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The Fallacy of Money Mania

November 29, 2007

Tags Booms and BustsThe FedFinancial Markets

It's been a grueling Fall 2007, with the continued shocks from the housing mess, the market sell-off, oil still sky high, the dollar hitting new lows, and the rising gold price giving that ever-ominous sign of trouble ahead. Business conditions have deteriorated dramatically.

And the gold price reflects a general trend: the consumer and producer price indexes are continuing an uptrend that compares to the steep levels of the mid and late 1970s. And if you really want to wince, take a look at federal spending and debt. It's unreal: $8.2 trillion in debt, with nearly $5 trillion of it held by the public as an investment .

Ah, but wait! One day in November, the stock market soars and traders are wild with glee. The storm clouds are gone and the sun is out. What happened? No fundamentals changed. No new reports came in. No numbers were revised. What happened was but a few words from the vice chairman of the Federal Reserve, spoken at a roundtable at the Council on Foreign Relations.

He said the Fed would follow "flexible and pragmatic policy making" and "act as needed."

Woo hoo! You see, to markets that are worried about the future, this was interpreted as pledge to lower interest rates and flood the economy with more credit.

Let's ask ourselves: why would this make anyone optimistic? Let's say that you are playing the game Monopoly and one player proposes to double the money stock for everyone. The problem would be obvious to everyone. If the prices on the board could change, they would double. Since they can't, the game will only last twice as long as before. Meanwhile, players would become more reckless with their investments in houses and hotels. It wouldn't really make the players wealthier; it would only create an illusion that would be temporary.

The analogy isn't exact, but the point should be clear. Paper money is not the same thing as wealth. Wealth comes from trade, investment, and capital accumulation. Money is merely a tool that facilitates the creation of wealth; it is not identical to it.

So what good does the new money do? From the perspective of Wall Street, it forestalls a recession. But what if a recession is needed? That is to say, what if a business downturn is what the economic fundamentals call for? In that case, new money injections do positive harm by preventing a correction and only adding to the eventual problems that we all must face. It is no favor to the drug addict to keep him high until he is a corpse, and it is not good economic management to keep an economy drugged up until it hits the wall.

But shouldn't we do something to address the credit crunch? Yes, and that is the following: let it happen. After all, a credit crunch is not act of nature. It is a response to an economic expansion that is not justified by fundamentals. How does this occur? It is not part of the structural dynamic of the market economy that an economy suddenly embarks on irrational exuberance for no good reason. Misdirected investment in some projects at the expense of others is brought about by credit expansion beyond which it is justified.

Sure enough, we can look at the money-supply figures and see the big run up to the current crisis. The trouble begins in 2001, with a sudden and really shocking rate of money creation. Between 2001 and 2006, nearly $2 trillion in artificial (phony) money was injected by the Fed into the economy, via the credit markets, much of which landed in real estate and other sectors. This created a false prosperity, precisely as Albert L. Hahn describes in The Economics of Illusion.

This is even clearer when you look at the change in money supply expansion over a quarter of a century.

Here we see the physical evidence of a dollar flood taking place after 2001. The graph charts what seems to be an abstraction but the evidence of its effects are all too real. It generates patterns of economic behavior that are contrary to what reality in a normal market economy would dictate. We are kidding ourselves if we think that this is not going to have an effect.

Looking further at the percentage change from the previous year, we can observe that money expansion rates shot up to 20% in 2001 and settled to 10% over the following three years. After briefly settling down in early 2005, the rate of money creation took off again and is now approaching 13% per year.

So why is Wall Street cheering? Is the investor class merely looking for another credit subsidy? The sad truth is yes, that is precisely what the financial markets want. This should not surprise us. A profligate and drunken son might be ruining his life, but the last thing he desires is to be denied access to his parents' credit cards.

If the Federal Reserve were responsible and wise, it would say no to the demand for more money creation. And yet that would run contrary to its institutional reason for existence. It was founded by the federal government to create new money to fund World War I and immunize the banks from the risks associated with excess lending. The government loves this approach because it means not having to tax people. Taxing makes people angry. Money expansion destroys wealth in more sinister and coy ways. It reduces people's purchasing power and sneakily robs them of their savings, even as it creates a false sense of rising prosperity.

So we can see, then, that money expansion is a big lie, and the Fed is what makes this lie possible. Indeed, it was founded precisely so that it could do so. Similarly, the popular notion survives out there that the Fed's main job is to keep inflation low and the economy stable. And yet the Fed is the very cause of inflation and instability — standing ready to open the flood gates when the political pressure builds, when the banks get in trouble, when the state needs funds, or when the biggest corporate players demand more credit.

Will more monetary injections work to puff up the economy? They might, but only temporarily. There comes a point at which no matter how much the Fed floods the markets with credit, it can still find no takers. It's happened before: in 1930 and following, for example. The Fed tried desperately to inflate but to no avail. It could happen again.

Here's what I would like to see: the whole of Wall Street rising up against the Fed and demanding that it turn off the spigots and let the economy get back on an even keel. Let the correction happen and let profits and wages fall in the overblown sectors. Then we could even disgorge the Fed of its powers and establish a free-market monetary system.

Of course in doing this, the corporate class would have to forego its short-term interests in favor of the long-term interests of everyone. But that's what good economic thinking is all about.


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