Economics and Stock Market27 Nov 2010 05:13 pm

Though the stock market has rebounded and the recession officially ended well over a year ago most people agree that the US economy is not in good shape. The remnants of the financial crisis and the “great recession” still linger as does a healthy amount of skepticism that things have actually improved.

Pretty much everyone is in agreement that the US is drowning in a sea of debt. Between consumer debt, government debt and residential and commercial mortgage debt it is pretty obvious that the entire economy is in peril of becoming bankrupt and unable to make their payments.

Likewise most people also agree that the job market is poor and too many people are unemployed or underemployed. Many point to the loss of manufacturing jobs to emerging nations as a root cause of the lack of jobs in the US.

The solutions to these problems fall into two camps. One camp focuses on the debt problem and feels that the consumer needs to act in fiscally responsible manner and pay off their credit card and mortgage debt. A majority of these people also feel that the government needs to curtail its debt and balance its budget. Often these same people claim that government is too big and too powerful and that its interventions only interfere with the free market system healing itself.

The other camp focuses on the poor job market and believes the US economy is in need of stimulus to get its economy functioning again. This crowd generally favors giving tax breaks to small and large businesses so that they have the funds to expand businesses, hire employees and successfully compete in the global economy. Many of this crowd also feels bail outs and stimulus packages may be necessary to stave off crises and create a business friendly environment enticing businesses to stay in the US and employ its own citizens. Leaders of this camp state that the only through printing more money can we have enough to pay off our debts while helping fund businesses to expand and hire new workers.

I myself have always been a frugal person who has viewed debt and the borrowing of money as reckless and not very smart. Yet, this does not prevent me from seeing the flaws in the paying down the debt solution offered by that anti-debt camp. Since wages in the US have not and show no signs of skyrocketing the only way for most consumers to reduce their debt is through saving their money and consuming less.

Economic experts are fond of saying that the consumer (through consumption) is responsible for 70% of the economy. Now, even if that percentage is a little high the fact remains our economy will have a hard time surviving if the consumer stops buying goods and services. By definition a consumer who is saving and paying off debt is one who is cutting back on the purchasing of goods and services. A contraction of money spent by the consumer will cause a contraction in the economy, which is by definition a recession.

Now some would say we need a lengthier recession in order to wring out the excesses if our economy (debt). These same people would state that this is the role of recession in the standard business cycle and that we just need to accept this fact. Yet, the problem with that logic is that our debt load is historically high and could take years if not decades to “wring out” of the system. In the meantime many people would lose their jobs, houses, go bankrupt, and suffer if not starve.

Also during this time of fiscal responsibility it would be hard for any new jobs to be created in a consumer service based economy. In an environment where the majority of Americans are cutting back on purchases, saving money and paying off debt who would want to open up a new or expand an existing business. In such an environment businesses close and lay off workers and anyone foolish enough to make what people aren’t buying will not stay in business long.

Likewise if the government were balancing its budget and paying down its mountain of debt the economy would continue to contract. A fiscally conservative government would not be able to stimulate the economy through giving money to businesses or consumers to encourage them to spend and create jobs.

The truth be told this has only been the case which our extreme debt crisis is only emphasizing. A fiscally responsible society in which its citizens saved their money and only bought what they needed would never be affluent or have enough jobs for its citizens. The majority of jobs that we have would never have existed if people only bought what they truly needed, or even lived inside their means. This is especially true of a modern society where automation and mass production reduce the number of employees needed to produce goods and services for people to consume.

The libertarian contention that a true free market capitalistic system based on supply and demand would cure all our ills including the lows of the business cycle are not rooted in the real world. Not only does it ignore human nature, the imbalances inherent in amassing capital and the complications caused by urban and global markets, but it just doesn’t take into consideration automation and the simple fact that we cannot provide 6 billion people with truly gainful employment.

Taking a look at the camp which advocates the printing of money and all other forms of stimulating the economy through fiscal stimuli, we find a host of new limitations to their solutions. First of all much of the bailouts are a continuation of the trickle down theory of economics which has greatly assisted in the creation of imbalances inherent in our debt laden society.

Since the 80’s the relative wealth of the majority of Americans has declined while an increasingly shrinking percentage of Americans are hoarding a larger and larger percentage of total wealth. An escalation or even a continuation of the rate of printing more money is likely to only enhance the gulf between the have’s and have nots.

The stated goal of expanding the money supply (printing money) is to stimulate the economy by making funds available for consumers and businesses to pay down their debt while providing businesses with the necessary funds to expand their operations and thereby hire employees.

Yet, many of the dynamics and repercussions of monetary expansion and bailouts only inflame the debt problem and make the monetary gulf amongst American’s more exaggerated. Let’s take a look at a few of the most obvious flaws and historical limitations of monetary expansion.

First it should be pointed out that we have been expanding the monetary supply for decades which has had the net result of depreciating the dollar and inflating the national debt through many different vehicles including the trade deficit.

When you add money to the overall pool of money in existence you are immediately making each dollar worth less. As the money supply grows each individual dollar losses some purchasing power. Imagine playing monopoly and you had $500 dollars and the bank totaled 10,000. In that case you would have one 20th or 5% of all the money available. In a game involving four of five people you’d be doing okay. Yet, if someone were to increase the banks total to 1,000,000 dollars your $500 would be far less impressive and you would now own about one two thousandth of the amount and no where near even one hundredth of one percent of the money available.

This is essentially what happens to our purchasing power as the money supply increases. The only people who immediately benefit from monetary expansion are those able to borrow money and those that lend the money. When the federal reserve prints money they and the banking system make money through the interest acquired by loaning the money out. Since the Fed is a private banking cartel which has a contract with our government we the taxpayers pay the interest that the government owes for the money being printed.

Currently we have interest rates at historically low levels whereby the money being printed is not very costly to a borrower. This allows wealthy people an opportunity to borrow a good portion of the money with little overhead. While this does present the opportunity for the wealthy to use this money for business expansion and job creation the reality is that the money is more often than not used for other purposes.

The money invested in business expansion could be used to build factories abroad where labor is cheaper and thereby not helping the US’s unemployment problem. Second, the money borrowed at low rates can be used to buy longer term US bonds or foreign bonds with higher yields. The borrower can then use a portion of the money borrowed to pay off the interest and use the higher yield of the bonds they purchased to generate a sizable profit.

The profit garnered through the higher yield bonds can be reported as earning by a corporation giving off the impression their business is improving and thereby entice investors to buy their stock which further increases their profits in a self perpetuating cycle of profit allowing corporate profits to surge despite low growth or even a decrease in earnings generated in their actual business.

Money printed by the Federal Reserve is money, we through our government, have to pay interest on. All printed dollars added to the money supply weaken the purchasing power of already existing money (by diluting the money supply) while increasing the amount of government, and hence, tax payer debt.

The goal of printing dollars is to stimulate economic growth. In an ideal situation you would gain more than a dollars worth of growth for every dollar printed. Yet, statistics have shown that this is not so. About two decades ago we created about a dollars worth of growth for every three dollars printed (borrowed). The relationship has deteriorated ever since and the last statistics I saw had us needing to print about $10 for every dollar of economic growth.

What the above paragraph says is that while printing money does in fact stimulate economic growth it causes a much more significant growth in debt. In other words for every dollar we print we are incurring more than a dollar’s worth of debt plus the interest owed to repay the Federal Reserve for their efforts.

The more money you print the less purchasing power the dollar has, which is what we mean when we say that the dollar is being devalued. What this means is the more dollars in circulation the more dollars you need to pay for the same item purchased before the money supply increased. This commonly referred to as inflation.

So while printing dollars may stimulate the economy it also causes inflation. Inflation causes a rise in the cost of living. So, unless workers wages are climbing faster than the rate of inflation, a rise in the money supply makes it harder for people to purchase things. Inflation making things more expensive has a tendency to slow down economic growth. So, in most situations one lowers interest rates to stimulate the economy. Yet, since our interest rates are already at historic lows (between 0 and .25%) we are unable to lower rates to stimulate our economy.

In essence we are currently trying to borrow our way out of debt. Yet, printing money causes more debt and makes it harder for people to pay off their debt. If things cost more people will have to spend more on basics such as food and shelter and use the rest to keep up with or hopefully pay down some of their debt. Inflation means more and more consumers will cut down on purchases and the number of people going bankrupt and having their homes go into foreclosure will increase. Businesses, likewise, will have a hard time paying off their debts and staying in business. Many of those not closing their doors will be forced to lay off workers in order to survive.

As the title of this post suggests we are in an economic Catch 22, where both cutting back on consumption and printing money (increasing debt) will cause more job unemployment and further contraction of the economy (recession or depression). At this point in time it seems that our policy makers are content to try and keep things afloat for as long as possible.

The best analogy I can think of is that we are in a skyscraper that is on fire. Without a means of putting the fire out we are deciding to try and out run the fire. Instead of jumping out the third story window, we are running up the stairs to higher floors as the fire chases up after us. Having no water we stack all the furniture we have to block the path of the fire allowing us to race up to higher floors hoping the fire burns itself out. Yet, the barriers we place in front of the fire (furniture = debt and inflation) is a known fuel for fires making it likely the fire will only quicken and strengthen. The higher we climb the less of a chance we have for a safe and successful leap from the inferno.

In sum having people focus on reducing consumption and reducing their debt will likely result in slowing down the economy even further resulting in increased unemployment, foreclosures and bankruptcy. While increasing the amount of debt through printing money and corporate bail outs will only increase the mountain of debt choking consumers and businesses. In such an environment business contraction and not expansion is likely and larger corporations can make money off money borrowed and if they do expand businesses it will be in countries or communities with cheap labor.

This post has gotten far too long, so in my next post I will explain why I think this Catch 22 exists and what should be done about it.

Jim Guido

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