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Can someone explain how the Fed monetizing debt is suppose to stimulate the economy?

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Gipper posted on Wed, Aug 11 2010 4:40 PM

If hyperinflation is going to vastly raise prices, how is that suppose to "stimulate" the economy? What is the theory behind this, I never understood it.

What is the thinking of these people? Flooding supply will increase demand, blah, blah blah.

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The objective isn't hyperinflation, it is just inflation.  The "thinking" is: defeat deflation at all costs.

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Deflation and HyperInflation are antithetical to State desires. "Modest" inflation is the only way they can sustain the long term gravy train so that's what they have to sell to the masses.

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The way I heard it, give people money and they will buy stuff, so the makers of things make money and indeed feel a need to make more stuff, so they hire more workers and unemployment is fini.

The flaw is that the money has to come from somewhere, right? So when you "give people money", you are atsome point taking it away from someone else.

As your post mentions, if the method of giving people money is by printing it, you take it away with hyperinflation.

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Greg replied on Wed, Aug 11 2010 8:42 PM

I was hearing NBC Nightly News in the background in the other room and couldn't help but hear a certain perspective at what is happening with the market right now and thought I'd see what you guys would have to say. Essentially it's "BEWARE OF DEFLATION!" I'll paraphrase:

There is serious risk of deflation and this can be very problematic because rapidly falling prices will cause buisinesses to not have enough money to pay employees and etc. There would be massive unemployment but this crisis can be averted with steady inflation on the part of the Federal Reserve.

"Now inflation has been quite a scare word in public recently" (maybe a good sign they had to address that) but this is not actually a problem because inflation rates are around %1.3. <<< I'm quite a noob but as compared to what? Would a number like this only be important in the context of some passage of time? How the hell do you come up with one number anyway when it affects different places differently?  

Is there little inflation and a risk of deflation? I know you can't predict the future especially regarding to markets but would it be fair to assume the massive expansion of money since 2007 should lead to a massive inflation-  at least certainly not deflation?

"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." - F.A. Hayek
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DD5 replied on Wed, Aug 11 2010 8:57 PM

 

It's about aggregate demand.  Inflation will increase aggregate demand.  Aggregate demand will stimulate production and put people back to work.  It's brilliant!  

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Gregory Drew:

There is serious risk of deflation and this can be very problematic because rapidly falling prices will cause buisinesses to not have enough money to pay employees and etc. There would be massive unemployment but this crisis can be averted with steady inflation on the part of the Federal Reserve.

Here's a good quote from http://mises.org/daily/4623:

"

The Wall Street Journal's James B. Stewart claims deflation is bad because "deflation erodes profits and asset values," in his "Smartmoney" column.

People wait to buy expecting lower prices, reducing demand. Lower profits cause companies to cut expenses, including employees. It is a downward spiral that, if Japan's experience is any indication, is difficult to arrest.

Mr. Stewart is wrong on all counts. Profits are the difference between the price we sell a good for and the price it costs to produce that good. As Jörg Guido Hülsmann makes clear in his book Deflation & Liberty, "In a deflation, both sets of prices drop, and as a consequence for-profit production can go on."

And while asset values may drop, the assets don't go away. The real wealth of the nation — assets used for production — are still available to produce. However, it may be that because the debt is liquidated on those assets as prices fall, new owners will own and operate the assets, but commerce and production will certainly carry on.

Lower prices increase demand; they do not reduce or delay it. That's why more and more people own flat-screen TVs, cellular telephones, and laptop computers: the prices of these goods have fallen, and people with lower incomes can afford them. And there are more low-income people than high-income people.

Lower prices don't mean lower profits; nor do they mean that employees will be laid off. More demand for a good or service means more employees needed to produce those goods and services. "There is no reason why inflation should ever reduce rather than increase unemployment," Hülsmann writes.

People become unemployed or remain unemployed when they do not wish to work, or if they are forcibly prevented from working for the wage rate an employer is willing to pay. Inflation does not change this fact.

Hülsmann goes on to point out that only if workers underestimate the amount of money created by the central bank and therefore reduce their real wage-rate demands will unemployment be reduced. "All plans to reduce unemployment through inflation therefore boil down to fooling the workers — a childish strategy, to say the least."

"Now inflation has been quite a scare word in public recently" (maybe a good sign they had to address that) but this is not actually a problem because inflation rates are around %1.3. <<< I'm quite a noob but as compared to what? Would a number like this only be important in the context of some passage of time? How the hell do you come up with one number anyway when it affects different places differently?

For some reason, the Fed has decided that inflation of 3% a year is a wonderful thing. I'm guessing because it's what they can get away with without too much grumbling on the part of the people being fleeced. But of course inflation is much much more than 1.3%.You can try a search for "CPI fraud" on google to get an idea why.

Is there little inflation and a risk of deflation? I know you can't predict the future especially regarding to markets but would it be fair to assume the massive expansion of money since 2007 should lead to a massive inflation-  at least certainly not deflation?

First, deflation is not a "risk". It's good. See http://mises.org/daily/4602.

Second, there seems to be a disagreement of opinion about this. Some say all that money printing has to make the dollar worth less, i.e inflation. Others say all those bad debts and defaults the banks cannot collect means they wil lend less, meaning less fractional reserve banking, meaning deflation of a sort. I don't have an educated enough opinion.

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Gipper:
Can someone explain how the Fed monetizing the debt is supposed to stimulate the economy?...What is the theory behind this, I never understood it.

Part of the problem is you are approaching the question logically.  Here is the non-scientific but accurate explanation:

1) The government wants to spend more than it can confiscate in taxes.  (Can this be refuted?)

2) The government can only borrow so much before investors say "no more".  (Can this be refuted?)

3) The central bank was created for the purpose of monetizing government debt, a buyer of last resort, giving bond holders confidence that at least they will get repaid. (Can it be refuted that the Fed IS the buyer of last resort?)

4) This has the additional benefit of creating bank "reserves", allowing all banks in the system to expand together, greatly facilitating the fractional reserve system. (Refute?)

5) The Fed is a powerful lobby to influence Congress to transfer the cost of bank system failure to the taxpayer. (Refute?)

It should be clear that whether or not the economy is stimulated or not has nothing to do with what the Fed's actions. It is concerned with bailing out the banking system (the cartel) and keeping the bond market confident that their investment in government bonds will not crash.  Nothing in #1 through #5 indicate any concern for the economy at all. 

The economy simply does not influence the Fed's actions, but one would not realize that given the emphasis on economic jaw boning.

Austrians (correctly) point out why intervention does not "stimulate".  Interventionist economists point to equations (two years of advanced calculus to understand), empirical observation, and ad hoc theories to justify intervention. 

Do not apply logic to this question.  It will drive you crazy.

"The market is a process." - Ludwig von Mises, as related by Israel Kirzner.   "Capital formation is a beautiful thing" - Chloe732.

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Student replied on Wed, Aug 11 2010 10:06 PM

has anyone tried googling "liquidity trap" before posting? or did you decide to skip the research and jump straight into mocking the mainstream for such obviously illogical policy prescriptions?

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chloe732 replied on Wed, Aug 11 2010 10:53 PM

@ Student:

Thanks, Student, for straightening me out on this.  It's good to hear from you again. 

By the way, where was the "mocking" in my post?  I did not mock the interventionist economics profession.   If it is the word "interventionist" that you find mocking, I actually did not intend it that way.  I was trying to be descriptive, to draw a distinction between "Austrian" and "interventionist".  

If you prefer "mainstream", no problem, simply read it as mainstream.  My reference to "ad hoc" theories?  Again, no offense intended, just trying to be descriptive.  Compared to the Austrian method, mainstream theories do seem to be ad hoc to me, that's all.

My reference to "logic" had nothing to do with the mainstream's policy prescriptions.  I am trying to describe what drives the Fed to do what it does.   The Fed's motivation has nothing to do with economics.  It is futile to try to find a "logical" reason for the Fed's actions.  That is my point, you certainly don't have to agree.

I welcome your critiques, and respect your knowledge of economics.  But I don't appreciate your biting attacks.  If you disagree with me, please help me understand where I am wrong.  You have had enough conversations with me to know I am a laymen, and lack formal education in economics. 

I do have one advantage, though, that your formal education in economics may not have given you.  I witnessed this credit expansion, boom, and collapse first hand, from the inside, from 2002 to 2008.  The Austrian theory regarding the business cycle is correct.  

Look forward to having civil conversations with you.  The problem is, I've never had advanced calculus so I will have no understanding about what you are trying to explain since mainstream theory cannot be separated from mathematics.  The theory is the equation, so to speak.

[EDIT: Did any other forum members find my post to be mocking?  I thought it was factual.]

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Chloe,

I may have read too much into your post. When you described the Fed's policies as being illogical, I thought you were being snide. Clearly thats not the case so I apologize.

I don't know if I have so much of a critique of your post as an alternative explaination for the Fed's pursuit of inflation (which I would actually characterize as half-hearted as of late). Namely, I believe the Fed would like to drive up inflation in order to break the "deflationary expectations trap" that some believe we have entered.

Basically, here's how I think they see the problem.** Suppose that as a result of the 2008 credit collapse, U.S. citizens expect prices in general to start falling. This means the money in their pocket will be worth more tomorrow than it will be today (in other words, the expected rate of return on holding hard cash suddenly went up). As a result, citizens decide to hold their cash longer rather than spending it on goods or investing it in assets (the fact that percieved risk with many investments suddenly went up in 2008 might also feed the move toward increasing money balances). As a result, economic activity contracts and prices start falling as predicted (or more accurately, start increasing at a slower rate). The Fed worries that this self-fulfilling prophecy might only feed people's deflationary expectations and that rather than spending their cash they will continue to hold onto it (with expectations that prices will fall even further later), which would further depress economic activity and so on and so forth. The best way for the Fed to break this cycle is by breaking people's deflationary expectations with rising inflation. 

Now, I don't think there is anything inherently illogical (if you grant its assumptions, you get its conclusions), but there are many ways one can disagree with it. For one, you could argue that the assumptions are false and that the recession isn't driven by declines in aggregate demand, but by supply-side factors such as frictions from labor shifting from one sector to another as a result of the housing collapse (this view is held by mainstream economists like John Taylor as well as most Austrians I would assume). Or one could argue that even if you buy the Fed's argument that the recession is caused by a decline in aggregate demand, but you don't think that warrants intervention because eventually prices will fall far enough and people will start spending money again (i would say this more a matter of political preferences though).

My main point is that I believe the above economic story better explains why the Fed is doing what its doing than a story of how the Fed is used to support government spending and bail out the banking system at all costs.

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Basically, here's how I think they see the problem.** Suppose that as a result of the 2008 credit collapse, U.S. citizens expect prices in general to start falling. This means the money in their pocket will be worth more tomorrow than it will be today (in other words, the expected rate of return on holding hard cash suddenly went up). As a result, citizens decide to hold their cash longer rather than spending it on goods or investing it in assets (the fact that percieved risk with many investments suddenly went up in 2008 might also feed the move toward increasing money balances). As a result, economic activity contracts and prices start falling as predicted (or more accurately, start increasing at a slower rate). The Fed worries that this self-fulfilling prophecy might only feed people's deflationary expectations and that rather than spending their cash they will continue to hold onto it (with expectations that prices will fall even further later), which would further depress economic activity and so on and so forth. The best way for the Fed to break this cycle is by breaking people's deflationary expectations with rising inflation. 

 

You see, the problem I have with this logic is that, wouldn't people's deflationary expectations as consumers be exactly counterbalanced by their deflationary expectations as earners?  In other words, as Friedman said "inflation is always and everywhere a monetary phenomenon", why would people necessarily expect nominal prices of goods they consume to fall faster than their nominal incomes?  To accept this, don't you have to wholly swallow the Keynesian "sticky wages" theory that people will not recognize falling income in a deflationary environment can still equate to unchanged real income?

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Or one could argue that even if you buy the Fed's argument that the recession is caused by a decline in aggregate demand, but you don't think that warrants intervention because eventually prices will fall far enough and people will start spending money again (i would say this more a matter of political preferences though).

A decline in aggregate demand is not an objective problem.  That is the greater issue than whether it "causes" (defines) a recession.

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Mises Pieces,

You're right that you would have to make some assumptions about sticky wages. Or at least assume that people would expect their wages would fall less quickly than prices (not an impossible thing to imagine, my pay is only nagotiated once a year, i would imagine the price of most goods change more often). 

Just to clarify, there are plenty of reasons to doubt we are in an deflationary expectations trap. I am not asking anyone to buy the story, just to recognize that it is a possibility and that concern of this possibility is a better explaination for Fed policy than other answers offered in this thread.  

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chloe732 replied on Thu, Aug 12 2010 11:13 PM

@ Student

You explained the mainstream explanation very clearly.  Nothing new there, I already understood the mainstream position which is why I reject it.

You mention that one could argue that the assumptions are false and the recession isn't driven by declines in aggregate demand.   You were really on track here, and I thought you would then mention that one could argue from the standpoint of ABCT (distortions in the structure of production, malinvestment, the problem lies within the cause of the boom, not the bust, etc) but you instead described "supply-side factors" which "most Austrians" would agree with.  I don't see how any Austrian would point to "supply-side" factors since such factors have nothing to do with ABCT.

The mainstream explanation is wrong (the assumptions are false) not due to supply-side factors, but rather due to the consequences of the Fed's expansion of the money supply and subsequent fiat credit expansion pyramided on top of it.  The explanation lies in ABCT, not in declines in aggregate demand.

We will simply have to agree to disagree.

"The market is a process." - Ludwig von Mises, as related by Israel Kirzner.   "Capital formation is a beautiful thing" - Chloe732.

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