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10 Points Americans Must Understand About the Economy

January 15, 2010 5 comments

1. The interest rate is a price – the price of credit like the price of any good.  In a free market the price would be set like the price of any good at the intersection of the supply of funds (our savings), and demand for funds (businesses’ and individuals’ investing wants).  Instead, we have an interest rate that is arbitrarily picked by a handful of economists from the Federal Reserve Banks.  To repeat, one committee centrally plans the cost of credit, of which interest rates on all debt are directly or indirectly based.

2. The Federal Reserve has the monopoly power to print or inflate the money supply, thus artificially lowering the cost of money (the aforementioned interest rate).  This means that they can (and always do) devalue the money in your pocket as every dollar printed decreases the value of all dollars to come before them.  Inflating the money supply may not lead to an increase in prices if an equal or greater amount of goods is produced, but the purchasing power of the dollar will still be reduced because without printing money, your dollars would have been able to buy more goods.  Alternatively, if more dollars are printed than goods are produced, prices will increase though not necessarily uniformly across all goods.  Inflation may not manifest itself in explicitly higher prices but merely impede prices from falling for certain goods as they would were the money supply to remain constant.

3. When you deposit money in a regular checking account, the bank doesn’t hold onto this money.  Banks only keep a small percentage of the money you deposit on hand in their reserves, lending the majority of the money you (or the Fed for that matter) deposit to others who lend it to still others and so on, in the process substantially increasing the money supply.  This is known as fractional reserve banking.  If everyone in America or even a decent percentage of Americans tried to take their money out of the bank on a given day, millions would be unable to access their cash.  Effectively, even with FDIC Insurance, all of the banks are insolvent as they do not hold anywhere near 100% of the money you deposit in their vaults, nor does the FDIC have the funds to cover all deposits.  The hypothetical that the Fed could potentially print up money for the FDIC to distribute is beyond the scope of this post.

4. The government’s debt is merely an insidious tax like inflation.  Government debt can only be paid down by taxing the people.  This tax can occur through direct confiscation by government, or indirectly when holders of our government’s debt demand a higher rate of interest, which in turn signals to markets that our economy is not generating sufficient revenues to pay down the debt, which leads to a perception of economic weakness and thus an increased cost of borrowing for everyone in the economy.  If the government prints money to pay down debt (which in and of itself should cause our debt holders to flood the markets with our debt and thus raise interest rates on everyone), this will represent a tax on the people as well.

5. Deflation, or a decrease in the money supply is the only antidote to inflation.  If the money supply is decreased, each dollar in your pocket becomes worth more.  The concomitant fall in prices will correct the artificial initial rise in prices from government printing of money.  In the process, since decreasing the money supply increases the cost of money, unsustainable enterprises with heavy debt loads will be put out of business, cleansing the economy by freeing up unproductive resources.  Where debtors benefit from an increase in the money supply because they can pay down their borrowings with cheaper dollars, creditors will benefit from a decrease in the money supply because they are paid back with more valuable dollars, which is one of the reasons why government prefers to inflate as it can lessen its own debt load and that of many of its constituents.

6. Deflation in prices while a symptom of deflation of the money supply is also the natural result of increases in productivity, as goods produced more cheaply in greater quantities (in the absence of money printing) will lead to falling prices which benefits consumers.  The so-called “paradox of thrift” that the MSM uses to vilify deflation in prices is wrongheaded, as people will spend on all sorts of products knowing that over time they will fall in price, as we have witnessed with numerous electronics over the years.  Even during a depression, when asset prices fall to certain levels there will always be buyers.  And if people are paying off their debt and/or saving in a time of falling prices in lieu of spending, this will be good for the economy because increasing the pool of real savings lowers the interest rate and allows businesses and individuals to borrow funds for investment at lower cost, legitimately stimulating the economy.

7. Despite the wishes of President Obama, all taxes are passed on to consumers as companies raise their prices to compensate for the increased cost of doing business.

8. Government cannot create wealth.  All it can do is take money from some people and redistribute it to others.  Every dollar the government uses must be taken from the private economy. Printing money to pay for things as we noted merely devalues your dollars, effectively taxing you.  Government financing through debt represents a claim on your wealth, a tax which as noted may be paid directly or indirectly.  Thus, while federal, state and local taxes may appear on a historical basis relatively low, the tax rate is deceptively masked by excluding government bilking through inflation and debt.  Government is a wealth killer, not a wealth creator.

9. The real estate problem in our economy centers on the fact that people owe more money on their mortgages than they are able to pay down.  The only fix to this problem is for people to either generate more income to service their mortgages, or default.  Any intervention to keep people in homes they can’t afford will merely perpetuate market imbalances, propping up the value of real estate and preventing qualified buyers from purchasing homes at fair prices.  There will be no true recovery in the mortgage-backed securities  market until the forces of supply and demand sort out this mess.

10. Our economic crisis at the most basic level occurred because too much money and credit were pumped into the economy, given that again the interest rate was set artificially low not by supply and demand in the market but by government fiat.  The recession signals that we must fix the distortions and malinvestments resulting from the centrally planned interest rate. The healthy path to recovery is to allow prices to fall (aided by debt repayment), liquidate failed enterprises (encouraging reallocation of land, labor and capital to more productive and profitable lines of business) and encourage saving to increase the pool of loanable funds for economic expansion. Any actions to the contrary (i.e. more or less all government policies being implemented or bandied about) will merely prolong the pain.

Note that this is by no means a comprehensive study of the above subjects, but rather a cursory look at essentials that the American public must grasp before we can ever expect to return to prosperity.