates down to practically zero, they crippled the ability of the world economy to heal itself after the overconsumption of the housing boom. People all over the world need to be saving right now, and yet governments are doing everything they can to squander what’s left of the capital stock.

I had resisted predicting that we are now living through the early period of the Great Depression II. After all, the conventional statistics today are nowhere near as bad as they were in the 1930s. However, the recent tussle over AIG bonus payments convinced me that we are in this one for the long haul. In particular, Senator Charles Schumer’s comments — and the proposed legislation to back them up — show that we no longer have property rights in this country:

My colleagues and I are sending a letter to [AIG CEO] Mr. Liddy informing him that he can go right ahead and tell these employees that are scheduled to get bonuses that they should voluntarily return them, because if they don’t, we plan to virtually tax all of it. He should tell these employees if they don’t give the money back, we’ll put in place a new law, that will allow us to [tax] these bonuses at a very high rate, so that it’s returned to its rightful owners, the taxpayers. So for those of you who are getting these bonuses, be forewarned: You will not be getting to keep them.

This is an extremely dangerous precedent. It’s true — as many outraged callers to the AM talk shows explain — AIG received billions in government handouts, and so there is a plausible case to be made that those contractual arrangements with its executives should have been amended. But if that’s the case, then the government should have made that a condition of the original loan, or at the very least the government should now exercise its power as the de facto owner of AIG. Liddy was handpicked by the government to run the company, so if the politicians don’t like his decisions, they should fire him.

In contrast, look what Schumer & Co. have done. They are establishing the precedent that if a particular group of rich people does something that angers the government, and if this group happens to be wildly unpopular with the general public, then it is noble for the government to implement ex post facto changes to the tax code, singling these people out and basically robbing them. Schumer’s speech against AIG executives is not much different from him declaring, So I say to Rush Limbaugh and other talk show hosts: Go ahead and continue preaching your hatred and pessimism about the U.S. economy; this is a free country and you have the right to do that. But be forewarned that we are crafting new legislation that will tax 90 percent of your ad revenues from doing so.

What people need to realize is that the government is going to keep making this worse. In other words, it is not enough to step back and say, Well, the feds have already partially nationalized the entire banking system, and brought politics into all major business decisions — including how executives choose to travel to business meetings. What are the effects? On the contrary, we need to realize that as things continue to deteriorate — and they will — the Obama Administration will keep upping the ante. What? The first stimulus didn’t work? OK let’s borrow and spend another $1 trillion; maybe that will ‘take.’

The American people need to prepare themselves for hyper-depression. The future is still uncertain, and if the folks in Washington suddenly found free market religion, that terrible outcome could be avoided. But I’m not holding my breath.

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