The US is stuck between a rock and a very hard place

The United States has two main options.  Let the financial system seize up as the market correctly revalues billions of dollars of assets or create money of out of thin air to buy up all these dubious assets massively devaluing the US dollar.  Fun Fun I say!

I’ve tried to acquire a cursory understanding of this economic tumult in the US.  Near as I can tell there are a number of different kinds of economists out there.  Some, like Keynes who seemed really smart when espoused his theories but lost his shine when his ideas were actually implemented.  Keynes believed the government should engage in deficit spending to jump start a stalled economy.  It was his ideas, much more than Trudeau or Mulroney that put Canada in the debt situation we are in.

One the more notable players in the US scene is Ron Paul.  He isn’t an economist, he was a republican candidate for the presidency.  He follows the Austrian school of economics.  The Austrian school places a lot of faith in the market and has a very dim view of government intervention and regulation.  Mr. Paul believes that the US Central Bank, the Federal Reserve, created this crisis by making credit too easy to get.  When credit is cheap and easy to get people buy more stuff driving up prices and businesses engage in projects that wouldn’t otherwise be profitable.  If interest rates are low more people can borrow more money to buy homes and they are willing to spend more to get one.  When all this credit dries up then it is harder for people to borrow money.  Less money means they can’t afford to spend as much.  Prices come back down as lots of things people bought with all that credit isn’t worth as much anymore like houses and stocks.  When stocks and houses become over-valued because of a credit expansion it is like a big bubble that eventually bursts.  When it does the over-confidence people had in their investments suddenly reverts to fear and panic.  Eventually the market reaches bottom and all these assets are valued appropriately.  This is normally called a recession and they are a normal and necessary part of the economic cycle.

The other prominent side on this is issue is Ben Bernanke and the monetarist school.  He would argue that the great depression was caused by a significant drop in the money supply.  The United States was on the Gold Standard which meant all the money in circulation was connected to how much gold was held in the vault.  More gold meant more money.  After the stock market crash people began to lose confidence in the economy.  Just like today banks started to fail.  Depositors started withdrawing their money and hiding the cash in their homes.  The Federal Reserve did not intervene to save teetering banks or put more money back in to the system.  This caused deflation as the prices for goods and services dropped along with wages.  This was particularly hard on the huge amount of people who bought radios, cars and stocks on credit in the 20s.  Those who had a $100 a month mortgage payment suddenly found themselves making $600 a month rather than $800.  Those who had an income spent most of it on their loan payments which meant they weren’t buying cars and radios.  Everything went in to a tail spin.

Who is right?  I really don’t know but the troublesome reality is if Ron Paul is right and the 700 billion dollar bailout goes through a severe recession will become a depression.  If Ben Bernanke is right and the bailout doesn’t go through then we will have a depression. 

The danger with the bailout is that it could pull out the legs from the US currency.  The US government doesn’t have 700 billion dollars and China isn’t going to lend it to them.  The federal reserve, which is no longer tied to a gold standard, will have to “print” the money.  The media gives off the impression that the bail out is about tax payers bailing out investment banks.  In reality it is every one who holds a US dollar that bails them out because the value of that currency will drop.  What happens next depends on how much confidence foreign holders of American debt have in the US dollar.  If they lose confidence they will use their dollar reserves to buy up every hard asset they can then dump the rest.  Japan, China and South Korea will no longer bankroll America’s free spending ways.  The value of the dollar will finally plummet and all these fine manufactured goods that America imports will become much more expensive.  The world will start selling oil and other commodities in other currencies and t he US dollar will lose its favoured status as the world reserve currency.  A country with exported manufacturing base and desperate addiction to foreign oil will not deal well with massive currency devaluation. 

The choices are between deflation and inflation.  Neither is particularly fun.  The best economic minds in the world are making their best guesses about what to do.  Most of them were wrong in 1929. 

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