The Wishy Washy Liquidity Trap

The markets have certainly sold off lately and there are few places left to hide.  Some are saying it’s a repeat of 2008 happening.  It’s going to be far worse I’m afraid.  Sorry to be the bearer of bad news.

It’s interesting to listen to “experts” from both the inflation and deflation camps explain what we need to do in order to fix the global economy.  Of particular interest (for entertainment value alone) is Nobel prize winning neo-Keynesian Paul Krugman.  He contributes regularly to his blog on the NY Times and doesn’t hold back when sharing his delusions views.

Of course he’s firmly in the deflation camp and believes that the US is stuck in a classic liquidity trap and that the recovery hasn’t gained traction because Bernanke and the Fed haven’t acted aggressively enough.  He states that if he were in charge, he’d have thrown far more stimulus at the system.  In fact, on one of his posts he goes on to say that the best thing that could happen to the economy would be to start a fictitious war against imaginary aliens.  ”Super” Krugman claims he’d  save the economy by creating American jobs building weapons and defences in preparation for a war that would of course never happen.  This “stimulus” would give the economy the much needed traction it needs and the private sector would step in as the program wound down.  He must love the positive effect hurricanes and earthquakes have on the economy!  Think of all of the construction jobs the clean up and re-building creates.

The logic is tragically flawed.  It’s typical Keynesian dogma that believes in creating productivity out of thin air.  The reality is, you just can’t.  Sure, you create jobs and in turn the dollars earned in those new jobs work their way into the local economy.  But in order to “create” jobs, the resources must first be taken away from somewhere else.  Winston Churchill summed this up rather nicely.

We contend that for a nation to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.

We must always remember that whatever the government gives, it must first take away.  If they are “creating” jobs, the money to pay those wages must come from somewhere.  It has a neutral effect at best.  In the US, it’s worse because the money is borrowed and accumulates interest.

The markets lately sure seem to reflect deflation though don’t they?  In the US, lending remains stagnant, housing prices continue to fall, the markets are falling, gold and silver have fallen significantly and interest rates are reman at all time lows.  People and corporations are hoarding cash and sitting on the side lines so the economy remains stalled.  Seems like the the deflationists are winning right?  Where’s all of the massive inflation and soaring interest rates that some predicted?

The answer lies in the solutions laid forth thus far.  Take housing for example.  The astronomical rise in home prices was instigated by the federal reserve lowering interest rates and holding them at record lows for far too long.  As people realized they could borrow money cheaply, many used the leverage offered to them to speculate in real estate.  As this “new” money entered the system, it created inflation in the housing sector.  In order to work off the effects of this bubble, the free market needs adjust prices back to affordable levels for regular Americans.  The government has repeatedly tried unsuccessfully to revive this bubble to spur economic growth.  Homebuyer tax credits and record low interest rates aren’t enough to encourage Americans to buy.  They’ve been burned too badly, plus many don’t have the credit worthiness to allow them to borrow or refinance.

Gold has risen significantly over the last year.  In fact, it has risen every year over the last decade.  But to say it has risen is actually misguided.  In reality, gold IS money.  Its value remains constant.  No government can set its price.  All they can do is manipulate their fiat currency.  So if it used to cost $400 US dollars to buy an ounce of gold and it now takes $1,600, the dollar has in fact lost $1,200 in purchasing power.  Sure, other prices haven’t risen that much in the local economy, yet.  That’s because prices and wages tend to be sticky and take a while to adjust to the true effects of inflation.  But once inflation really takes off, prices will rise significantly.

The official reported inflation numbers are very misleading.  For starters, they exclude food and energy.  They also use formulas based on hedonic regression to offset the true rise in the price of goods.  For example, they would state that if a business has a recent computer that’s 5 times more powerful than one bought 3 years ago, then those using that computer are by proxy, 5 times more productive.  Ridiculous I know, but it’s what they do.  For a more accurate measure of inflation statistics, Shadow Stats offer figures based on non manipulated numbers.

So is the theory of a liquidity trap really something we need to worry about?  After all, deflation seems to be a major worry as people won’t spend money if they think they can get the same goods and services for less at a later date, right?  Reality tells us a resounding NO!  Do people hold off on buying the latest TV, iPhone, or computer because they know it’ll cost way less for the same item later?  Do people put off filling their tank with gas or eating if they suspect prices will drop in the future?  You know the answer.  And what’s wrong with people saving money anyway?  After all, we don’t have a demand problem at all.  The market always has enough demand for viable resources and services.  I’m sure demand fell for horses and carriages when Henry Ford invented the Model T.  But that’s what progress does.  Society moves on.  If they implemented modern economic policy back in Ford’s day, they might have bailed out the horse breeders to “stimulate” growth in that sector.

Reality is much simpler than fiction.  It’s also true that common sense isn’t so common.  We all seem to suffer from a major case of analysis paralysis.  What we should do is shrink the size of government and get them out of the economy.  We need real progress and real job creation, not life support for obsolete professions.  We need infrastructure, modern transportation methods and cleaner energy.  But not if we have to foot our grand children with the bill.  I’m sure I’d be much more efficient if I had a private jet instead of a car to get around.  But you know what?  I can’t afford a jet, so I make do with what I have.  Citizens, governments and businesses around the world need to learn this lesson.  It’s not those with the most resources that win.  It’s those who are most resourceful and resilient that thrive.

Finally, I’d like to end by to putting a final nail in the coffin on the tired theory of deflation.   Falling prices are not the real threat at all.  Governments all use fiat currency nowadays and have access to a printing press.  They can print as much money as they like.  They can create as much inflation as they would like.  In fact, all central banks CAN do effectively is create inflation.  So no threat of deflation could ever not be countered by the far more powerful inflation creating tools they already hold.

I anticipate the G20 nations to continue to stimulate and prop up defunct industries and countries.  But in the end, the free market is far more powerful and will ultimately rule.  Simply buying time and in turn, making the problems worse by nationalizing debts is far from a solution.  The bubble we’re experiencing right now is the government.  It too will pop and it’ll be ugly.  Socialism is already dead.  It has never and will never work over the long run.  The world is learning this right now. You can’t spend more than you take in long term .  It just doesn’t work.  The sooner we embrace this, the sooner the real economy can recover.  God speed!