An economic primer from my man Josh.

Sunday, September 14, 2008 – 10:53 PM

Lehman, Bear, Freddie, Fannie: What Does It All Mean???
With the ink not yet dry on the massive bailout of Fannie Mae and Freddie Mac, today Lehman Brothers is expected to announce its bankruptcy, making it the second of the top ten American investment banks to go under this year. The numbers involved are so staggering that it is difficult to put them in perspective. How are we to make sense of a $10 billion loss, a $100 billion loss, a $1 trillion loss? For most people these numbers are beyond comprehension, and many Americans are left scratching their heads wondering what it all means.

As John Maynard Keynes – the greatest economist of the 20th Century – remarked after World War I, “The vast expenditures of the war, the inflation of prices, and the depreciation of currency, leading up to a complete instability of the unit of value, have made us lose all sense of number and magnitude in matters of finance. What we believed to be the limits of possibility have been so enormously exceeded. And those who founded their expectations on the past have been so often wrong, that the man in the street is now prepared to believe anything which is told him with some show of authority, and the larger the figure the more readily he swallows it.”

The media and government tell us (with as much show of authority as they can muster) that the choices we currently face involve trade-offs between private interests and American taxpayers. This is a misleading oversimplification. After all, when the government backed the $30 billion takeover of Bear Stearns, our taxes didn’t go up. (In fact, the government sent us all a nice tax rebate check right around the same time.)

It is basic common sense that we can’t spend hundreds of billions of dollars on wars while simultaneously bailing out banks without a corresponding increase in taxes. The US government owes almost $10 trillion. It’s the biggest debtor in the history of the planet, so what does it really mean when the Treasury offers to lend money to failing financial institutions? Where does this money come from?

The answer is that the US government has the power to print money, and they have been doing so at an ever increasing rate in order to hold off the financial tsunami that threatens to sink the entire economy. The problem is that doing so does nothing to solve the problems that caused the tsunami in the first place and only makes matters worse in the long run.

So, in reality the trade-off involved when deciding whether to bail out a bank is not between private interests and taxpayers, but rather between debtors and creditors. There is nothing stopping the Treasury from printing $1 trillion every day. With that amount of money they could bail out every bank in the country. Of course, simply adding indiscriminately to the money supply (without a corresponding increase in production of real goods and services) would lead to a massive fall in the value of the currency (i.e. inflation).

Herein lies the real trade-off involved when the government prints money to bail out debtors (whether they be huge investment banks or millions of struggling homeowners). Since debts are denominated in dollars, they must be repaid in dollars. But no one ever said that the value of the dollar must remain the same between the time a loan is made and when it is repaid. If the government decides to drastically increase the money supply in the meantime, anyone who borrowed money will be repaying their debts with depreciated dollars. Thus inflation amounts to a windfall for debtors at the expense of creditors.

Since it is becoming increasingly obvious that individuals, corporations, and the US government have borrowed more money than they can ever hope to repay, the temptation is very strong to debase the currency. Its much more politically expedient than to institute the massive tax increases that would be required to balance our national finances. People don’t like tax increases and vote against them, but how do you vote against inflation? As Keynes said, “There is no subtler, no surer means of overturning the existing basis of Society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner than not one man in a million is able to diagnose.”

Just consider the uproar over rising gas prices. Everyone in government and the media tells us that it is due to increased Chinese demand, stagnant production, or speculation. Did they ever stop to think that maybe the value of oil hasn’t been going up so much as the value of the US dollar has been going down?

Of course, the financial authorities will always pay lip service to “maintaining a strong dollar”, but actions speak louder than words. For every problem we face today, the government’s response is the same – just print more dollars. The actions of the government make it abundantly clear that they are willing to sacrifice the dollar in order to avert a massive wave of defaults. Unfortunately, the ones who will pay are those who behaved responsibly – those who worked hard, avoided debt, and saved.

And, paradoxically, this state of affairs gives people more incentive than ever to act irresponsibly. If we know that the US government is going to cause the dollar to depreciate severely, the sensible course of action is to run out and borrow money to purchase real assets. After all, if the dollars we have to repay will be worth a fraction of what they’re now worth, that house, car, or gold coin will still be worth a house, a car, or gold coin.

This observation also sheds light on another aspect of the “credit crunch” that the government and the media never talk about. We are told that all of a sudden banks have “tightened up their lending standards”, and this is to blame for the horrible state of the real estate market. Could it also be that those who have money to lend are wising up and don’t want to lend money at 6% if inflation is going to run 10% or higher? (If there’s anyone out there who wants to lend me some money for 10 years at 6% interest, please get in touch!)

As Keynes observed, there is “an almost unbroken chronicle in every country which has a history, back to the earliest dawn of historic record, of a progressive deterioration in the real value of the successive legal tenders which have represented money… The creation of legal tender has been and is a Government’s ultimate reserve; and no State or Government is likely to decree its own bankruptcy or its own downfall so long as this instrument lies at hand unused.”

2 Responses to “An economic primer from my man Josh.”

  • Stravingus:

    Brilliant observation. I was in a conversation recently and used a near verbatim argument concerning the spreadsheet.

    The idea of high gas prices stemming from a low dollar makes a lot of sense to me. Although I still believe that having two oilmen in the White House is the reason, more so than inflation.

    Nonetheless, it’s a profound concept. In watching the blood on Wall St. today, I became happy that I’ve learned how to survive with less money than your average USA citizen.

    I see it as an advantage in 2008.

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