Wednesday, April 15, 2009

Twist and Shout

On March 18th, the Federal Reserve announced it will keep the Fed Funds rate between 0 and 0.25%, buy $750 billion in mortgage backed securities, and buy $100 billion in agency debt. While injecting $850 billion into the economy is problematic, the almost unnoticed announcement is that the Fed plans to buy $300 billion in long-term Treasury securities.

The last time the government tried to manipulate long-term interest rates was in 1961, during the Kennedy Administration. The goal of a project called “Operation Twist” was to flatten the yield curve by raising short-term rates while maintaining long-term rates. Legislators thought that higher short-term rates would reduce the flow of capital from the US, while lower long-term rates would encourage domestic investment. Operation Twist was a disaster because the result was the opposite of what the Fed intended.

Unfortunately, our economy is in a recession – the downside of the business cycle. The business cycle works something like the following. Suppose that a student is assigned a research paper that is due tomorrow at 8am. Since the student hasn’t started the paper, she is in for a long night. By 11pm, the student is getting tired but hasn’t finished the paper. What does the student do? Quite naturally, she reaches for some coffee, a sugary soda, or whatever else that has a lot of caffeine. The jolt of caffeine gets her moving again; but, around 3am, she’s slowing down. What does she do? Grab more caffeine! However, now to get the same jolt, she needs a bigger dose. Each artificial jolt cannot last, and the next jolt requires an even larger dose. Eventually, 8am arrives and the student hands in the paper. Then, she crashes! A long sleep is necessary to flush the junk out of her system and restore her to a normal state.

Our economy has been on an artificial all-nighter for the past several years. It is now time to clear the “junk” out of the system. The junk that needs to be cleared out consists of malinvestments, which were built up during the artificial boom of the last several years of expansionist monetary policy. Now, the time has come to hand in the paper and flush these malinvestments from our economy.

The only way that we can get back to a solid foundation for economic growth is by increasing saving. Savings provide the wherewithal for investment. Investment allows for capital accumulation. Capital includes better tools, better machines, and better equipment, which are necessary for workers to become more productive and raise the standard of living. This is the “Magic Formula” for economic growth; but it’s really not magic. The formula has been known and followed since the beginning of the 1800s. Following this magic formula transformed the US from a bunch of backwater colonies into the largest economy in history.

The opposite approach, the one we are currently taking, is to encourage consumption, except that method doesn’t work. We cannot consume our way to prosperity. A basic tenant of economics is that our wants and desires are unlimited; however, supply is the limiting factor. Stimulating demand alone will not increase the amount of stuff that is being produced.

Furthermore, the Fed is engaging in a policy that allows the entrepreneurs who malinvested capital to persist unnaturally. Unfortunately, those businesses must fail for the economy to recover. When they go out of business, other entrepreneurs can buy their assets for pennies on the dollar. This process allows new firms to use those very same resources (and perhaps the very same employees) with a much lower cost structure. Lower costs are good for firms and very good for consumers, especially those without jobs.

The Fed policy is propping up failing firms while attempting to keep prices high. This policy is backwards. The Fed’s action of pumping money into the economy today will force prices to be much, much higher in the future. The last thing those who have lost their jobs or suffered wage cuts need is for prices to remain high.

Every delay in the painful liquidation phase of the business cycle makes the future reckoning worse. It’s like not going to the dentist when you have a cavity. The drilling will be bad, but if we let it fester, it will become much worse.

We need to shout to the Fed, “Stop drinking those heavily caffeinated, sugary sodas! Stop flooding the market with all of this artificial credit! And let the economy wash out the malinvestments!” Perhaps the song “Twist and Shout” will always be in style; unfortunately Operation Twist is a policy that should have remained in the past.


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