Ending the Business Cycle with Guesswork

In the fall of 2010, the U.S. economy had been in recovery for about 18 months.  At least that was the official word from the National Bureau of Economic Research, which dated the recession from December 2007 to June 2009.  But for many it felt like the recovery had yet to come.

If there was in fact recovery it wasn’t the sort of robust growth one would expect following a great recession.  Rather it was the sort of lethargic recovery of an octogenarian from pneumonia.  Given enough antibiotics the virus may be beaten back…but the old fellow still gasps for breath after a short trudge to the corner mailbox.

So to, larded over with enough easy credit, the U.S. economy had been able to fry up several quarters of positive GDP.  Yet the misallocations of the bubble years were still hanging around like an overstayed party guest into the late night hours.  If recessions are supposed to purge out the rot leftover from the preceding expansion, this one failed immensely.

It had been a peculiar recovery for anyone who bothered to think about it.  It wasn’t based on the spending of savings accumulated during the recession.  Nor was it based on capital spending and investment.

Instead it was based on deficit spending funded by Federal Reserve lending to the Treasury via purchases of Treasury Notes.  But that’s not the half of it.  For whence does the Federal Reserve get the money to loan to the Treasury?

You know the answer… They create it from thin air.  What this means is, in addition to moral and ethical flaws, the recovery was a fraud.  So it was that, in the fall of 2010, the Federal Reserve began diligently creating another $600 billion of phony money to support the phony recovery.

QE2, as it has come to be called, will expire next month.  Last week markets hinted at their anxiety over its conclusion.  Over the coming weeks we’ll have plenty of meditations on the end of QE2.  But today we’ll consider its beginning…what instructed the Fed to hatch it in the first place?

Business Cycle Review

Federal Reserve Chairman Ben Bernanke has a tough job.  Not only is he tasked with protecting the value of the dollar and promoting long-term growth and employment, he’s also tasked with eliminating the business cycle.  What this means is his job description requires him to do the impossible.

The business cycle rises and falls like any other cycle.  Following a period of economic expansion, there comes a period of economic contraction.  Then, following a period of recovery, new economic growth resumes.

Typically, as growth increases, interest rates decrease…borrowing becomes cheap while asset prices go up.  Inevitably, however, the boom exhausts itself…borrowers become too overextended…and the economy can no longer support its debt.

The boom then turns to bust…bankruptcies follow…and the market punishes the imprudent for their reckless mistakes.  Asset prices no longer go up – they go down – and interest rates go up…borrowing becomes expensive.  Economic growth decreases as consumption declines.  Unemployment increases along with savings, furthering the economic recession or depression.

Yet distorting the natural ups and downs of the business cycle is government intervention.  Monetary policy intervenes by controlling the money supply through the actions of the central bank and fiscal policy intervenes through taxation and deficit spending to transfer the wealth of the economy from one hand to another.

Ending the Business Cycle with Guesswork

Government intervention gives false signals to consumers, businesses and investor, which result in distortions and misallocations of capital.  One guy may borrow money to expand his chain of retail electronics stores to meet the increased demand for flat screen TVs and IPODs.  Little does he know that the increased demand’s being driven by consumers extracting cash from their homes, whose value has been inflated by artificially low interest rates courtesy of the Federal Reserve.

What’s more, some enterprising fellow in China has also borrowed money, to build out his warehouse, and increase production of these electronic gadgets that are selling with gusto in the United States.  Up and down…in and out…of the economy’s web these distortions and misallocations of capital go until capacity has far overstretched demand.

When the economy turns, as it inevitably does, and credit tightens, it becomes dramatically clear just how false the apparent demand has distorted reality.  You find, for instance, that out in the boonies of the California desert, far from the pacific ocean, and the mediterranean climate, some exuberant developer’s taken the false signals of the housing boom and the Federal Reserve’s cheap credit to cover the landscape with a sea of tract homes…which they can’t even give away at cost.  Moreover, the Wickes furniture chain store, that had gone in at the freshly erected strip mall to serve the coming demand of the housing development, sits empty as its corporate officers have filed for bankruptcy.

Regrettably, government intervention is capable of postponing declines in the business cycle by propping the economy up with cheap credit.  However, the longer these naturally occurring declines are put off, the bigger the bust and destruction when the collapse comes.

The point it, tasking a central banker with eliminating the business cycle is absurd…

Can a physicist suspend gravity?  Can a doctor remove cancer cells from a patient’s lungs?  Can a mathematician make pi a rational number?  Can a chemist boil water at 200 degrees Fahrenheit?

Eliminating the business cycle would be equally impressive.  All business endeavors would turn a profit.  Money could be borrowed without risk.  And stock prices would never go down.  It would be like eliminating night after day, reaping harvest without toil, or having yin without yang.

In the face of this impossibility the Fed Chairman goes about the task of eliminating the business cycle quite differently than a carpenter goes about constructing a cabinet with a measuring tape and wood saw.  A good carpenter, no doubt, will always measure twice and cut once.  A central banker just creates money as guesswork instructs him…

“We’ll try $600 billion this time.  If that doesn’t work, what the heck, we’ll try $1 trillion.”

Sincerely,

MN Gordon
for Economic Prism

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