The Goldilocks conditions continue, with low mortgage rates supporting home prices and equity extraction, allowing debt to continue growing and funding consumption.

Trees don’t grow to the sky, and debts can’t grow indefinitely. Somewhere there is a limit.

The endlessly debated question is, as we approach the limit, whether we end up with a deflationary crash and depression as defaults cause the money supply to tank, or money-printing spirals out of control causing a Weimar-style hyperinflation.

The conflicting forces of inflation and deflation can clearly be seen. Commodities and financial assets are increasing in price at spectacular rates. But the supply of labor from rapidly developing countries such as China and India is exerting a strong deflationary pressure on wages and employment. The net result is that price increases in consumer goods and services are restrained, as of course are personal incomes.

The bond market is saying that inflation is not going to be a problem, that 4% yields will be a satisfactory return. Usually the bond market is right. Alan Greenspan is steadily ratcheting up short-term interest rates, a quarter-point every six weeks or so. He’s at 2.75% now. The big question is, where will he stop? We know that an inverted yield curve is an almost certain harbinger of recession. Every time he ratchets the short rates, the profit opportunity from the “carry trade” (borrow short and lend long) diminishes. Just by itself, this is already starting to hit the profitability of the financial services industry.

Unless we see consistent and sustained growth in wages and employment, it seems unlikely that an inflationary spiral in incomes can be sustained. This means that consumption will ultimately hit a wall as consumers find debt service draining their discretionary budget. If consumption hits a wall, then Alan Greenspan will once again start lowering interest rates and printing more money. Will that serve to increase incomes? I doubt it. Long rates will probably decline even further, encouraging more refis in a debt spiral. But eventually incomes won’t allow the debt service and it will be default time. When? Ah, there’s the question…