A Quick Run Down of Why the Economy is Performing So Terribly
OK, OK, so I said that I wouldn't write about any of this. I won't get too specific. Yet, I really couldn't write on much of anything if I didn't address some current issues, so I'm going to write a primer on why booms and busts occur.
How Money Works
There is no such thing in this world anymore as sound money. I would define sound money as a tool of trade available in a relatively stagnant quantity that retains similar value amongst all participants in the economy that allows for the determination of relative valuation of goods and services while they are traded. Sound money is usually tied to a resource in relatively static supply (often gold) to maintain this stagnant quantity. The actual numbers are irrelevant in a sound money system. If Paul and John each have one dollar, and it costs one dollar to buy a loaf of bread, each of them can afford a loaf of bread. If they each have ten dollars, and a loaf of bread is ten dollars, then they can each afford a loaf of bread. In this case, ten times the amount of currency in the system didn't impact the relative value of each man's wealth. The trade for bread could be carried out just as easily in a one dollar world or a ten dollar world. If the value of the money is unchanging, the bread's value may fluctuate over time due to changes in supply and demand, but the specific digits don't matter. Similarly, If the US suddenly stated that every dollar is now ten dollars and in real time multiplied everyone's savings by exactly 10x, and multiplied everyone's debts, obligations, salaries, etc... simultaneously, the result would be inflation to 10x current value with no real change in the economy, as everyone would have 10x as much money.
When we think about it logically, there is no reason to ever multiply everyone's money by 10x. The simple act of creating more digits does absolutely nothing to improve the economy. In the above scenario, the printing of 10x the money supply will simply cause goods and services to increase in cost by 10X. It doesn't make everyone 10x richer.
Let's take what happens in the US. There is no sound money. The US dollar is not attached to a gold, or silver, or platinum, or anything standard. The money supply can change on a whim (and the quick turning on of the printing press by Ben Bernanke at the Federal Reserve). If all of the money that they printed hit the market at the same time equally in relative proportion to current wealth and all current obligations were changed accordingly, the only impact on the economy would be the excessive waste of paper. However, this doesn't resemble the current situation. Currently, money enters the system at certain points. It goes to banks in the system of fractional reserve banking, and it goes to the government. This gives both banks and the government (along with those well connected to the government) a real time financial advantage. To use the previous example, the banks and the government see their 10x increase before the cost of the bread goes up 10x, giving them greater relative purchasing power. Eventually, the money will even out in the economy, and the bread will rise by whatever percentage increase has occurred, but not before the banks and government have had the opportunity to purchase bread at the lower price with the new money. This allows them to accumulate resources with greater ease than other players in the economy.
The other thing that does not change in the current system is debt obligation. If I make a loan, and I charge a 10% interest rate, the balance of the loan isn't impacted by relative inflation. In other words, if I lend you $100, and the money supply goes up by 2x, you still only have to pay back $100, which is now only half as much money in a relative sense. Lenders cannot automatically determine exactly how the government will mess with the money supply, but an adjustment for inflation must be built into any banks lending portfolio if they want to stay in business. In other words, if I determine that with all risk and cost, that I can profitably lend at 5%, and I assume 3% inflation, I must actually lend at 8%.
Another point is that the relative change in wealth due to the entry points for a non-sound money supply cause distortions in the value of different goods. Things for which the banks lend money, or the government supports, will increase in relative cost to other goods. This can cause all sorts of confusion in the economy. As the money makes its way into the economy at large, inflation will occur in some sectors, while deflation occurs in sectors where the money first hit. In other words, lets say that the government prints an extra 10% of the money supply, which goes primarily to banks through the Federal Reserve. Banks use this to invest in abandoned mines. The relative increase in money initially going towards abandoned mines will be much greater than 10%, as all 10% increase in the money supply is going towards something that was much less than 100% of the economy. This may triple, quadruple, quintuple the cost of an abandoned mine. However, assuming no further distortions, that 10% will eventually work its way into the economy, and the value of all other goods and services should increase in relative proportion by 10% while severe deflation hits the abandoned mine industry and knocks prices down to only about 10% above the original price (and possibly even lower for a time, as its hard to tell exactly where this bottom price is.)
How Does This Apply to the US?
Ever since the creation of the Federal Reserve, the lack of sound money has caused ebbs and flows in economic distortion. As I've already pointed out, increasing the money supply eventually leads to inflation of cost by a similar amount with distortions brought about along the way as the money balances out in the economy. The concept that the government could in some way increase productivity and wealth by printing lots of money is based on the writings of the economist Keynes. It has never worked in action ever, but it is the basis for everything that we've done to bring us to this point. The economic distortions, followed by their corrections, are the likely cause of the business cycle, and the current situation is nothing but an overblown business cycle.
After 9/11, the economy went into a recession. It was not severe, and it made sense. Total economic activity declined in the environment. A sound money economic theory would tell you that the recession was due to a real decline in national productivity and that the solution would be to wait for productivity to pick up again. Instead, Alan Greenspan (chairman of the Federal Reserve at the time) implemented a loose monetary policy. This means that he essentially flooded the market with new money to "jump start" the economy. The tools that he used were primarily aimed at banks. Banks make loans, and the increase in economic activity went towards large capital investments that banks make loans for. This caused a relative expansion in business (one for which there may not have been demand to justify), an increase in cost for higher education, and more conspicuously began to drive up the price of real estate.
This policy became a runaway disaster. At one point, 8% of the entire money supply was being printed annually. As with my example of the abandoned mines, the relative increase in cost in certain industries that are primarily financed by lending was MUCH greater as the relative distortion hit those industries first. In other words, instead of everyone getting 8% more money and paying 8% more for goods, we saw huge increases in wealth amongst a few people and hyperinflation in real estate (and to a lesser extent higher education and large scale business investment products).
People well connected to the government or close to the banks made HUGE amounts of money. Meanwhile, regular individuals became priced out of many housing markets, because they were now trying to purchase the more expensive houses without any increase in personal wealth from the original dollar. The only way to access these things became to borrow money. Real estate debt skyrocketed. Student debt skyrocketed. The relatively loose lending standards that came to exist due to the excess of money at the banks led to easy loans and this brought the distortion into other luxury industries, as people were able to borrow against their hyperinflating real estate values in the form of HELOCs (home equity lines of credit). Labor was also misallocated, as jobs in real estate, construction, lending, etc... took workers that might have worked in other industries.
Then it all ended. As the money has made its way into the economy at large, we are seeing inflation in some goods with a severe deflation in real estate. This is just like the example of the abandoned mines. In many ways this is GOOD. Houses will no longer be out of reach for normal people without exotic bank loans. People will be able to work in industries where they will produce things for which the demand is not artificial.
The problem is that there is a period in which these distortions have to work themselves out. These distortions were severe, and thus the correction is also severe. All of the people who were employed in real estate, construction, lending, etc.. are now unemployed. They are now not producing anything, which causes a real loss of productivity and growth. This reduces demand, which causes other industries to suffer, and the whole thing ripples like a wave through the economy. This doesn't even take into account the simultaneous correction of distortions in business investment and the loss of the luxury distortions due to the HELOC falling out of favor with declining real estate prices. The point really is, that the economy was severely distorted due to the departure from sound monetary practices and now the correction is severe
The end result of all of this should eventually be the new money working its way through the economy and a return to normal relative valuations with the natural fluctuations due to changes in supply and demand. The recession is not permanent. The loss of productivity is not permanent. People will eventually find work again, and the recessionary cycle will unwind.
Except....
The Wrong Solution
The current philosophy of the US government is to attempt to print more money to "jump start" the economy again. Bail-out, stimulus, TARP, whatever, it all means the same thing. These pork-laden bills funded again with fake printed money will only cause distortions in favor of whatever is in them, which will lead to future recessions. Instead of a real estate bubble, we could have a green jobs bubble, or an infrastructure bubble, or a health IT bubble. It's all the same concept. Attempts to save the artificially inflated housing market will only distort the market further and delay a recovery to natural prices.
One only needs to look at what other nations have already done. Japan spent trillions trying to save itself from its own real estate bubble in the 80s, and parts of the economy still haven't recovered. In many European nations, with France being my favorite example, bad monetary policy coupled with severe restrictions on business, wages, hiring, and firing creates a distorted environment in which the economy isn't even allowed to adapt. This leads to perpetually high unemployment, as cycles and corrections lay one on top of the other, and nothing resembling a steady state is ever reached.
We should be looking in the exact opposite direction for an effective public policy. STOP DISTORTING THE MARKETS. STOP PRINTING NEW MONEY. Let the economy correct.
That's what's happening in the US, and that is why the economy is performing so terribly.
How Money Works
There is no such thing in this world anymore as sound money. I would define sound money as a tool of trade available in a relatively stagnant quantity that retains similar value amongst all participants in the economy that allows for the determination of relative valuation of goods and services while they are traded. Sound money is usually tied to a resource in relatively static supply (often gold) to maintain this stagnant quantity. The actual numbers are irrelevant in a sound money system. If Paul and John each have one dollar, and it costs one dollar to buy a loaf of bread, each of them can afford a loaf of bread. If they each have ten dollars, and a loaf of bread is ten dollars, then they can each afford a loaf of bread. In this case, ten times the amount of currency in the system didn't impact the relative value of each man's wealth. The trade for bread could be carried out just as easily in a one dollar world or a ten dollar world. If the value of the money is unchanging, the bread's value may fluctuate over time due to changes in supply and demand, but the specific digits don't matter. Similarly, If the US suddenly stated that every dollar is now ten dollars and in real time multiplied everyone's savings by exactly 10x, and multiplied everyone's debts, obligations, salaries, etc... simultaneously, the result would be inflation to 10x current value with no real change in the economy, as everyone would have 10x as much money.
When we think about it logically, there is no reason to ever multiply everyone's money by 10x. The simple act of creating more digits does absolutely nothing to improve the economy. In the above scenario, the printing of 10x the money supply will simply cause goods and services to increase in cost by 10X. It doesn't make everyone 10x richer.
Let's take what happens in the US. There is no sound money. The US dollar is not attached to a gold, or silver, or platinum, or anything standard. The money supply can change on a whim (and the quick turning on of the printing press by Ben Bernanke at the Federal Reserve). If all of the money that they printed hit the market at the same time equally in relative proportion to current wealth and all current obligations were changed accordingly, the only impact on the economy would be the excessive waste of paper. However, this doesn't resemble the current situation. Currently, money enters the system at certain points. It goes to banks in the system of fractional reserve banking, and it goes to the government. This gives both banks and the government (along with those well connected to the government) a real time financial advantage. To use the previous example, the banks and the government see their 10x increase before the cost of the bread goes up 10x, giving them greater relative purchasing power. Eventually, the money will even out in the economy, and the bread will rise by whatever percentage increase has occurred, but not before the banks and government have had the opportunity to purchase bread at the lower price with the new money. This allows them to accumulate resources with greater ease than other players in the economy.
The other thing that does not change in the current system is debt obligation. If I make a loan, and I charge a 10% interest rate, the balance of the loan isn't impacted by relative inflation. In other words, if I lend you $100, and the money supply goes up by 2x, you still only have to pay back $100, which is now only half as much money in a relative sense. Lenders cannot automatically determine exactly how the government will mess with the money supply, but an adjustment for inflation must be built into any banks lending portfolio if they want to stay in business. In other words, if I determine that with all risk and cost, that I can profitably lend at 5%, and I assume 3% inflation, I must actually lend at 8%.
Another point is that the relative change in wealth due to the entry points for a non-sound money supply cause distortions in the value of different goods. Things for which the banks lend money, or the government supports, will increase in relative cost to other goods. This can cause all sorts of confusion in the economy. As the money makes its way into the economy at large, inflation will occur in some sectors, while deflation occurs in sectors where the money first hit. In other words, lets say that the government prints an extra 10% of the money supply, which goes primarily to banks through the Federal Reserve. Banks use this to invest in abandoned mines. The relative increase in money initially going towards abandoned mines will be much greater than 10%, as all 10% increase in the money supply is going towards something that was much less than 100% of the economy. This may triple, quadruple, quintuple the cost of an abandoned mine. However, assuming no further distortions, that 10% will eventually work its way into the economy, and the value of all other goods and services should increase in relative proportion by 10% while severe deflation hits the abandoned mine industry and knocks prices down to only about 10% above the original price (and possibly even lower for a time, as its hard to tell exactly where this bottom price is.)
How Does This Apply to the US?
Ever since the creation of the Federal Reserve, the lack of sound money has caused ebbs and flows in economic distortion. As I've already pointed out, increasing the money supply eventually leads to inflation of cost by a similar amount with distortions brought about along the way as the money balances out in the economy. The concept that the government could in some way increase productivity and wealth by printing lots of money is based on the writings of the economist Keynes. It has never worked in action ever, but it is the basis for everything that we've done to bring us to this point. The economic distortions, followed by their corrections, are the likely cause of the business cycle, and the current situation is nothing but an overblown business cycle.
After 9/11, the economy went into a recession. It was not severe, and it made sense. Total economic activity declined in the environment. A sound money economic theory would tell you that the recession was due to a real decline in national productivity and that the solution would be to wait for productivity to pick up again. Instead, Alan Greenspan (chairman of the Federal Reserve at the time) implemented a loose monetary policy. This means that he essentially flooded the market with new money to "jump start" the economy. The tools that he used were primarily aimed at banks. Banks make loans, and the increase in economic activity went towards large capital investments that banks make loans for. This caused a relative expansion in business (one for which there may not have been demand to justify), an increase in cost for higher education, and more conspicuously began to drive up the price of real estate.
This policy became a runaway disaster. At one point, 8% of the entire money supply was being printed annually. As with my example of the abandoned mines, the relative increase in cost in certain industries that are primarily financed by lending was MUCH greater as the relative distortion hit those industries first. In other words, instead of everyone getting 8% more money and paying 8% more for goods, we saw huge increases in wealth amongst a few people and hyperinflation in real estate (and to a lesser extent higher education and large scale business investment products).
People well connected to the government or close to the banks made HUGE amounts of money. Meanwhile, regular individuals became priced out of many housing markets, because they were now trying to purchase the more expensive houses without any increase in personal wealth from the original dollar. The only way to access these things became to borrow money. Real estate debt skyrocketed. Student debt skyrocketed. The relatively loose lending standards that came to exist due to the excess of money at the banks led to easy loans and this brought the distortion into other luxury industries, as people were able to borrow against their hyperinflating real estate values in the form of HELOCs (home equity lines of credit). Labor was also misallocated, as jobs in real estate, construction, lending, etc... took workers that might have worked in other industries.
Then it all ended. As the money has made its way into the economy at large, we are seeing inflation in some goods with a severe deflation in real estate. This is just like the example of the abandoned mines. In many ways this is GOOD. Houses will no longer be out of reach for normal people without exotic bank loans. People will be able to work in industries where they will produce things for which the demand is not artificial.
The problem is that there is a period in which these distortions have to work themselves out. These distortions were severe, and thus the correction is also severe. All of the people who were employed in real estate, construction, lending, etc.. are now unemployed. They are now not producing anything, which causes a real loss of productivity and growth. This reduces demand, which causes other industries to suffer, and the whole thing ripples like a wave through the economy. This doesn't even take into account the simultaneous correction of distortions in business investment and the loss of the luxury distortions due to the HELOC falling out of favor with declining real estate prices. The point really is, that the economy was severely distorted due to the departure from sound monetary practices and now the correction is severe
The end result of all of this should eventually be the new money working its way through the economy and a return to normal relative valuations with the natural fluctuations due to changes in supply and demand. The recession is not permanent. The loss of productivity is not permanent. People will eventually find work again, and the recessionary cycle will unwind.
Except....
The Wrong Solution
The current philosophy of the US government is to attempt to print more money to "jump start" the economy again. Bail-out, stimulus, TARP, whatever, it all means the same thing. These pork-laden bills funded again with fake printed money will only cause distortions in favor of whatever is in them, which will lead to future recessions. Instead of a real estate bubble, we could have a green jobs bubble, or an infrastructure bubble, or a health IT bubble. It's all the same concept. Attempts to save the artificially inflated housing market will only distort the market further and delay a recovery to natural prices.
One only needs to look at what other nations have already done. Japan spent trillions trying to save itself from its own real estate bubble in the 80s, and parts of the economy still haven't recovered. In many European nations, with France being my favorite example, bad monetary policy coupled with severe restrictions on business, wages, hiring, and firing creates a distorted environment in which the economy isn't even allowed to adapt. This leads to perpetually high unemployment, as cycles and corrections lay one on top of the other, and nothing resembling a steady state is ever reached.
We should be looking in the exact opposite direction for an effective public policy. STOP DISTORTING THE MARKETS. STOP PRINTING NEW MONEY. Let the economy correct.
That's what's happening in the US, and that is why the economy is performing so terribly.
posted by MiamiMed at 7:26 AM
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