Saturday, March 21, 2009

Federal Reserve's Keynesian "Solution"

From the Belfast Telegraph:

"The US Federal Reserve has announced plans to inject around one trillion dollars into the economy in an effort to lift the country out of recession.

The Fed says it will buy up to $300bn worth of long-term bonds and will buy another $750bn worth of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac.

Analysts say the move should keep mortgage rates low for a long period of time."

The Fed injects money by printing up dollars. The U.S. GDP in 2008 was a little over $14 trillion. This means that prices will soon go up 7%. That's like an across-the-board 7% tax increase. In addition, the current economic downturn was caused in part by low mortgage rates. How is it that people in Washington think that more of what caused the problem in the first place is what will solve the problem? Certainly artificial inflation, caused by the Fed printing up more money, won't help matters any.

Here's the problem:

The people in Washington are primarily influenced by the work of John Maynard Keynes. Among his terrible ideas when it comes to macroeconomic theory is the fact that when he saw the correlation between inflation and a good economy and that between deflation and a bad economy, he thought that inflation caused the good economy, and deflation caused the bad economy. But he was getting the world exactly backwards. In a good economy, people compete for goods, and prices go up; in a bad economy, people wait for prices to go down, companies compete to lower prices, and you get deflation. Keynes said that if we print more money, it will help the economy (he also said deficit spending by government is also good for the economy). Reducing the money supply also slows the economy. Now, it does happen to be true that if you increase the money supply, it will send an inflationary signal that the economy is doing well, and people will respond to that -- but it is also true that once people catch on that this is a false signal, they realize that the economy actually isn't as strong as they thought, and they act as though there is a recession. This is what caused the stagflation of the 1970's in the U.S. and elsewhere around the world where, for the first time in world history, there was high inflation with a recession. It destroyed many economies, and so damaged the economies of the U.S. and Britain that those two countries elected Ronald Reagan and Margaret Thatcher, respectively. But it seems we haven't learned our lesson about Keynes, because here we are again, printing up money. Worse, the Fed is announcing it, meaning we won't even have the benefit of ignorance of the signal being false. We all know it's a false signal, so I suspect we won't even see a short-term benefit from it. More, it is so obvious that this is a hail-mary pass, it will likely scare people even more. In fact, the value of the dollar has already dropped 4.8% against the Euro, a record drop since 1985.

"This man is dying of alcohol poisoning! Quick! Bring me some whiskey!"

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