Home > Macro/Monetary Theory > Deflation, the Debt and the Rule of Law

Deflation, the Debt and the Rule of Law

In a real free market economic forecasting would be a matter of predicting natural events and the aggregated effects of individual actions.  These predictions would manifest themselves in the form of prices and those prices would direct scarce resources into their most valuable uses.  To predict the behavior of aggregate price levels you would have only to take into account expectations about the supply of money, by which I mean the amount of gold/silver etc. found in the ground, the amount of output in the economy and factors affecting velocity.  These predictions may be wrong at times and this may cause fluctuations in prices which may have other effects in the short run on the economy.  The important thing to notice though, is that none of these things would be controlled directly by the government or any other small group of individuals. 

By contrast, in our system the government and the Federal Reserve are constantly manipulating the most important signals that regulate an economy.  This makes the process of economic forecasting mainly an attempt at guessing what these people will do.   And to make matters worse, the rules governing their behavior are not even clear.

Case in point: the Federal Reserve and the Federal government are supposed to be separate entities so that the government does not have the power to print money and spend it at will which would constitute a disguised tax on people who hold dollars.  This would provide a great temptation for the government to simply spend as much as it wanted and never have to worry about where the money came from.  This is certainly not a very desirable situation.  But let’s look at what we have instead. 

We have a Federal Reserve system that prints money and they tell us that their job is to manage the rates of inflation and unemployment.  More specifically, they tell us that their goal is to maintain about 2% inflation per year.  Ok, so that should make economic forecasting fairly simple, after all they’re telling us exactly what they are trying to do so as long as we believe that they actually have the power to accomplish that goal there is no problem.  Except for the fact that they actually don’t have that power.  The way they create money typically is not just by printing it and spending it on something like the government would if they could print money.  Instead they print it and loan it out at interest.  This means that if nobody is willing to borrow it, they can’t inflate the money supply any more.  I’ve already discussed how this system breaks down so I won’t go over it all again.  To summarize, eventually the appetite for debt comes up too short to sustain the inflation rate at the promised level.  This causes a drastic contraction.  The only way to avoid it is to find a way to inject money into the economy to prop up prices.  So lets consider two ways of doing this.

One way is for the government to just print money and spend it.  They could print as much as they wanted and spend it and they would never accumulate any debt.  This would cause government to expand and in the long run likely make the currency unstable so I’m not advocating for this system but it at least would be capable of generating the desired inflation without much trouble.

Another system is one where in order to “inject liquidity” the government has to borrow.  Now the government has a potential problem when they borrow too much.  The problem is that people might get nervous and stop lending to them.  If this happened…. well nobody really knows what would happen, sovereign default, war, currency collapse?  Nobody knows.  The rules aren’t clear.  But wait a minute, there might be hope yet.  As luck would have it, there is a source of unlimited lending just when the government needs it.  You see, it turns out that the Fed is also in need of an endless source of borrowing.  So the government can just issue more and more debt and the Fed can buy it and everyone will be happy.  In fact, this will have the exact same effect as if the government just printed money itself.  Except for one thing–the debt. 

Instead of just printing the necessary dollars and “injecting” them into the economy and moving on, we are left with a massive collective debt to the Fed.  What does this mean?  Well… I don’t think anybody knows.  What if the Fed just keeps lending more and more to the government and the debt just gets bigger and bigger forever?  This might actually be possible but it would be exactly as bad as if we had no Fed and just let the government print as much as they wanted.  In other words we would likely get a lot of inflation.

What if the Fed decides to stop lending?  Do they have enough autonomy to do this?  Would the government change the rules to keep it from happening?  I don’t know.  What if the government actually pays off the debt?  Haha just kidding that one is impossible, if they did that it would cause a massive monetary contraction that would devastate the economy.  Either one of these would have the opposite effect, namely serious deflation. 

So how do you make long-term economic predictions?  It’s just a matter of guessing what a small number of elites in a smoke-filled room will do.  What rules will they make up when everything starts to fall apart?  Nobody knows.  If you guess inflation they can screw you.  If you guess deflation, they can still screw you.  But aren’t you glad that we’re not stuck “at the mercy of the free market?”

  1. February 6, 2013 at 10:45 am

    $10 gas? Oil production in the U.S. is now at an 8 year high, where’s the lower peircs the Repubs promise us if they could just drill more. And that 8 year high is at a time when like 10+ million people are out of work. I wish you would stop buying the BS, we can’t control oil peircs by drilling more. There isn’t enough oil to make a big enough dent on the world market. And if there was, someone else would cut back to raise the price. That oil isn’t even ours. Do ya know that?

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