The Energy Report: You’ve been tracking macroeconomic trends and their impact on energy commodities for decades and since 2004 through your Shadow Government Statistics newsletter. In a Nov. 10 piece on the trade deficit, you wrote:

Massive fundamental dollar dumping and dumping of dollar-denominated assets may start at any time with little or no further warning. With the U.S. government unwilling to balance or even address its uncontainable fiscal condition and with the Federal Reserve standing ready to prevent a systemic collapse so long as it is possible to print, spend, loan or guarantee whatever money is needed, it puts the U.S. dollar at increasing risk of losing its global reserve currency status. Much higher inflation lies ahead in a circumstance that rapidly could evolve into hyperinflation.

What would be the first sign that hyperinflation is taking hold?

John Williams: I’d look at the dollar. You’ll see massive selling of the U.S. dollar and dumping of U.S. dollar-denominated assets as an early indication. That will be very inflationary, and an indication of global loss of confidence in the U.S. currency. We’ve already crossed that bridge.

Based on generally accepted accounting principles, the annual U.S. budget deficit is running in excess of $5 trillion. Such a deficit is beyond control and containment and dooms the U.S. government to ultimate insolvency and a likely hyperinflation. Money is printed to meet obligations; the government cannot cover its debt otherwise. The efforts by the Fed and federal government to contain the current systemic solvency crisis have moved the onset of a hyperinflation from the end of this decade to the relatively near term.

If you look at the debt-ceiling negotiations and the deficit-reduction deals that were in progress back in early August, it became clear to the rest of the world that the people running the U.S. government had absolutely no political will to address its long-term insolvency. You saw a very heavy selling of the U.S. dollar right after that. This was even before the Standard & Poor’s downgrade.

TER: The downgrade was an indicator of the loss of confidence, though—not the cause.

JW: The downgrade only exacerbated the problem. Once it was clear that there was no political will to address the fiscal issues, dollar selling became intense. Official actions followed that provided temporary support for the U.S. currency. You saw the Swiss franc soar relative to the dollar. The Swiss then intervened, with a quasi-tying of the franc to the euro, which effectively also meant intervention to support the dollar. Gold prices soared, and gold future margins were narrowed.

The lack of global confidence in the dollar underpins the extremely volatile markets since that time. We’ve seen all sorts of interventions and all sorts of rumors floated, but I believe the fundamental global confidence in the dollar has been mortally shaken. As you see mounting selling pressure on the dollar, you’ll generally see spikes in commodities that are denominated in U.S. dollars, particularly oil. That’s very important to the U.S. in terms of inflation. That’s where heavy dollar selling will be seen as a trigger for rising consumer prices and as an early trigger for hyperinflation to move into full speed.

TER: What happens to oil prices in hyperinflation?

JW: It depends on how they’re denominated. I suspect if the dollar becomes weaker, we’ll see a very rapid and strong movement to base oil pricing in something other than U.S dollars. The value of the OPEC (Organization of the Petroleum Exporting Countries) members’ income will drop very quickly as the dollar value drops in terms of international exchange. If oil were denominated in Swiss francs, you might not see too much of a spike, but looking from the perspective of someone living in a U.S. dollar-denominated world, the pace of increase in oil prices will be directly and proportionately tied to the weakness in the dollar against whatever the valuation base is for oil.

TER: The Department of Energy (DOE) reported that gas prices declined 0.8% in September. Are you seeing that gas prices are declining or increasing according to your statistics?

JW: I think the DOE aggregate prices are reasonably accurate on gasoline. You’re going to have ups and downs in the market with very volatile oil prices, as we’ve seen over the past couple of years. Various factors will affect it. For instance, a crisis in the Middle East can spike oil prices very rapidly. But as the dollar comes under massive selling pressure, oil prices will spike, and a rapid decline in the U.S. dollar will result in a very rapid rise in oil prices in dollar-denominated terms.

TER: September gross domestic product (GDP) numbers showed a slightly narrower trade deficit compared to August, partly due to declining oil prices and import volume. Your newsletter suggests possible inaccuracies in federal data. Can these numbers be trusted?

JW: I pay no attention to GDP as an indicator of what’s happening in the broad economy. There’s a major problem with the way the government adjusts its data for inflation. The way it comes up with the headline number, growth is deflated by its estimate of inflation. To the extent that the inflation is understated, you end up with overstated GDP growth. Perhaps not too surprisingly, government-reported inflation is understated, which causes significant overstatement of official economic growth. That’s one reason the GDP is out of whack.

The GDP inflation estimate includes what the government calls hedonic adjustments, where nebulous quality adjustments are factored in and subtracted from inflation. I estimate this takes about two percentage points off the annual inflation number. If you deflate the GDP corrected for that, you’ll see that we never recovered from this recession.

TER: Is that the case with oil price estimates?

JW: Oil price impact on the GDP is not obvious to the casual observer. If oil prices rise, that usually means a higher inflation number and, therefore, it could be expected to weaken the inflation-adjusted economic numbers. So in terms of domestic oil production reflected in the GDP, in nominal terms—before inflation adjustment—part of the production number increases because oil prices are higher, but that gets reduced out when inflation it is factored in. That’s what most people think of as the inflation effect. But remember, we import more oil than we export, and the imports are subtracted from the GDP. So high oil inflation, which would traditionally lower the rate of growth, actually increases the pace of total GDP growth because the negative effect actually is subtracted out as part of the aggregate negative net exports.

In other words, higher oil prices actually spike GDP reporting because of the way the net exports are handled. That’s the nature of the GDP. Again, I put no value in the GDP as an indicator of economic activity.

TER: That’s for prices of oil. What about volume? In September, oil volume was down according to government statistics.

JW: I believe the government has fairly good measures of the physical flow of oil. The reporting of the flows, though, does not always hit when it should. The paperwork flow on imports is better than it is on exports. Duties are sometimes assessed on the imports so they keep much better track of that than they do for goods where they don’t collect money.

TER: So if oil imports were down from September to October, is it simply because, as you said, we never came out of the recession? Or does it mean we’re going into a double-dip recession?

JW: I wouldn’t read much into that because you can argue it either way. You can make all sorts of stories from it, and the people who hype the GDP numbers for the market are pretty good at spinning their yarns.

TER: So if we’re looking at hyperinflation sooner rather than later—which would affect oil prices very directly—how can individual investors protect themselves?

JW: They need to preserve their wealth, assets and purchasing power by getting into hard assets. If you look at oil as a hard asset, it will tend to preserve purchasing power, but it’s a consumable and not easily portable. You can’t stick it in your briefcase and carry it with you if you move from one place to another. It’s difficult to spend physically. So in terms of hedging, I would look primarily at the precious metals and getting assets outside the U.S. dollar into the stronger currencies, particularly the Australian dollar, the Canadian dollar or Swiss franc—despite the Swiss interventions. I’m looking long term. We can expect a lot of volatility short term, but when massive movement against the U.S. dollar begins, those areas will do very well.

TER: Any other energy-related issues that our readers should be aware of to prepare for hyperinflation?

JW: I’m looking at the hyperinflation primarily in the U.S. dollar, not in other currencies, so it’s largely a dollar problem, and the basic protection for those living in a dollar-denominated world is to be out of the U.S. dollar. If you live in a world denominated in Swiss francs or one of the other stronger currencies, you need to think seriously about where you have your dollar investments. That’s the basic consideration from the standpoint of hyperinflation, whether you’re in the energy industry or you’re a farmer or Wall Street trader.

TER: Is there any way to create store-of-wealth value in agriculture?

JW: Farm land is a good hedge, but there’s a difference between holding hard assets with short-term liquidity, such as physical gold, to get through the tough times until after things stabilize, versus assets that may have short-term liquidity issues. Real estate may present liquidity problems at various times, although long term, it’s a fine hedge in terms of maintaining purchasing power. Up front, though, your core assets hedging a hyperinflation have to have enough liquidity so that you can respond to circumstances as they evolve.

In this environment, those invested in the energy sector also have to realize that demand for energy goods will tend to be lower than it might be otherwise, because the U.S. economy will continue to be weak, and not much is being done to fundamentally address that. On the other hand, if domestic oil production could replace foreign production, you could still have a positive domestic demand environment. I’d push for that as much as possible.

TER: Could drilling for natural gas in the U.S. really have an impact on the import/export statistics going forward?

JW: If we can increase exports, that would be a plus. To the extent we produce it domestically and import less as a result, that also would be good for the economy. To the extent anything is produced domestically, that’s a big plus for the economy.

TER: Can we pump and use enough natural gas domestically from the shales to actually make a difference or are we talking too small of a number compared to the amount of oil we import?

JW: I am not an expert on natural gas production. Of course volume is an important factor, and a major increased production would have a significant, positive impact on the GDP. Anything that increases U.S. production and reduces the trade deficit is a plus. Usually increasing domestic production would have the effect of decreasing the deficit. The deficit is a negative for the economy and for jobs. So anything that reduces the trade deficit will be a positive factor for U.S. employment.

TER: That makes sense and is very helpful. Thank you for taking the time to talk with us.

Walter J. “John” Williams has been a private consulting economist and a specialist in government economic reporting for 30 years, working with individuals and Fortune 500 companies alike. He received his AB in economics, cum laude, from Dartmouth College in 1971 and earned his MBA from Dartmouth’s Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar. Williams, whose early work prompted him to study economic reporting and interview key government officials involved in the process, also surveyed business economists for their thinking about the quality of government statistics. What he learned led to front-page stories in the New York Times and Investor’s Business Daily, considerable coverage in the broadcast media and a joint meeting with representatives of all of the government’s statistical agencies. Despite a number of changes to the system since those days, Williams says that government reporting has deteriorated sharply in the last decade or so. His analyses and commentaries, which are available on his ShadowStats.com website have been featured widely in the popular domestic and international media.

I’d like to expand on Evelyn’s article and answer these questions: Why the heck would China put itself in this predicament? Why trade real goods for paper promises? Why put so much faith in the value of the Federal Reserve Note (FRN) and in the ability of the United States’ central bank to maintain the value of dollar-denominated assets?

As a developing (nearly developed) country transitioning from socialist central planning to a market economy, China has relied on the U.S. dollar as a means of stabilizing its own domestic currency, the yuan. For a long time, the yuan was pegged directly to the dollar so that its value went up or down with the FRN. But the U.S. Congress viewed this as “currency manipulation” and threatened high tariffs against Chinese imports if the yuan weren’t revalued. In other words, Congress demanded that China make the U.S. dollar weaker vs. the yuan, which would diminish the trade deficit – at least on paper.

Ever since the end of World War II, when the international gold standard was abandoned, the U.S. dollar has served as the world’s reserve currency. It has been the most stable and widely accepted of the world’s fiat money. But years of monetary expansion have eroded the FRN’s value, and the policies of aggressive debasement of Alan Greenspan and Ben Bernanke have led us to the place we find ourselves today: with the dollar rapidly losing its status to the euro.

What prevents China from switching out of the dollar and into the euro? Again, it holds too many dollars and dollar-denominated assets to make the trade without severely throwing the relationship between the dollar and the euro out of whack. Many other governments are in a similar quandary. And the U.S.’s military dominance still holds sway, particularly over petroleum-exporting countries who are literally forbidden from accepting anything other than the U.S. dollar in exchange for barrels of oil. Just ask Saddam Hussein.

Evelyn said it best when she called the U.S. financial system “Orwellian, bizarre, and unbalanced.” Another word she could have used is “unsustainable.” How and when the system will come crashing down remains to be seen, but my bet is that it happens sooner than most of us are are expecting.

What you may not realize, however, is that the recent federal bailout of the mortgage giants Fannie Mae and Freddie Mac stems in part from the strange and delicate trade relationship the U.S. has forged with China; a relationship that consists of lots of imported Chinese goods that Americans buy up with money that is essentially loaned to the U.S. by, you guessed it, the Chinese.

The Chinese do not issue loans directly to the U.S. the way that a bank would issue a loan to an individual. What the Chinese government does instead is buy up U.S. debt, mostly in the form of mortgage-backed securities. The recent tax rebate stimulus package designed to get shoppers out and spending money again to shore up the flagging U.S. economy came largely from this kind of investment by the Chinese in the debt held by American financial institutions.

While it may seem circular and confusing to think of the Chinese actually loaning the U.S. the money to buy Chinese products, the fact is that right now the U.S. government is heavily dependent on this kind of Chinese investment just for the continuation of its day-to-day business. In other words, without Chinese money being poured into the U.S. in the form of securities purchases, our government would experience such a budgetary shortfall, it would have to shut down.

The linchpin in this arrangement, obviously, is U.S. housing values. If the value of the properties backing the mortgage debt purchased by the Chinese remains stable or increases steadily, everything continues to hum along normally (or at least normally on the surface of it). The Chinese have an asset they see as increasing in value (that is, American mortgage-backed debt securities), and the U.S. government has the money it needs for its day-to-day operations. The Chinese make money off of their exports to the U.S. and off of their investments in U.S. housing-backed debt, and U.S. citizens continue to consume the cheap Chinese goods we have grown accustomed to buying.

That’s the U.S. consumer economy in a nutshell, and if it sounds a bit Orwellian, bizarre, and unbalanced, that’s because it is. Nevertheless, that’s how we roll these days, or did, until the housing bubble burst and the values of the properties actually backing all this mortgage debt began to drop precipitously. At first it was only subprime debt that went bad, but that spread to what is known in the mortgage industry as Alt-A debt (which is a notch above subprime and once considered quite a safe risk).

Now even homeowners who are in no danger of defaulting on their mortgages are seeing dramatic drops in their property values due to a badly inflated housing market and the subsequent bursting of that bubble. And as if that isn’t all bad enough, the problem is rapidly spreading to other kinds of U.S. debt: credit cards, car loans, home equity lines, and small business lines of credit.

To put it in just a few words: the actual assets backing U.S. debt are now depreciating instead of appreciating in value, leaving the Chinese holding substantial investments in the U.S. that are looking less and less profitable. The Chinese have been friendly to the U.S. because they are making lots of money from the relationship. With the bursting of the housing bubble, not so much. They have been growing more and more nervous about this fact.

What does that have to do with Fannie and Freddie?

Fannie Mae and Freddie Mac back most of the mortgage debt in the United States, but because they have always had a quasi-governmental status, they have not kept the kind of prudent reserves on hand that a private financial institution would be required to keep to mitigate such losses. As it became more and more clear over the course of the past year or so that Fannie and Freddie didn’t have adequate financial reserves to back the debt they held, the Federal Reserve and the Treasury Department began to talk about a bailout.

It’s a bad thing that housing values are plummeting in the U.S., but it has to happen because they were so wildly inflated during the boom years. That hard correction would be painful for the U.S. no matter what, and we are certainly feeling the pain already in the form of a major economic turndown that looks like it will last at least through the better part of 2009. But what would be even more catastrophic than the pain we are already feeling in our collective national pocketbook would be a decision by the Chinese to pull back on their investment in us. Such a move would literally throw us into a financial meltdown that would make the Depression era look pretty cheerful by comparison.

So, while it may or may not be true that Fannie and Freddie “are too big to be allowed to fail,” what is unquestionably true is that the U.S. government is too big to be allowed to fail, and fail it would without a steady influx of Chinese money.

All of this is more food for thought that I can possibly digest in a single sitting. If you pay close attention to the expressions on the faces of Bernanke and Paulson, you may well detect a hint of dyspepsia there, too.

The day is saved. Again. For now.

And yet once again, in the smoking (and indigestible) aftermath, a familiar and phrase rears its ugly head:

“What next?”