In my opinion, the Fed is now faced with an impossible choice of how to "fix" our current economy. There are only two possible scenarios to deal with and the Fed will be forced to choose one and it's imperative that they choose the right one. To know how I came up with these scenarios, I'll post the base for these two scenarios here so everyone can fully agree on how we got to where we are. This is the Austrian Theory of Business Cycles and it has played itself out so many times historically that it should now be accepted as fact. According to Ludwig Von Mises......
Now, hopefully this was a sufficient explanation so we can all agree that for every artificial boom caused by money expansion there must be a bust where prices of goods and the money supply chase each other to find a balanced equilibrium. If we can agree, then the question is: what do we do about it? For the Fed there is really only two choices:deflate or inflate even more.
Under the deflation scenario, the malinvestments(housing bubble) of the initial boom will be liquidated under bankruptcy. Since the dollar is currency formed out of debt, the new found money will be destroyed along with those debts. Since the money is contracting, this will make it even more difficult for debts to be paid off by everyone. This is better known as the debt-deflation spiral.
When the quantity of money decreases, prices tend to fall. This increases the real value of remaining debt and therefore the difficulty of repaying it, leading to more defaults. Because the debt consists of an asset on the balance sheet of banks, at some point the banks would become insolvent. If people became nervous and withdrew their cash from banks that would decrease bank reserves even more and accelerate the process. This wave of liquidation would likely cause a cascading chain of insolvency from the banks. They will be forced to write off the bad loans which will wipe out the leverage in the system.
Although the deflation model sounds terrifying, it is only a much needed and natural adjustment to the artificial wealth created by the State. Further, without any governmental intervention, this process would be short-lived. Once the equilibrium between currency and prices have been reached again, it will be easy for one to determine what needs to be saved,borrowed,consumed,etc.
The other scenario is hyperinflation and it's just as painful as deflation, but it inevitably will be more prolonged and drawn out.
Under hyperinflation, the Fed would monetize anything and everything possible. Debt can be inflated away and since the Fed is the "lender of last resort", they would flood the banks with money to keep them up and running for the time being. For modern(Keynesian) economists, this is a cure-all for the ills of the market, but under Austrian theory, this is only a short-term solution which prolongs the day of reckoning.
Under Austrian theory, there is only so long that a Central Bank can inflate the money supply. Inflating will only work so long as the price of goods is depressed from those using it's money supply. The Fed has done a good job of this by sending 65% of the money supply overseas.
The hyperinflation process starts when the people come to realize the effects of inflation and no longer have faith in the purchasing power of their money. People start buying whatever physical good they can while their money is still worth something. This bids the prices up even more. Prices start to multiply and then eventually skyrocket into the realm of the absurd.
The hyperinflation process has recently played out in several different countries like Bolivia,Argentina,Brazil, and most infamously, Zimbabwe. In Zimbabwe, their smallest note is a $500 and the price of a roll of toilet is around $145,000. As stated above, they choose not to put their money in banks, but invest in tangible goods with little chance of losing value like sugar or cornmeal.
There's no real predictor of when hyperinflation would ensue, only that it will after reinflation fails to sustain the artifacts of the initial boom. Now that people are starting to wake up to the devastating effects of inflation and fret over the value of their money, the prospect of hyperinflation grows as a possiblity.
Now, the question remains, what will the Fed do? There's alot of debate among economists on this issue.
On the one hand, it seems very unlikely that the Fed would just stand idly by as the banking industry implodes. During tough times, people demand that the government "just do something" so bailing out the banks seems like the most logical option for them to take. I have read many times where Bernanke has stated that the Great Depression could have been avoided by inflating. Although this might be true, he always omits that the enormous price of bailout is laid at the feet of the taxpayer in the form of inflation. Also, since the Fed is a private bank made up of private bankers, it only makes sense that they would step in on behalf of them.
On the other hand, what would be the recourse against the Fed after hyperinflation? The jig would surely be up for the Fed. Since it's the one charged with stabilizing our money supply, they would have to explain why they failed in the task charged to them. People would realize that Central Banking is a sham and was doomed to failure from the start. It's a double-edged sword and will be very interesting to see which way they decide to go. I know I'll be paying close attention.
Any thoughts,disagreements,ridicule,praise,etc.?
In a purely free market (without Government intervention), the rate of interest is determined by people's "willingness to save and invest" (which is called people's time preferences) for future use, as compared to how much they are "willingly to consume now". If people change their "willingness to save" (time preferences) and want to save more, the additional savings will cause the rate of interest to fall (increased supply of savings), and businesses will borrow and invest these additional savings. When the Central Bank (for example The Federal Reserve) increases the money supply and expands bank credit (which Central Banks does everywhere and all the time and always "out of thin air"), it initially lowers the rate of interest and thereby misleads businessmen to act in a manner as if true savings have increased, which in turn leads businessmen to invests those supposed savings in capital goods. New projects that were not profitable before, will now suddenly with this lower interest rate, be profitable. While this process is working, the economy is in an inflationary boom phase (expansion). Capital goods such as stocks, real estate etc, will be more demanded and invested in, and prices of those will rise faster and more intensely in relation to consumption goods. As these supposed savings have worked their way through the economy, prices of goods, services and wages have generally increased to a height which prices for them would have not reached without these supposed savings.
As mentioned, people's "willingness to save and invest" have not changed (people's time preferences have not changed) for it was only the Central Bank that increased, out of thin air, additional "savings". When supposed savings have worked their way through the economy and are received, finally, in increased wages, people still spend their real wages in the same manner as before. They save/ consume in real terms and in same proportion to each other, as before mentioned increase in supposed savings. Because of this, a lack of savings will occur and the rate of interest will rise. Projects that businessmen have invested in and that seemed to be profitable when the rate of interest was lowered are now revealed to be unprofitable. All those investments are revealed to be malinvestments. Businessmen will stop investing in those projects and lay off workers. Prices of capital goods, real estate, stocks etc, will fall sharply and relatively to the fall in prices of consumer goods. The economy is in a depression phase. When those investments are liquidated, the economy is adjusted to people's "willingness to save and invest" and to consume. The economic structure corresponds to the ratio which people want to save and consume. The economy is now healthy again.
As mentioned, people's "willingness to save and invest" have not changed (people's time preferences have not changed) for it was only the Central Bank that increased, out of thin air, additional "savings". When supposed savings have worked their way through the economy and are received, finally, in increased wages, people still spend their real wages in the same manner as before. They save/ consume in real terms and in same proportion to each other, as before mentioned increase in supposed savings. Because of this, a lack of savings will occur and the rate of interest will rise. Projects that businessmen have invested in and that seemed to be profitable when the rate of interest was lowered are now revealed to be unprofitable. All those investments are revealed to be malinvestments. Businessmen will stop investing in those projects and lay off workers. Prices of capital goods, real estate, stocks etc, will fall sharply and relatively to the fall in prices of consumer goods. The economy is in a depression phase. When those investments are liquidated, the economy is adjusted to people's "willingness to save and invest" and to consume. The economic structure corresponds to the ratio which people want to save and consume. The economy is now healthy again.
Now, hopefully this was a sufficient explanation so we can all agree that for every artificial boom caused by money expansion there must be a bust where prices of goods and the money supply chase each other to find a balanced equilibrium. If we can agree, then the question is: what do we do about it? For the Fed there is really only two choices:deflate or inflate even more.
Under the deflation scenario, the malinvestments(housing bubble) of the initial boom will be liquidated under bankruptcy. Since the dollar is currency formed out of debt, the new found money will be destroyed along with those debts. Since the money is contracting, this will make it even more difficult for debts to be paid off by everyone. This is better known as the debt-deflation spiral.
When the quantity of money decreases, prices tend to fall. This increases the real value of remaining debt and therefore the difficulty of repaying it, leading to more defaults. Because the debt consists of an asset on the balance sheet of banks, at some point the banks would become insolvent. If people became nervous and withdrew their cash from banks that would decrease bank reserves even more and accelerate the process. This wave of liquidation would likely cause a cascading chain of insolvency from the banks. They will be forced to write off the bad loans which will wipe out the leverage in the system.
Although the deflation model sounds terrifying, it is only a much needed and natural adjustment to the artificial wealth created by the State. Further, without any governmental intervention, this process would be short-lived. Once the equilibrium between currency and prices have been reached again, it will be easy for one to determine what needs to be saved,borrowed,consumed,etc.
The other scenario is hyperinflation and it's just as painful as deflation, but it inevitably will be more prolonged and drawn out.
Under hyperinflation, the Fed would monetize anything and everything possible. Debt can be inflated away and since the Fed is the "lender of last resort", they would flood the banks with money to keep them up and running for the time being. For modern(Keynesian) economists, this is a cure-all for the ills of the market, but under Austrian theory, this is only a short-term solution which prolongs the day of reckoning.
Under Austrian theory, there is only so long that a Central Bank can inflate the money supply. Inflating will only work so long as the price of goods is depressed from those using it's money supply. The Fed has done a good job of this by sending 65% of the money supply overseas.
The hyperinflation process starts when the people come to realize the effects of inflation and no longer have faith in the purchasing power of their money. People start buying whatever physical good they can while their money is still worth something. This bids the prices up even more. Prices start to multiply and then eventually skyrocket into the realm of the absurd.
The hyperinflation process has recently played out in several different countries like Bolivia,Argentina,Brazil, and most infamously, Zimbabwe. In Zimbabwe, their smallest note is a $500 and the price of a roll of toilet is around $145,000. As stated above, they choose not to put their money in banks, but invest in tangible goods with little chance of losing value like sugar or cornmeal.
There's no real predictor of when hyperinflation would ensue, only that it will after reinflation fails to sustain the artifacts of the initial boom. Now that people are starting to wake up to the devastating effects of inflation and fret over the value of their money, the prospect of hyperinflation grows as a possiblity.
Now, the question remains, what will the Fed do? There's alot of debate among economists on this issue.
On the one hand, it seems very unlikely that the Fed would just stand idly by as the banking industry implodes. During tough times, people demand that the government "just do something" so bailing out the banks seems like the most logical option for them to take. I have read many times where Bernanke has stated that the Great Depression could have been avoided by inflating. Although this might be true, he always omits that the enormous price of bailout is laid at the feet of the taxpayer in the form of inflation. Also, since the Fed is a private bank made up of private bankers, it only makes sense that they would step in on behalf of them.
On the other hand, what would be the recourse against the Fed after hyperinflation? The jig would surely be up for the Fed. Since it's the one charged with stabilizing our money supply, they would have to explain why they failed in the task charged to them. People would realize that Central Banking is a sham and was doomed to failure from the start. It's a double-edged sword and will be very interesting to see which way they decide to go. I know I'll be paying close attention.
Any thoughts,disagreements,ridicule,praise,etc.?
