Thursday, December 16, 2010

Spending is not the Path to Prosperity

Recently, the Chairman of the Federal Reserve, Ben Bernanke, announced the Fed’s plan to initiate further quantitative easing in an attempt to help stimulate the economy. This is now the fifth time the government has tried to stimulate the American economy since the initial decline in 2008. Starting with Bush’s Economic Stimulus Act of 2008, TARP, Obama’s American Recovery and Reinvestment Act of 2009, the first attempt at quantitative easing (pumping over a trillion dollars by buying treasuries from the financial institutions) in 2009, and now the second attempt of quantitative easing to the tune of $600 billion. This has been a parade of Keynesian failures, one right after another; except, of course, TARP’s success at inducing moral hazard by bailing out the large corporations via the American taxpayer.

These misguided policies aimed at promoting recovery by spending are based on a fundamental misunderstanding on what the real problem is and how we got here. In order to first understand what went wrong with our economy, we need to first have an understanding on how an economy experiences sustainable growth.

Imagine a small business owner making widgets and selling them from his home. At this point, he is capable of producing 4 widgets an hour. Desiring to expand his business, he decides to invest. However, in order to invest in his business he must first abstain from current spending. The business owner will have to be thrifty and put up with a lower satisfaction of present living conditions (i.e. not buying frivolous things, saving on energy etc.). After there is enough saved, the owner invests in capital equipment to help produce more widgets at a lower cost. Now he can produce 6 widgets an hour, thus providing the market with more goods at a lower price, while at the same time allowing the business owner more profit to then reinvest further.

In a very small nutshell, this is how an economy grows: NOT by spending, but by saving and investment. If no one ever saved to invest, but only spent everything one had, we would still be in the Stone Age. This desire to save is dictated by an individual’s time preference. A high time preference represents demand for present goods, whereas a low time preference represents demand for future goods, i.e. investing for a future return. In a free market, with free banking, the interest rate on loans would be based on the amount of savings available. The more savings there are the lower the interest rate, and vice versa. And the amount of savings available is dictated by the individual’s time preference. This allows for the interest rate to fluctuate freely based on the market, quickly snuffing out any investment boom before it gets out of hand by raising the interest rate in accordance with the now diminished savings available.

So what went wrong with our economy?

Essentially, this market process is not allowed to happen due to the monopoly called the Federal Reserve, which bases its interest rates arbitrarily. This manipulation of the interest rate distorts the economy and leads to these boom-bust cycles. Around a decade ago, in order to recover from the dot-com bust, Greenspan had the brilliant idea to artificially lower the interest rates in order to stimulate the economy. This persistent lowering of the interest rates for several years, mixed with bad Congressional policy to promote housing, flooded the housing market with money, raising the production and prices of housing, fueling the bubble.

Initially, this was seen as great for the economy. However, because the interest rate was artificially lowered, it did not reflect the aggregate time preferences of individuals within the economy. Therefore, the rate of spending was not slowing down to provide for adequate savings. Investors were taking out loans and investing at an artificially lowered rate. The structure of production was perverted, with investment projects underway that should not have been, while at the same time an increase in present spending as a consequence of inflation.

All booms, once started, are going to end on way or another, either through a total collapse of the currency and economy, or from the raising of the interest rates by the central bank. Fortunately, America’s case happens to be the latter. Once the interest rate is raised, the malinvestments are revealed, forcing the investors to liquidate, or abandon altogether the projects that were underway. Once this occurs there is a process of reallocation of capital, resources, and labor to reflect the actual demands of the economy. Unfortunately, those in power want to keep the binge going by pumping the economy with even more easy money slowing down the necessary process needed for real growth. In addition, due to rigid labor laws and government regulations, our economy becomes less adaptive and more incapable of fixing itself within any reasonable amount of time.

Currently, Bernanke and Obama believe that spending more money through stimulus packages and quantitative easing is what is necessary to fix the economy. This is absolutely wrong. The Federal Reserve, headed by Ben Bernanke, is doing the exact same thing that got us into this mess in the first place – expanding credit through the lowering of the interest rate in an attempt to prop up the prices of housing and goods in our economy. This inflationary policy punishes savers and incentivizes people to spend, exactly when we should not be. The housing market needs to hit bottom by reaching a market clearing price, allowing the excess houses that were built to be bought up. At the same time, Obama’s deficit spending only devalues the dollar more, and further deincentivizes the proper reallocation of our economy that is necessary. They are essentially trying to maintain the economy to the previous boom levels, not realizing that the economy should never have been at that level in the first place! The problem with the economy is the malinvestments and misallocations of resources that took place during the boom, not a sudden loss in aggregate demand as the Keynesians would tell you. It was the boom that should have never taken place; it was the distortion that should never have been. The economy was a house of cards, built off of “wealth” that was created out of thin air by the Federal Reserve, and it was coming down one way or another.

In order to stop these boom-bust cycles, the production of money should be put in private hands, allowing for competing currencies which incentivizes commodity money and allows the interest rate to fluctuate with the market, not the whims of a central planner. The housing boom would have never taken place if it were not for the Fed’s inflationary policies. Honestly, how can we say that we have a free market when the entire life blood of our economy is essentially socialized? In addition, cutting taxes, significantly cutting government spending, and deregulating the economy is vital if we are to have a prosperous and robust free economy.

This was a very condensed version and analysis from the Austrian school of economics’ perspective. If you are interested in learning more about theories on the business cycle, and other free market concepts, I highly recommend visiting


Brodie is a graduate student at UMKC studying political science. He enjoys economics.

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