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Print, Baby, Print!

Steve Saville
email:
sas888_hk@yahoo.com
Aug 17, 2010

Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 12th August, 2010.

According to an article by Jonathan Laing in the 9th August edition of Barrons magazine:

"The Fed should, and probably will change its tune by the fall and fire up the printing presses. Its current stance of watchful waiting in the face of slowing economic growth, inflation cycling below its preferred target rate of 1.7% to 2% and naggingly elevated unemployment strikes some observers as nothing short of mind-boggling. With good reason, these critics are pushing the Fed to adopt the deflation-fighting strategy that Bernanke mentioned in 2002, when he was a newly minted Fed governor. He suggested that the Fed could always buy long-term government bonds and corporate debt to mainline more liquidity into the financial system to counteract incipient deflation."

Bernanke was correct back in 2002 when he pointed out that the Fed could always devalue the dollar by increasing its supply, but as far as we can tell that's the only important economics concept he has ever been correct about. The problem with the whole approach of mainlining "more liquidity into the financial system to counteract incipient deflation" is manifold. First, creating more money doesn't create more wealth or more real savings. Money, after all, is simply the medium of exchange. Second, when money is devalued by inflation (that is, by increasing its supply) the devaluation isn't uniform; rather, some prices rise more than others. In fact, in the early stages of an inflation-driven monetary devaluation some prices -- often the prices that the central bank and government are trying to support -- will not rise at all or will continue to fall. These distortions of relative prices lead to mal-investments, which, in turn, lead to the destruction of real wealth. In other words, not only does increasing the money supply fail to expand the size of the 'wealth pie', it eventually brings about a reduction in the size of the pie. Third, devaluing money by increasing its supply punishes savers and anyone on a fixed income. This is not just misguided from a pragmatic economics perspective; it is ethically wrong.

One of the main reasons for the on-going popularity of the money-printing 'solution' is the widespread belief that consumer spending -- what many economists refer to as "aggregate demand" -- drives economic growth. If you believe that economic strength is due to increasing aggregate demand and that economic weakness is due to falling, or inadequate, aggregate demand, then anything that gets consumers borrowing and spending will be seen as a plus. The reality, however, is that an increase in consumer spending is an effect, rather than a cause, of economic growth. The economic growth chain begins with saving/investing, moves along to increased production and ENDS with an increase in consumer spending. Is it really so hard to understand that for someone to consume more he must first produce more?

It's actually not quite that simple, because it isn't just a matter of producing more; it's a matter of producing more of what people want today and will want in the future. For example, due to the inflation-fueled boom of 2003-2007 the US economy and many other economies geared up to produce far more houses per year than would be required to meet genuine/sustainable demand for new houses. Consequently, it is now essential for some of the resources dedicated to the housing industry to be reallocated. Exactly how should these resources be reallocated? The answer is that neither we nor anyone else is qualified to say. Price signals will determine the correct allocation, which is why the central bank and the government must avoid taking actions that distort prices. But instead of getting out of the way and letting the market clear, the policy-making clique has been doing what it can to support house prices and boost the demand for new homes.

The fear is that if the market is left to its own devices the economy will experience deflation. This fear is expressed as follows in the second-last paragraph of the Laing article:

"Once an economy succumbs to deflation, it's often hellishly difficult for a nation to escape the trap. Companies and consumers alike tend to defer their spending on the assumption that prices for goods and services figure only to get cheaper in the future. Real interest rates spiral higher, making debt burdens all the more onerous. Forced collateral liquidations result, driving asset prices ever lower."

In other words, the fear is that falling prices will cause purchases to be postponed, leading to even lower prices and economic contraction.

If falling prices really did endlessly feed on themselves and result in the continual putting-off until tomorrow of purchases that would otherwise be made today, then almost no computers would be sold each year. After all, everyone knows that computing power gets cheaper every year. Also, if falling prices got in the way of economic growth then there would have been no growth in the US economy from the mid 1870s through to the mid 1890s, but the US economy grew more during this 20-year period of relentless "price deflation" than it did during any subsequent 20-year period. The fact is that there will always be many things that people want to buy in the present, even if they believe that these same things will cost less in the future. The fear of falling prices is therefore an imaginary hobgoblin designed to alarm the populace and provide justification for more inflation.

Laing's article ends with: "It's high time to get out the money-printing machines. Damn the risks of triggering a bit of inflation and some modest investment bubbles. The alternatives are far worse."

Was absolutely nothing learned from the events of the past decade? Is it reasonable to believe that the US economy would be in a worse situation today if the Fed had let the market clear after the dot.com bubble collapsed, as opposed to fomenting new investment bubbles in housing, mortgage finance and securitisation? Given that the US economy has achieved ZERO growth in private-sector employment over the past 10 years, how much worse could the situation realistically be?

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Steve Saville
email: sas888_hk@yahoo.com
Hong Kong

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