Thursday, February 12, 2009

Stop! In the name of the LAW!

Ask any lawyer or police officer and they will tell you that ignorance of the law will not get you off the hook. The same is true when it comes to economic laws and their consequences. Regardless of the intentions behind the legislation, the consequences of economic policies have impacts that follow economic laws.

Today’s government’s strategy is to try to stimulate the economy by increasing aggregate demand by spending more than three-quarters of a trillion dollars on anything and everything. To help put this into perspective, the stimulus package, all by itself, would be the 15th largest economy in the world. So we need to ask, “Where is all of this money going to come from?”

Governments, all governments, have only three options open to them when it comes to raising money: taxation, borrowing, and money creation. Each method not only counteracts the intention of the spending (sustained economic growth), but creates a situation that is ultimately economically worse.

It does not matter whether the law places a new tax on either the consumers or the producers; the burden of the tax is identical. The side that is less price-sensitive will end up carrying the heavier burden of the tax. Furthermore, taxes create what economists call dead-weight losses. These are burdens to all of society because some buyers are willing to buy and some sellers are willing to sell, but because the tax has increased the selling price and lowered the revenue from the sale, they walk away from the exchange undone and frustrated. The bottom line when it comes to taxes is this, it takes before it gives. If the government is hoping that its spending will create “economic stimulus,” it must first take away that economic energy out of the economy if it taxes. The net result is a wealth transfer, but not sustainable economic growth.

The second method of borrowing the money to pay for the spending package has a similar result. The government is not constrained by market forces when it comes to offering interest rates on their securities. Thus to get people to borrow from it, it can keep raising interest rates in order to get the saved dollars. When the government behaves this way, it “Crowds Out” private sector investment. Investors are looking to put their money into a vehicle that will give them a strong return. When the government starts bidding up interest rates, private companies cannot compete and they end up going without. The best possible effect of this crowding-out is a simple wealth transfer, but this is not really the case. The market is looking to put dollars into areas that send resources to their highest valued uses. However, the government does not spend money according to market signals, and as a result, it spends money in areas that do not have the highest valued uses. The net result is that instead of recovery, the economy slows further.

The third method financing the spending is through money creation. Where does the Federal Reserve get this money from? The answer is nowhere. Money is literally created out of nothingness. When this new money is put into the economy it has several effects. The first is that it changes the relationship between debtors and creditors in favor of the debtors. The second implication is that it adds static to the price signal that entrepreneurs follow. Suppose that you are an entrepreneur and you see the prices of your goods are rising by 5%. Is this because there is an increased demand for your goods? Or is it because of inflation? Or is it some combination between the two? What could that ratio be? It makes the already difficult job of the entrepreneur that much harder, thus slowing down the economy.

The most insidious implication that results from monetary expansion is the wealth transfer that occurs. Money is not neutral. When people think of inflation, they think of a price level rising. They think of the water level rising evenly across the surface of a pool. This thinking is, unfortunately, completely wrong. Money affects prices in ways that has real effects on prices and wealth.

Money is never injected into an economy equally across the entire economy. It is injected at specific points. Some people and businesses get the new money first. When they get this new money, they use it. They purchase consumer goods and services and make investments. By making these transactions, they are applying upward pressures to the prices of the items they are buying. They are literally out bidding others to attract goods and services to themselves. The specific pattern of which prices rise and by how much completely depends on who gets the new money first and what their tastes and preferences happen to be at that moment.

There is another group who are witnessing the prices rising, but they have not yet received the new money; it has not filtered to them. An example is those on fixed-incomes. As they see prices rise, their real wealth falls because their incomes have not changed. Thus, there is a real wealth transfer from those that get the new money last to those that get the new money first. The people whose real wealth is declining use their savings to maintain themselves during a recession. Savings are the key to economic growth and recovery, and inflation causes it to dry up. The result is that the economy moves two steps backwards.

Who are the people and businesses that are getting the bail-outs and the government spending? It is those companies that are inefficient and losing money. We are transferring wealth from the healthy part of the economy to the part that is inefficient and needs to be liquidated.

To all of these misguided economic policies, we need to say, “Stop! In the name of the LAW!”


Anonymous said...

So Paul, you disagree with our current direction. What instead should we be doing?


P F Cwik said...

What you're asking is, of course, the big question. The solution to the problem is not an easy one. Unfortunately it took some time to get into this mess and it is going to take time to get out of it. Many politically expedient government "solutions" can certainly prolong the recession and make it worse.

Economists have known the formula for economic growth: savings leads to investment which leads to capital accumulation and higher levels of productivity. Higher levels of productivity allows for the creation of more stuff and higher living standards. However, this formula is not what the politicians like to hear.

To get out of a recession means that we need the economy to grow. So we cannot consume or spend our way to prosperity; instead we need savings and capital formation. That means we need to do the opposite of what the politicians in Washington, D.C. are telling us.

Cut taxes on savings and savers, stop the crazy government spending, stop creating money, stop government borrowing, let prices fall, and let companies fail. Only by clearing out the previously built up malinvestments will we have a solid foundation for growth.

That's not the politically popular thing to advocate, but sometimes economists have to play the bad guy.

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