Tuesday, March 18, 2008

The Fed Reserve's Wrong Moves?

I'm not feeling well enough right now to write lengthy posts, but I thought that this article is worth reading and considering as right now we're hearing talking heads talk opine as to how the Fed Reserve is making all the right moves or all the wrong moves (emphases mine):
Fighting Recession With Panic
By John L. Chapman
Tuesday, March 18, 2008

Why the Federal Reserve’s aggressive monetary easing is the wrong solution to America’s economic woes.

After a weekend in which the collapse of Bear, Stearns & Co., the fifth largest investment bank in the United States, prompted the Federal Reserve to make an unprecedented loan to JPMorgan Chase, the Fed’s Open Market Committee holds its regular six-week review meeting today. There is wide anticipation that interest rates will be cut yet again, amid signs that the U.S. economy is slowing after several years of respectable growth, technology-led productivity gains, a booming stock market, low unemployment, expanding international trade, and low inflation. But can economists at the Federal Reserve Board and the U.S. Treasury prevent a recession?

Let’s start by going back to the summer of 1929. Following the 1921 recession, real GDP growth had averaged 4.8 percent per year, and the consumer price level had been virtually unchanged (meaning there was no inflation). By the end of the decade, unemployment stood at just over 3 percent. Massive changes in transportation and communications technologies had fed an industrialization that had radically increased productivity; and as a result, real wages and corporate profits exploded: the stock market index grew by more than 23 percent per year during the 1920s, reaching an all-time high on September 3, 1929.

On that fateful day, however, no one could have guessed that the Dow Jones Industrial Average would not see this level again for a quarter century—not until late 1954—or that unemployment would triple in one year’s time. By 1933, unemployment stood at 24.9 percent, real GDP had declined by a fourth, and rising protectionism had cut world trade in half.

Federal Reserve Chairman Ben Bernanke knows this history well: he is perhaps the world’s foremost living authority on the Great Depression. Bernanke has asserted that such a catastrophe could not happen again, because our understanding of trade and fiscal and monetary policy tools is far superior today. For example, Bernanke argues that a passive Fed was too restrictive in terms of money supply growth back then. As a result, 40 percent of all U.S. banks failed in the 1930s, contributing significantly to the contraction. This would never happen today.

Perhaps with that history in mind, the Fed has responded proactively to news of falling home prices, a credit crunch, two consecutive months of job losses to begin 2008, and now an insolvent Wall Street firm. Indeed, it has cut benchmark interest rates repeatedly and announced a $400 billion monetary infusion to shore up the credit markets. With many economists now expecting a recession this year, the Fed has moved aggressively to pump more liquidity into the U.S. banking system.

Bernanke also endorsed the Economic Stimulus Act of 2008, which was signed into law on February 13. This stimulus bill calls for $168 billion to be funneled into the economy, primarily via tax “rebates” (which include some outright transfers) to an estimated 128 million Americans in lower- and middle-income tax brackets. Another $50 billion is allocated for business tax breaks. Meanwhile, separate legislation has been proposed to aid troubled mortgage lenders.

Can the combination of monetary easing and fiscal stimulus serve to jump-start a sagging economy? The 1920s and 1930s provide us with two big lessons to consider.

Lesson 1: Recessions are often a case of monetary mismanagement.

The 1920s were a time of significant growth in the money supply. This did not show up in consumer prices only because of technology-induced productivity gains throughout the economy—that is, the increasing supply of goods and services kept prices low. But monetary ease resulted in artificially lower interest rates, which led to a boom in capital investment. This led to a quintupling of the stock market in eight years and highly leveraged asset prices: between the end of 1927 and October 1929, broker loans for equity purchases increased by 92 percent. Clearly the 1929 crash was the bursting of an asset bubble driven by easy credit.

We are now on the precipice of a new era of stagflation: a time of slow growth and inflation, with sharply higher interest rates. This storyline parallels the current era. Over the past decade, the MZM (“Money of Zero Maturity”) money supply, which measures the most liquid funds available for spending, grew from $3.5 trillion to $8.2 trillion, which translates into an average annual growth rate of 8.8 percent. Tremendous gains in productivity—as well as heightened global competition—have kept pressure on consumer prices. However, following the 2001 recession, artificially-low interest rates induced easy credit and a boom in housing and highly-leveraged home buying. As in the 1930s, the de-leveraging and the liquidation of irresponsible capital investment will cause economic pain.

Unlike in the 1930s, however, the U.S. dollar is now (and has long been) the de facto international reserve currency, a role formerly held by gold. This has led to strong demand for dollar-denominated instruments, and effectively has allowed the United States to borrow, run fiscal deficits, and “export” inflation abroad. This game can work as long as the U.S. economy is growing and the Fed is seen as a force for anti-inflation stability. But when the economy slows and the Fed becomes an engine of easy money, the U.S. dollar will weaken, which only exacerbates inflation.

Such is the case today. Consumer prices have spiked dramatically in the last twelve months, rising by 4.5 percent. We are now on the precipice of a new era of stagflation: a time of slow growth and inflation, with sharply higher interest rates.

Lesson 2: Fiscal measures designed to promote growth without inducing increased production are doomed to fail.

In the 1930s, economist John Maynard Keynes advocated “building pyramids and digging holes in the ground,” if need be, to stimulate spending. But America’s economic slump persisted, because government itself can never create wealth; it is purely an agent of redistribution.

That basic fact seems lost on advocates of the 2008 stimulus bill.
The tax “rebates” are not being distributed pro rata to all taxpayers, but instead via a redistributive formula to lower- and middle-income households, some of whom paid no federal income taxes in 2007. This will merely redistribute wealth from current and future taxpayers to rebate recipients. Additionally, the tax “rebate” funds will be borrowed in the current year, thereby expanding the fiscal deficit and, at the margin, crowding out job-creating investment. This all serves to increase downward pressure on the dollar. It does nothing to encourage the entrepreneurship and capital formation so necessary to GDP expansion and real wage growth.

A society becomes wealthier when more goods are produced per unit of resource input. Increased consumption is thus an effect of increasing wealth, and not a cause, as Keynes argued. Incentives to produce are optimized when monetary policy yields a currency which maintains its value. Stable money promotes saving, capital formation, trade, and entrepreneurial risk-taking, all of which spur job creation and economic growth.

In short, government fosters economic growth when its policy mix includes low taxes on capital, income, and profits; sensible regulation and low barriers to trade; and stable money. Therefore, the stimulus bill, the Fed’s recent monetary easing, and the growing threats of trade protectionism are all unhelpful errors that portend harder economic times ahead.

John L. Chapman is an NRI fellow at the
American Enterprise Institute.
In my view, the steps taken by the Fed Reserve and the economic-stimulus package will serve only to postpone the inevitable and deepening recession. Whereas the Fed Reserve used to serve as the lender of last resort for commercial banks, with the J.P. Morgan-Bear Stearns deal, the Fed Reserve has assumed the financial burden for a different kind of financial institution.

Those of us who have lived frugally and within our means will be paying for the failures of those who didn't use financial discretion. Are we seeing the early stages of the redistribution of financial wealth — a redistribution which will affect the majority of Americans?


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posted by Always On Watch @ 3/18/2008 09:18:00 AM