Updated 9/14/2012.
The bellow is now happening. But it is even worse than we thought. The Fed announced that they will be buying 40 billion dollars worth of mortgage backed securities a month, in attempt to pump up the housing market. This type of activity is what lead to the mal-investments that caused the housing bubble in the first place. When loans are bought off a bank’s hands, that banks incentive to make more loans increases. To make more loans you need to lower standards. Here we go again.
In light of the news that the Fed is contemplating another round of quantitative easing, aka money printing, so close to the November election, I feel compelled it comment on this issue. We all know who would benefit politically from another round of money printings, right? Well if you don’t, the beneficiary would be the incumbent President and his party, Obama and the democrats. Why would they benefit politically? Well, when the Fed prints some new money out of thin air, the recipient of this money will be able to increase their spending while no other entity in the economy needs to cut back on its current spending, thus increasing the overall spending in the economy. An increase in overall spending will in most situations lead to more hiring and a decrease in unemployment. Obama and the democrats can then boast on how their policies are working and the economy is recovering.
But if Fed money printing can decrease unemployment, doesn’t this benefit all of us? Not really. You see technically the Fed can print enough money to employ every individual in the United States, in the short run, that is full employment. But unless the jobs that we are hired to do are productive, the next day, we would all be employed, but with nothing to eat.
To understand why this is so, one would need to understand the difference between productive and unproductive investments. Imagine a simple economy, one of farmers, farm hands, and unemployed people. The government feels compelled to increase employment because the unemployed are going with out food and this makes government sad. So they print some money and use it to hire the unemployed people to dig ditches. They dig ditches, get paid, and take their money to the farmers in order to purchase various goods. After all, they do not need the ditches they have dug, so the only goods of any value on the market are the ones made by farmers. Farmers see an increase in demand for their goods, hire more farm hands, and produce more goods to meet the demand. All this hiring brings the economy to nearly full employment. All is well, or so it seems. The extra hired farm hands take their cash and also bring it to the market. Just the same as before, they find no value in purchasing ditches, so the goods they buy are the ones provided by the farmers. This drives the demand for farm goods even further up. But before the farmers decide to ratchet up production again they want to spend some of the extra cash they made. They take their cash to the market to find something they can spend it on, but find out that the only thing available is ditches. Seeing that the extra cash they made brings them no extra value, they now have a decision to make about the future production of their farms. They have a few choices. They can freeze production at current levels. But this won’t meet the higher demand and cause a shortage of food. This means that like before some people will have to go without eating. Except now, there is a crucial difference, the people who are going to go hungry are doing work, and even worse some of them are farm hands. There is no possible way for farmers to tell where the cash is coming from, so it is inevitable that some farm hands will go hungry. The farm hands that go hungry will not continue to do work for very long. Even if there is some type of rationing system, productivity will inevitably go down. When that happens even less food will be produced, leaving even more farm hands hungry, and the spiral will continue until there is no food or very little of it for anyone. So this is not a good options.
Another option that the farmers can take is just raising the prices to decrease demand. However, all this means, is that not all people will be able to afford the same amount of goods as they did before. A small price to pay for full employment? Seemingly. However, not everyone is willing to work as hard as they did before for less goods. Some of these people will be farm hands. So the farm hands will either work less hard, decreasing productivity and taking us on the same spiral as described above, or they will demand higher wages. The rich farmers, or the ones that can afford it will raise their wages. Higher wages, will lead to higher demand, which will prompt other farmers to raise prices. As the wages race after the prices one of two things can happen. If everything else stays unchanged, the market will rid its self from the unproductive element as the farmers and farm hands raise the prices and wages to crowd out any cash coming from digging ditches. If the wages for digging ditches are not raised, and as prices for farm goods rise, the ability of people who dig ditches to buy these farm goods will decrease. As wages from digging ditches buy less and less goods, the demand for the goods will decrease, relieving some of the upwards pressure on prices. Eventually when all purchasing power of the ditch diggers is eliminated, a new equilibrium of prices will be reached. However, since ditch digging will no longer provide people with the ability to purchase goods, they will quit, and this will put us back to square one, where a certain unemployed population goes hungry. This scenario, is however unlikely to happen. Government, is unlikely to let its ditch digging program fail, and it will, most likely raise the wages for digging ditches as the prices for farm goods rise. So wages will continue to race after the prices, and there will inevitably be moments when a farm hand’s wage cannot afford as much goods as it did previously. Not all farm hands will tolerate such events, and productivity will drop, putting us back in the spiral mentioned in the first scenario. A spiral which ends with very little or no food for anyone.
So as you see, for new investments to be beneficial they have to be productive, they have to produce new value that people are willing to purchase. In our example the unproductive activity was digging ditches, however, this can be substituted with anything that people do not want or value. Solar panels that no one wants to use, cars that no one wants to drive, road, bridges, or airports that no one uses, a cell phone that no one buys. Really it could be anything. It is not only government, but also private individuals that can make bad, unproductive investments. However, in the private sector there is a mechanism to deal with bad investments. Payments in the private sector are voluntary so any bad investment that people do not value quickly runs out of funding and the unproductive element is removed. In the government sector payments are mandatory, and so not only does government tend to make more unproductive investments but those investments tend to get funded indefinitely.
So why is money printing in order to boost economy on a large scale, considered as poison to the economy, but on a small scale considered a benefit? I don’t know why people still consider it a benefit, it is still in fact poison, just a much smaller dose. The Fed hopes that if they print just exactly the right amount of new money the economy needs, it will create a situation where the new spending is done on mostly productive endeavors. Unfortunately, as history has shown, this seldom happens. The investments encouraged by such actions are largely unproductive, resulting a short run boom, and a long run bust.
To illustrate this point further imagine you live in a city which is about to host the Olympic games. As the games start, the city enjoys an influx of people. A restaurant owner unaware of the Olympic games, assumes that there is a increased demand for his restaurant, and as a result invests considerable amount of capital to expand it. For short time he enjoys record profits, but when the games end and the demand falls of, he can no longer afford to keep such a large restaurant in business. So he scales down, losing his capital investment, or completely goes out of business. Boom and Bust.
Now think of the injustice of doing this right before an election. The artificially inflated spending will for some create an illusion of an economic recovery only to be followed by a bust at sometime after the election. Some people will be fooled into believing that the recovery is due to the incumbents party’s polices, and might even be persuaded to vote. The Fed is the best SuperPac a politician can ask for. And if you are an Obama supporter, the same can be done to you in future, and has been done in the past. During Bush’s years the Fed for example helped prop up the economy by inflating the housing bubble.
So why is the Fed compelled to participate in such irrational behavior? Because it is part of their mandate or mission as legislated by congress, to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. So every time unemployment begins to go up, the Federal reserve chief is compelled to make him self relevant and print some money, even though it is counter productive to the goal in the long term.
I suggest that while we fight to end the Fed all together, we put forth the idea of amending it in the short run. All we need to do is pass some legislation that would remove maximum employment as a mandate of the federal reserve. This would remove much of the economic meddling the Fed participates in.
