The Big Knob

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.  -- Paul Krugman, "Dubya's Double Dip?", The New York Times, 2 August 2002

If you only have a hammer, you tend to see every problem as a nail. -- Abraham Maslow


For nearly all my adult years, I have advocated against the size of government on the simple basis that government and freedom are inverses of each other. This is 100% true, and reason enough all by itself for patriots to act. Large governments are overly restrictive and a burden and a brake on productivity. It's a fine line between economic freedom and personal freedom. If a person's wealth derives from his or her work, then the two are certainly one and the same. A person's output is also his impact on an economy. The economy naturally produces savers and those who need access to someone's savings to accomplish their goals. Think of the farmers that share a tractor. It is borrowed and loaned regardless of who owns it. The local economy works.

Back when your Wizer was an average citizen, I was also a small investor. I would get an extra hundred bucks, and would buy a few shares of a well managed company.  In this way, money was loaned into a capital market. Then, the government sponsored terrorism known as the global financial meltdown happened, and that money was inexplicably lost. What went wrong? It occurred to me that the CEO of the well managed company was no match for the financial big-wigs that were creating this crisis. So, instead of suing Bernanke, I sought to watch and learn whatever I could about macro-economics. My studies have been continuous since about 2007, and I've read up on the crisis and other writings from many economists, including those who seek to influence public opinion (like Paul Krugman and Thomas Woods).

The basics are pretty simple. The Federal Reserve is this politically appointed, though independently run organization that is paid for by a tax on the bankers. In return the bankers get first dibs on freshly printed money. When unemployment goes up, the Fed increases the money supply (by initiating bond purchases), thereby lowering interest rates. In turn, a flurry of credit activity from the banks to the businesses quickly puts people back to work. That's the way it's designed and supposed to work. As soon as full employment is reached, the Fed can then sell off all the bonds it bought with printed money, and let the money supply fall back to it's normal trajectory (some rational trajectory, I imagine, mirroring the natural growth of the economy). It's supposed to be the only knob the Fed can turn, but it's a big one. If they overturn this knob, you get runaway inflation.

Since this unemployment cycle was itself a big one, the Fed found it necessary to turn this knob all the way up. That's where it is set now. However, the expected result (increased "velocity of money", full employment, and highly active credit market) has not materialized. There are many reasons for this:

The excess reserves that the banks are holding are at historic highs. The risk of lending outweighs the benefits (after all market rates are too low to take on a lot of risk). People are deleveraging now, it is said, because their home equity took an enormous hit; they are therefore not seeking to borrow more money at any rate.

Large companies have stockpiled capital to prepare for a very serious backlash that may occur when the costs of Obamacare and other new regulations are fully known. As a group, they are not willing to add to employment. Small companies are concerned because large companies are concerned, and they are not taking on the risk of a large payroll either.

From this, we can consider a hypothetical scenario. Let's say this concern about new government regulations turns out to be not as bad as thought, and the Russell 2000 small companies resume their pre-2008 hiring plans. Then, employment more or less unexpectedly spikes up. If it does, then the outstanding capital, 800 Billion in excess reserves, a like number in reserve corporate capital, and finally, the borrowing and spending at the consumer level will heats up.  All this will happen at the same time. Because the money supply is enormous compared to the size of the economy, this will create an inflationary tsunami that will make 1979 look like a kiddie pool.

The other scenario is worse, so I'll stay with this one for now. In the best case scenario for Obamacare (which is a blow for freedom, but may have short term economic firepower), employment returns to normal. Then the result is inflation which feeds the next bubble (probably the bond market). The incredibly large money reservoir will burst. All these dollars will be chasing anything of value, and inflation could reach 10% per month. Think Zimbabwe. If there's any doubt that this could happen, consider the difference between 2007 and 2008 in terms of economic activity. Everything happens faster in the future.

So, is there a way to keep that from happening? Yes, but no political animal is likely to attempt this. The bigger bolder thing to do is to mop up all the excess liquidity, and allow a deflationary period to ensue. Eliminate wage floors, so that full employment can be reached in the private sector, and despite a strong dollar, exports will grow due to better cost and price on the global market. Reduce government spending so that it does not crowd out private investment. Oh, and roll back the debt on a very aggressive schedule. This is the right way get out of a depression.

Instead, the Fed seems intent on replaying 1932, and this time with new multipliers: The incredibly high debt (which we will cover in some detail later), and the large percentage of government spending as a percent of GDP (also to be covered later). Both are choking off any semblance of a recovery.

See also:
http://www.washingtontimes.com/news/2011/dec/19/government-spending-jobs-myth/