Indispensable Economics Where's the Recovery?

Sep 6, 2010

The other day, I was watching the news on television and the news anchor was interviewing an economist who was defending the government stimulus. The conversation was occasioned by the continued bad economic reports we have so learned to expect. The economist was explaining why the stimulus was the right way to go, and then made the following statement with positive excitement: "There is so much liquidity in the system (this means so much cash put in by Federal deficit spending and the printing of money by the Federal Reserve Bank) that the economy should be really chugging along!"

Ironically, the conversation was about the fact that the economy was clearly not "chugging along." It should be noted - if I did not make it quite clear - that the economist said this in a positive vein. He definitely was NOT saying that the economy was not chugging along and I cannot figure out why it is not. He was saying that his paradigm says that we have done what we should have done, and any second it will be chugging along.

Let us take a silly yet analogous story. Say that you were told that to lose weight, you need to eat five of the big Hershey chocolate bars every day. After stepping off the scale and noticing that you gained 10 pounds this week, you say positively, "I ate so much candy this week that I should be losing a ton!" Your paradigm predicted a weight loss and, since you followed the plan, any second you should see a significant weight loss.

In both of these scenarios we see a defection from reality. Everyone knows that to lose weight, one needs to eat less candy, not more. But you accepted a cockamamie theory, and then used the theory to color your perception of reality. It is the same with this economist. He accepted the Keynesian paradigm of government involvement in the economy, which says that in times of economic downturn, it is the job of various government agencies to "stimulate" the economy by injections of money, which will bring the country out of the recession. The economist does not believe the actual data, just as you do not really believe the scale, because the theory "predicts" an economic upturn or a weight loss. This is blindness.

Let us examine why pumping money into the economy does not cause it to recover. First of all we have to realize that all macroeconomic theory has to have a microeconomic foundation or it is just fantasy. One major fault of Keynes is exactly that: he has no microeconomic foundation for his theory. He treats the macroeconomy as if it is a machine. If you press the gas pedal, it pumps more gas and air into the engine, raises the RPM, and the result is an increase in speed. This is like the child's version of economics. We need to ask how the influx of mere cash into the economy will affect the behavior of actual persons.

An increase in actual economic activity begins with savings being available for the purchase of capital goods, which are used to make consumer goods in the long run. Even if there are savings, those saving must be willing to risk their savings by investing in projects which over time will result in more consumer goods. All the plans of the entrepreneur for the production of consumer goods come to naught without the savings needed to purchase capital goods. Savings are an indication of savers’ time preferences. All men have a desire for things now, not later. To persuade persons to save, that is, to put off acquiring consumer goods now, their time preference must become lower. In order for a person to lower their time preference, they must be compensated in the future for goods not purchased now. That compensation is called interest or profit. The lower the time preference, that is, the longer that person is going to go without the availability of his money, the higher the interest rate is going to be; that is, the more compensation a person will demand. In economically uncertain times, additional interest that will be demanded is called a "risk premium." Now the interest paid to the saver becomes the "cost of capital" to the producer. The producer needs to predict that he will make enough money from selling his final product to pay the interest to all those who saved to help him produce the product. The higher the interest rate, the higher the cost of capital; the higher the cost of capital, the higher the cost to bring the product to market. But in an economic downturn, people are not able or willing to pay more for things, but actually look for cheaper things. The result is that the entrepreneur is reluctant to borrow money for his project because he might not be able to sell it.

So the Keynesian-Obama solution is to pump money into the economy from deficit spending and/or money created out of nothing by the Federal Reserve Bank. The theory goes that an increase in liquidity will lower interest rates and make borrowing cheaper, so that business will be more likely to borrow and invest in capital goods, thus picking up production and employing workers again. Problem number one with this theory is that the lower the interest rate, the less people are likely to save, because their return is not worth the lower time preference. Secondly, the Keynesian-Obamaites do not understand that people learn from previous events. The most recent one is the housing boom, which started this economic downturn in the first place. The Federal Reserve, to stimulate interest-sensitive industries like the housing market, pumped money into the economy, forcing interest rates to an artificial low. Many people, who before could not afford to buy a house because the higher interest rates made housing too expensive and increased the requirements for borrowing, now wanted to purchase housing. Seeing this increased demand, the building industry, which wanted to take advantage of the boom, began investing in house-building. Now while the increase of houses for sale would lower the price for borrowers, this artificial boom put strain on all the things needed to build houses. So now wood, plumbing supplies, shingles, construction equipment, and workers are relatively scarce as compared to the previous housing market, which makes the prices and wages go up, which also means that the houses built later on in the boom are no longer cheap. The result is that people who thought they could afford a house due to the artificially low interest rates now cannot afford them because of the price. Builders are now stuck with houses they cannot sell, and now declare bankruptcy.

In addition to this government-caused disaster, the federal government passed the Community Reinvestment Act, which pressured banks to give housing loans to those who were hardly credit-worthy. Banks, with the help of government corporations like Fannie Mae and Freddie Mac, lost tons of money because of defaults.

So the Obama administration came up with bailouts. And what did the banks do with the money given them by the federal government? They covered the losses in their balance sheets caused by the widespread defaults, instead of what Obama thought they would do—lend the money out again.

To make matters worse, the Democratic administration has created a period of great uncertainty with the great deficits, threats of soaking the rich (that is, soaking the movers and shakers of the economy), and the massive health care "reform." So nothing in the economy is moving. Entrepreneurs are afraid to begin projects, savers are unwilling to lend, and people are unwilling to borrow for or buy even a cheap house. In Detroit (that gem of liberal politician successes), there are houses that go for a few thousand dollars—and no one will buy them.

In short, that is why there is no recovery, and Vice-President Biden’s Summer of Recovery tour is a big joke covered with lies about how things are coming back. So, to the economist on television the other day, I say, your paradigm is dead wrong, and I knew even as an undergraduate in the 1960s that things like this do not and will never work. Where have you been?