The Cobden Centre

We’re delighted to announce that Jamie Whyte is now a Senior Fellow at the Cobden Centre.

In addition to his articles for The Times, The Telegraph, The Wall Street Journal, City A.M., and of course for us, Jamie has been actively promoting free market principles on BBC Radio.

Following the success of his Yo, Hayek documentary and the LSE’s Keynes-Hayek debate, Jamie recently featured in Michael Portillo’s Capitalism on Trial (from 18m 54s), and Wednesday night’s Moral Maze (from 20m 31s).

It is a beautiful autumn day in London, unseasonably warm and sunny, the city looking its very best, and I am trying to find a hook for this blog. I should speak about the European debt crisis, the sharp drop in equity markets last week after “Operation Twist” was announced, and the washout in commodity markets, not least in gold. I will cover all these topics but what should my hook be?

A good place to start is always the mainstream media, first and foremost the Financial Times, that most mainstream of mainstream organs, reliable purveyor of common wisdom, a paper written by the establishment for the establishment in the unshakable belief that for every problem there is a political solution. If this won’t shake me out of my jetlag and stomach-bug induced stupor, nothing will.

In today’s FT Martin Wolf writes again about the European debt crisis, a problem for which, so he believes, there is a political solution.

“The emergence of doubt”

Before we go to the solution, let’s specify the problem first. After the usual references to the great and powerful who met in Washington last week, the “clear, compelling, courageous” analysis by the great IMF, and quotes from Mr. Wolf’s favourite celebrity bureaucrats, Mr. Geithner and Mme Legarde, he correctly identifies the problem: Most sovereign states are bust and so are the banks, which are today a protectorate of the state and have repaid the generosity of their protectors by lending excessively to them. Mr. Wolf is too skilled and sophisticated a writer to put it this bluntly but if you read his article that is what it boils down to:

“The emergence of doubt about the ability of sovereigns to manage their debt undermines the perceived soundness of the banks, both directly, because the latter hold much of the debt of the former, and indirectly, via the dwindling value of the sovereign insurance.”

And why are we in this mess? Because some time ago we adopted a system of limitless and constantly expanding fiat money. In such a system, the privileged money producers – no prize for guessing who they are, correct, the state and the banks – apparently never have to shrink and can conduct their financial affairs in the comforting knowledge of unlimited access to the printing press. No credit contraction, no bank failures, no sovereign defaults. Whenever the money runs out we simply lower interest rates, create more bank reserves out of nothing, and off we go again. This has worked for 40 years. Alas, no more.

The present problems, the unsustainable bank balance sheets, the out-of-control budget deficits, and the mindboggling levels of public debt, are inconceivable without a system of constant fiat money creation and extended periods of artificially low interest rates courtesy of the central banks. Or, to put it the other way round, a monetary system like ours, in which interest rates can be set administratively to encourage bank lending and to underwrite the constant growth of state and banks, must ultimately lead to a bloated public sector and a bloated banking industry. The fiat money system is feeding its own disintegration.

Bail me out again, Sam.

Mr. Wolf offers two solutions. Both are dangerously misguided, which means that both stand an excellent chance of becoming policy.

Apparently, Mr. Wolf does not want to deprive the banks and the states of their special status. They lent too much and they borrowed too much but the laws of economics, the laws of gravity and the laws of logic are still not supposed to apply to them. They should be saved again.

Wolf says the banks should be “recapitalized”.

Wait a minute. These are failed corporations. They lent billions to corrupt Greek politicians. They put their chips on red and black came. They lost.

For capitalism to work it requires that the market be cleansed of failed corporations, not that these corporations get “recapitalized”. We are simply perpetuating the bad habits of our fundamentally flawed and anti-capitalist monetary system by shielding the banking industry from its mistakes and never allowing market forces to shrink it. This is not only a mistake for reasons of “moral hazard”. That is the least of it. It is simply a fact that after a forty-year fiat money binge the banking industry is too big, it is now sized for a never-ending credit boom when we just entered the credit bust. We should not be relying for our economic future on an ever more bizarrely propped-up banking sector.

But this “solution” begs another question: who is going to pay for this? We just learnt that the state is bust, too.

Well, while he is at it, Mr. Wolf also wants to save the state. How? Via a super-sized EFSF (European Financial Stability Facility) – a mega bailout fund. Mr. Wolf joins his buddy, Tim Geithner, in recommending “shock and awe” – not that this term conjures many positive memories.

In short, more money is needed. Much more.

“Given the funding needs of banks and sovereigns, this translates into well more than €1,000bn, and, quite plausibly, several times that number.”

Bring your bazooka

Several trillion? – Me thinks that Mr. Wolf has been hanging out it in Washington too much. I am convinced that in the macho atmosphere of IMF and World Bank power banquets you are now looked down upon as a policy-making lightweight if you are still content with assigning only billion dollar price tags to your pathetic policy initiatives. ‘Trillion’ is the new denomination for the grown-ups in the policy elite. Hey, Europeans, if you want to be players you better add a few zeros!

But again, where does the money come from?

Want to guess?

Here is Wolf again, warming to the military theme:

“The eurozone needs a much bigger bazooka. Apparently, five different plans are under discussion. These involve leveraging up the EFSF’s money, by issuing guarantees rather than loans, or borrowing from the European Central Bank, or by borrowing in the markets. But if action needs to be immediate, as it does, the only entity able to supply the needed funds is the central bank.”

Ah, here we are. The central bank. Finally. After all the elegant prose, the bureaucracy worship and the habitual name-dropping, the bottom-line is this: turn on the printing press! Print more money! Print! Print!

This is madness, so I do think it is precisely what will happen. Mr. Wolf will get his way. Because the policy elite thinks just like he does. Default is not an option. Banks cannot be allowed to fail. States – at least if they are not called Greece for which this comes too late – cannot be allowed to fail either. We rather try and print our way out of this. Everybody gets bailed out – via the printing press.

Believe me it will not work. It will lead to complete disaster. But it will be tried.

Mr. Wolf looks at it in hope, I look at it in horror. Once this gets implemented and the market realizes what is going on, it will dump government bonds, real yields will shoot up, and confidence in state paper money will evaporate. What will the central banks do then? Print money faster as the overstretched system cannot cope with higher real yields.

So what should you do to protect yourself? – Well, I don’t want to give investment advice, so please treat this carefully – I could be wrong, so this may not work but I think it wouldn’t be unreasonable to ditch government bonds, and while you are at it, ALL bonds, and man the lifeboats, which consist of gold and silver.

But what did markets do last week? They trashed gold and silver and lifted government bonds to new heights. Does it make sense? No, it doesn’t. But here is why I think it happened.

The market was apparently disappointed with “Operation Twist”. This surprised me, and maybe surprised the Fed. I didn’t think that any more than a portfolio adjustment at the Fed was expected at this meeting. There was always a chance of QE3, or a lowering of the interest rate the Fed pays the banks on the gargantuan reserves they are presently keeping at the central bank, but in my view, most people had assigned small possibilities to these scenarios at this point in time. Maybe it was the combination of the bleak assessment of the economy by the Fed and the absence of any promise of future quantitative easing that disappointed the market so much.

Is the Fed done?

Could it be, as Russell Napier, one of the speakers at the conference I attended last week in Hong Kong, suggested, that the Fed was reaching the limits of balance sheet expansion and money printing? Had monetary policy reached the end of what could be expected of it? Would a deflationary correction, which the market had been craving for many years, a cleansing of its accumulated dislocations, finally be allowed to unfold, if not by political design, then by necessity?

The Fed’s balance sheet has reached a leverage ratio of more than 50-to-one, as Russell pointed out in Hong Kong. When Bear Stearns and Lehman Brothers went under they had ratios of 30-to-one and 40-to-one. Additionally, Bernanke is getting a lot of flak and may get tired of being called Helicopter Ben at those power banquets in Washington with Geithner, Legarde and Martin Wolf. Could the prospect of no more cash from Ben even explain the drop in the gold price last week, and the rise of the dollar in fx markets? Does paper money get a lifeline?

No, I don’t think so. But let’s look at gold.

As my good friend, the Swiss-based bon vivant and intellectual, Tristan Geschex, said to me, there are a couple of explanations for the drop in gold:

First, while gold remains, first and foremost, eternal money and is always the monetary asset of choice when paper money dies, it is also still an industrial commodity. I suspect that only a small portion of its present market value reflects compensation for industrial use but when industrial commodities get hammered because of a weak economic outlook, that element of the gold price – even if it is a minor element – will get ‘adjusted’ as well.

Second, there are market dynamics. Gold is held alongside other assets in the diverse portfolios of hedge funds and other institutional investors. When those take a hit in some markets, they may also reduce positions in other markets, in particular those where they can still realize a profit, and investors most certainly could still take profits last week on their long gold positions. Sharp sell-offs in equity markets initiate balance-sheet reductions and traditional de-risking (i.e. returns to the paper-dollar base) at financial firms and leveraged funds. These also tend to affect gold, at least in the short term. In the second half of 2008, gold famously took a big dive, although it then rallied sharply when the market woke up to what the policy response would be.

Third, the rehabilitation of paper money as a result of the Fed’s reluctance to print more money.

This is the most serious threat to anybody who is holding gold as a monetary asset, as the ultimate self-defence in an economy characterized by weak banks, overburdened sovereigns and excessive debt loads, in which the printing press is already being used to postpone the inevitable. Is the Fed now finally becoming reluctant to print more money?

Sadly, I don’t think so. I think they should stop the printing press but I don’t think they will.

Continue reading at Paper Money Collapse.

Following this reporting this

I am now pleased to report that Richard Sulik’s work is now available in English. You can download your copy here.

Well, that was the week that the Pollyanna’s prayers weren’t answered and the Panglosses’ pleas went resolutely unheard.

Despite all the unsubtle prompting from the Bulge Bracket and all the wishful thinking from the rest of the sell side, the Bernanke Fed signally failed to live up to its billing as Deus ex Machina, with its much-vaunted ’Operation Twist’ proving a severe disappointment.

It should not really have come as much of a surprise to readers of this publication, for we have long warned that, such is the political revulsion against bailing out the plutocracy at the expense of the purchasing power of the masses, the Fed had too little political cover to enact anything more dramatic—that, as we have put it several times before, the ‘Bernanke Put’ is likely to lie further out of the money than Wall St. might hope. And so, indeed, it proved.

Yes, by his narrowly ingenious lights, Blackhawk Ben tried to achieve the maximum impact on long yields by spreading the buy programme further out the curve than most of the commentariat had expected.

Yes, again, he may have been more crafty than has yet been recognised in announcing that MBS and Agency redemptions would be re-invested in more mortgage product since this provides the Fed with a mechanism whereby it can cushion the blow if the Administration ever does put his mass refinance proposals into operation at some future remove.

But, what he could not do was offer a route to more, naked monetization of debt and so, the price exacted to play such games as he could was a high one.

The sense that the Uberdoves have temporarily run out of bullets (or that dissent on the FOMC will not allow these to be discharged) was compounded by the fact that, in order to justify even this latest chicanery, the accompanying declaration had to offer a post hoc endorsement to every stock bear and double-dipper out there, by painting the bleakest economic picture possible.

Even without that, this fixation with reducing long rates is a futile one. No less than 320 years ago, Sir Dudley North already knew better than Ben Bernanke that to assume that low interest rates are a cause, rather than an effect, of prosperity is to put the cart very much before the horse.

In his 1691 ‘Discourses Upon Trade’, he argued that:-

These things consider’d, it will be found, that as plenty makes cheapness in other things, as Corn, Wool, etc. when they come to Market in greater Quantities than there are Buyers to deal for, the Price will fall; so if there be more Lenders than Borrowers, Interest will also fall; wherefore it is not low Interest makes Trade, but Trade increasing, the Stock of the Nation makes Interest low.

It is said, that in Holland Interest is lower than in England. I answer, It is; because their Stock is greater than ours. I cannot hear that they ever made a law to restrain [it]…

What our good Fed Chairman also seems unable to grasp is that businessmen do not work simply off their direct arithmetical estimate of the negative cash flow consequences of a hypothetical borrowing, but they must also be assured of the positive cash flow prospects of whatever it is that they are borrowing to achieve, i.e., the hurdle rate they apply is usually the decisive factor and this hurdle always contains a sizeable, subjective—and eminently variable—risk factor.

Thus, it will be to little avail if Bernanke reduces the going bond yield by 50bps if, in doing it, he is so adding to the general uncertainty that hurdle rates go up by 500!!

It is interesting to note that, in the ten quarters since the crisis broke out, US non-financial corporates have switched from being net takers of $1.2 trillion in funds, to net lenders of a near equal-and-opposite $1.1 trillion and that, more to the point, they have devoted almost 40% of that hoard to piling up cash and near-cash holdings—a sum not far short of the net amount devoted to making direct investments abroad, their other primary outlet in this period.

This has left them with a modern era high proportion of 11.5% of net worth and 6.0% of total assets parked in quasi-cash instruments—a testimony to the paralyzing effect of the regime uncertainty imposed by the likes of the Fed, a degree of unease which has mounted even in the face of the record, nominal after-tax profits they have simultaneously secured for themselves.

Meanwhile, the empty round continues wherein the Fed tries to find ever more convoluted ways to help the government spend new money into existence and that same government borrows ever more from foreign export surplus nations so that it can hand out record amounts of subsidies and transfer payments. These are what purchases those same exports while the whole helps maintain (and inflate) domestic corporate revenues.

That extended and expanded dole next helps obviate the need for the Captains of Industry to employ anyone so that the hirees may earn the means with which to buy their wares, while also increasing the comparative disutility of labour and so perpetuating the scourge of unemployment (check out the jobless duration time series in comparison with its behaviour in previous recessions).

Thus, despite the elevated profits, everyone becomes so concerned about the sustainability of all this market suppression over the longer horizon and each is so frightened of sudden, arbitrary changes to currency parities, import duties, energy taxes, etc., by way of ‘fixes’ for the ongoing malaise, that they pile up cash with banks who are themselves still so mutually distrustful that THEY can think of nothing better to do with the money they receive than park it with the local central bank, whence first it emanated.

Having tried more and more of the same, to the only end of digging us all deeper and deeper into the same hole, you might think it was about time we pretended that Hoover had retired harmlessly while still Commerce Secretary and that Roosevelt had stuck to swanning about on his yacht, indolently squandering the sinecures he acquired from his numerous family connections. In this more rational alternative universe, we could then assume that we all go back to letting recessions blow themselves out by themselves, just like we used to until the end of the fateful third decade of the 20th century.

In the spirit of such counterfactual imagining, let us just suppose that, having exhausted all the other possibilities, we summon up some vestige of economic clarity and strike some exceedingly rare vein of political courage and proceed roughly as follows.

First, we allow for bankruptcy to proceed as swiftly as possible for all entities, individual, corporate, or sovereign who can show sufficient legal proof of their inability to meet their existing obligations. As much debt as possible is then commuted into equity—including, in the sovereign case, the privatization of any and all identifiable state assets and the transfer of the relevant title deeds to their creditors.

Any lender or stockholder brought low by this cleansing should be similarly wrapped up and its residual estate disposed of forthwith. Any bank which requires it should be then be privately recapitalised, but only after forcing all financial entities into a mutual bonfire of the vanity of their $60 trillion-odd of on– and $550 trillion-plus of off-balance sheet claims on one another in a grand ripping up and netting off of the inhibiting legacy of their long years of undercapitalized, state-sanctioned, casino capitalism. This  act of mutually assured reconstruction will have the salutary effect of both cleaning the Augean stables of mark-to-myth and reducing total assets to a level where the required amount of new equity is minimised to the greatest degree possible

Any bank which cannot survive this should also be summarily put out of its misery. If it is absolutely necessary to do so, this triage may be effected via the temporary agency of a governmental ’bad bank’ and—accepting the unfortunate fait accompli of an unstable fractional reserve system—to the accompaniment of a time-limited guarantee of retail and SME deposits and the payments system.

Will there be redundancies? Yes. Will there be hardship? Yes. Will many find that they are not as rich as they once thought or that their skills and experience are not so readily marketable? Yes, again. Whether there will be more such losses than we are suffering at present, whether they will take longer to make good, or whether the hardship will be distributed any less equitably under this more direct approach is, however, a very moot point indeed.

In trying to decide this, what we must not lose sight of is the fact that none of this will diminish the material patrimony or the sum of individual efforts which form the actual machinery of our subsistence, occasional luxury, and secular self-betterment. All it will do is reprice its components in line with a fairer estimate of their ability to generate income. It will inevitably reallocate it to presumably more competent hands, or at least into the control of those who have proved their superior stewardship of the assets heretofore entrusted to them, men and women whom we can therefore expect will do just as good a job of maximising the value to be extracted from whatever its is they also now acquire as the reward of their foresight, thrift, and entrepreneurship.

If, amid the less forgiving financial scrutiny of this brave new reality, there is a service which can no longer be provided by the lazy deceit of unfunded state spending, there will also be no impediment to any private enterprise from attempting to make an honest living in providing it to those who retain a discretionary control over their pocket books. If, in fact, they do turn out not to want it, its provision can be regarded as nothing other than wasteful—no matter what the legal status of the provider—and the resources devoted to it should be redeployed elsewhere at once.

If some sprawling, Ozymandian works are revealed as the easy-money follies we already suspect them to be, well, they can always be parcelled out to fulfil other purposes; broken up and recycled as scrap; or turned into leisure facilities or museum pieces with a radically different price tag to reflect the real measure of their worth, but also with a bracing absence of a dead weight of unserviceable debt hanging about both them and all those who might otherwise have been expropriated to maintain the pretence that they were actually useful.

A steep, overt recession we would surely have, in place of the insidious, covert erosion of our wealth which we have been suffering these past four years and more.

Many, many things would fall in price, especially where those prices have been borne artificially upward by an infusion of irredeemable Ponzi credit. But, assuming that the core money supply is not allowed to contract—that is, assuming there is no deliberate deflation—and that the relentless writing off of unserviceable liabilities and the unsentimental renegotiation of contracts take their course unhindered, each fall in price would improve some potential buyer’s real income until a floor was found, a floor which could not but correspond more closely to each item’s genuine value in a world now dedicated to honest accounting, sound money, and minimal government.

To expect all of this to come to pass in today’s world is, frankly, unrealistic, but while the stalwarts of the Bundesbank continue to resist the evil allure of Bernankism and so provide a standard around which north European politicians can rally their consciences alongside their common sense, it just might be that the Old Continent achieves rather more of this healing than anyone currently credits.

Then, if the Fed would only spend a little less time listening to the wheedling of its pack of welfare brats on Wall St., devote less time wallowing up to its ivory-towered armpits in the deranged divinations of DSGE theory, and a great deal more time paying heed to what actual wealth creating businesses are saying and doing, who knows? — we might even spark a genuine recovery one of these fine days!

I wrote the following essay yesterday for TheStreet.com.

Yesterday the U.S. Federal Reserve delivered no real surprises. Its new policy was expected by the market and those members of the public who still follow the central bank’s every move with interest and, I can only assume, in the misguided belief that it has the answer to our problems. As part of “Operation Twist” the Fed will purchase $ 400 billion of long-dated government bonds and sell an equivalent number of short-dated securities from its extensive portfolio over the coming nine months. The operation is aimed at lowering long-term market rates and flattening the yield curve. In their infinite wisdom, the bureaucrats on the central bank’s policy-setting committee decided that here was another set of market prices that required their astute adjustment, or at least gentle guidance.

The Fed has recently acquired quite a taste for correcting market prices. Remember that the goal of the first round of debt monetization – euphemistically called “quantitative easing” – was to free bank balance sheets from the toxic waste accumulated during the boom and thus prevent banks from unloading unwanted mortgage securities in the market place at distressed prices, which would not only have burnt a considerable hole into their capital but would also have revealed the lack of true demand for these securities. This required the printing by the Fed of a brand new $ 1 trillion – give or take a few hundred billion – and provided a nice subsidy to the hard-pressed American financial system. The second round of debt monetization – QE2 – was squarely aimed at manipulating the prices of Treasury securities. Treasury yields were simply not in line with what the committee deemed appropriate for the planned recovery and had thus to be massaged to lower levels. Another $ 600 billion had to be printed for this initiative.

For the benefit of those Americans who were beginning by now to feel that monetary policy in the United States was acquiring a whiff of Weimar Germany, and who were still beholden to the quaint idea that the setting of asset prices and yields, just as any other price, should best be left to the market, Fed chairman Ben Bernanke, in an op-ed in the Washington Post in November 2010, spelled out the advantages of clever price manipulation by the central bank (I know, I know, you readers of the Schlichter files have read this quote already a few times. But it is simply too delicious to miss any opportunity to quote it again):

“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Well, the virtuous circle has not arrived yet. Defenders of this policy will argue that things would look even worse without it, and that for a while “quantitative easing” boosted equity markets and other risk assets. Hooray for that. Although it has to be said that the idea that we, the public, can easily be cajoled into feeling confident and behaving in more expansionary modes economically via the open manipulation of market prices strikes me as somewhat condescending and hubristic. But we are talking about a state agency here, so we shouldn’t be surprised.

The Fed’s entire policy program suffers from the same defect that all market interventions suffer from. The moment you stop intervening, the underlying problems come to the surface again. Just look at the short-lived results of QE2. Administrative price setting does not change economic reality, at least not for the better. The interventionist has to keep intervening and do so at an accelerating pace.

Surprisingly few people seem willing to ask what exactly the underlying economic problem is. As long as we avoid that question and simply talk superficially about slow growth, the risk of a ‘double-dip’ and the need for ‘stimulus’, I guess the Fed will continue to get away with portraying an image of, at worst, innocent bystander or, at best, a well-meaning and public-service minded bureaucracy that just keeps trying to fight the recession, diligently exploring all available policy tools. According to this popular view, our economic difficulties seem to have come over us like a bad harvest or an alien invasion. They appear to be entirely exogenous, and the Fed is our friend and partner helping us to get out of this mess.

The reality is different. Like all state bureaucracies, the Fed is in fact struggling with problems that are predominantly of its own making. The Fed is the reason we are in this crisis. Or, more specifically, the present economic crisis is the inevitable consequence of the political decision to adopt a system of unconstrained, constantly expanding fiat money, in which the central bank, in its role as lender-of-last-resort, systematically encourages bank lending and thereby the extension of credit on the basis of money printing rather than true savings. This system came into full bloom only in 1971, when Nixon severed the last link to gold and thus initiated, for the first time in history, a global system of unrestricted fiat money creation.

Our present problems are excessive levels of debt, now mainly public sector debt, weak financial institutions and distorted asset markets. On their present scale these problems would be inconceivable without a system of fully elastic fiat money and persistent periods of artificially low interest rates. Abandoning the gold anchor allowed the Fed, and other central banks, to cheapen credit and encourage borrowing for periods of unprecedented length. Today the Fed is promising us a way out of the crisis by providing monetary policy accommodation. This is hardly original. The Fed has practically always provided policy accommodation. Policy accommodation was the raison d’etre for the Fed. The Fed was founded in 1913 to support the banks’ money and credit creation and to avoid credit corrections. Hard and inflexible commodity money has now everywhere been replaced with elastic fiat money under central bank control so that the level of interest rates and the availability of credit in the economy are no longer constrained by the extent of voluntary saving but can be determined administratively by the central bank for the purpose of extra growth.

When Nixon took the dollar off gold internationally, the monetary base and bank reserves in the U.S., that is, the part of the overall money supply that the Fed controls directly, was $69.8 billion. Ten years later it was $147 billion, another ten years later it was $319.7 billion, another ten years later it was $645.1 billion, and last month, exactly 40 years after the dollar was ‘freed’ from gold, it was $2,679.5 billion. Like all interventionists, the Fed has to run ever faster to prevent the laws of economics to catch up with the unintended consequences of its interventions.

“Operation Twist” is another attempt to keep interest rates low and to encourage borrowing when the present crisis is in fact the result of low interest rates and excessive borrowing. The only solution to our problems is to stop printing ever larger quantities of money and to finally allow the market to set interest rates and to cleanse the economy of its accumulated dislocations.

Read more from Detlev at Paper Money Collapse.

Most experts are of the view that still-subdued economic activity requires a more aggressive stance from policy makers in order to revive the economy. Since the end of 2007 the Federal Reserve pumped about $2 trillion into the banking system while the US central bank policy rate – the federal funds rate target – was lowered from 4.25% in December 2007 to 0.25% at present.

A week ago US President Obama suggested a $450 billion stimulus package to revive the economy. Observe that in February 2009 the Congress had approved Obama’s first stimulus package of $787 billion. Despite all the aggressive measures taken by the Fed and the US government the economy remains depressed. Since the approval of the first fiscal stimulus package almost 2 million jobs were lost. While since the end of December 2007, when the aggressive pumping by the Fed was introduced, almost 7 million jobs have disappeared. The unemployment rate has jumped from 5% in December 2007 to 9.1% in August this year.

Why then should Obama’s additional fiscal stimulus package and more aggressive Fed pumping revive the economy? The experts are of the view that given the lack of positive response by the US economy to all the fiscal and monetary stimulatory policies, it implies that the economy has strongly deviated from the path of balanced economic growth. On this way of thinking the economy is seen as some kind of space ship that has deviated from its trajectory. To bring it back onto the correct path policy makers must give it an external push. So if the first push in terms of loose monetary and fiscal policies didn’t produce the required results then policy makers must become more aggressive until the space ship is brought onto the correct growth path.

Loose policies can only damage not strengthen the economy

The purpose of production is to generate final consumer goods and services that maintain and improve individuals’ life and well being. Various means are employed for this such as tools and machinery and labor. All these resources whilst important are not sufficient.

What is required is an adequate pool of final consumer goods and services that will maintain the life and well beings of individuals engaged in various stages of production that range from the production of final consumer goods and services to the production of tools and machinery i.e. capital goods. It is the pool of final consumer goods and services that funds various activities. The size of this pool dictates the type of activities that can be undertaken.

For instance, if the size of the pool permits the building of a very basic tool then the building of more advanced machinery cannot be undertaken, notwithstanding the plentiful of natural resources, technological knowhow and skilled labor.

In order to be able to make more advanced machinery individuals, instead of consuming existent produced final goods, would have to save a portion of these goods and allocate them towards the enhancement and the expansion of tools and machinery. With better tools i.e. capital goods, a greater production of final consumer goods can be undertaken, which in turn will permit the making of a more sophisticated infrastructure.

Note that any form of economic activity must be funded by means of final consumer goods and services. Neither the government nor the Fed have the ability to generate final consumer goods to fund the building and the enhancement of infrastructure.

For instance when the Fed pushes more money to the economy all it is doing is increasing the amount of the means of exchange. An increase in money supply sets in motion an exchange of nothing for something i.e. it diverts final consumer goods or wealth from wealth generating activities towards non-wealth generating activities. This in turn undermines rather than strengthens the economy’s ability to expand real wealth. (It is exactly the same outcome produced by a counterfeiter).

Likewise loose fiscal policies produce the same results as printing money does – it diverts wealth from wealth generators to non-wealth generating projects. What then is the point of trying to boost employment by means of loose fiscal policies, which in the process weakens the economy’s ability to generate more wealth (such as digging ditches and making pyramids)?

Once the central bank tightens its stance for whatever reasons the diversion of wealth to non-productive activities stops and various useless projects must be aborted. Obviously various individuals employed in these projects become unemployed.

It is true that now we have idle resources. Contrary to popular thinking the employment of idle resources with the help of loose policies is not cost-free, this requires the diversion of wealth from wealth generating activities.

Also, it is false that loose fiscal and monetary policies are required to fix the unemployment and revive the economy.

Remember that loose policies only weaken the ability to generate wealth. Obviously then we require less and not more of these policies to grow the economy.

A better alternative is to curtail the ability of the Fed and the government to engage in aggressive loose policies. This will leave more wealth in the hands of wealth generators and will enable them to get on with the job of setting in motion true economic growth.

With the expansion in the production of wealth, all other things being equal, a greater demand for resources including labor will ensue. In short more wealth will make it easier to absorb so called idle resources.

Conclusion

Despite aggressive fiscal and monetary policies the US economy remains subdued. Since December 2007 almost 7 million jobs have disappeared. Experts, however, are of the view that a more aggressive monetary and fiscal stance is required to revive the US economy. We suggest that loose monetary and fiscal stance will only further damage the foundations of the economy.