Tuesday, August 10, 2010

Too Many Economists Spoil...Everything

Ask 3 or 4 economists what’s in store for us given the national debt, the recession and other current data and you may get 3 or 4 different answers. Why? Because predicting human behavior via a reliable mathematical formula is a pipe dream. People’s behavior changes as their experience, knowledge and awareness changes and the behavior of people is ultimately what economics is all about. There are also opposing forces within our financial system which ebb and flow from day to day, week to week and year to year.

You may have heard the financial collapse in late 2008 caused a “liquidity crisis”. That’s because most of the money we use in every day transactions is not actually Treasury issued U.S. dollars. It’s I.O.U.’s from banks to other banks. The amount of I.O.U.’s any bank can have outstanding is dependent on their deposits and other assets. If someone fails to pay back a loan, it has an exponential effect on the amount of money a bank is allowed to loan out. Your $1 default can cost the bank $10 or more in available cash flow. That’s why a default rate of 5, 6 or 7% can be enough to make a bank insolvent.

The Federal Reserve has attempted to counter the loss in total currency resulting from defaults by engaging in “quantitative easing” which is a cool way of saying “creating money out of thin air”. They don’t even go to the trouble of printing it. It’s just an adjustment to the balance sheet. They use this new money to buy assets like Treasuries and corporate bonds from banks, which gives them more cash, which they can leverage to make more loans using something called the “deposit multiplier”.

Countering the Fed’s counter measures is America’s increased savings rate. As people grow more and more skeptical of our government’s ability to competently manage the nation’s business, they start squirreling away cash. They borrow less and some even horde cash at home, rather than in banks. Remember, the bank can loan out several times the amount of money you deposit, so if you put $1 under your mattress instead of in your bank account, the bank loses several dollars in potential cash flow.

Another factor at work in the economy is the fact that profits from the financial markets have accounted for as much as 41% of corporate earnings in recent years. Financial sector profits come largely from fees on transactions (as does government tax revenues). Fewer transactions means fewer opportunities for fees. Hence both the banks and the government have a vested interest in creating more transactions, whether they lead to any actual added value or not. They view any activity as stimulus, when in reality, much of it is just waste.

Ultimately you create a thriving economy when you give people incentive to work harder and/or smarter to create value for one another. You have to make trade easier and more rewarding at all levels, from individual to small business to mega corporation. Creating more money, more rules and new fees isn’t going to get us there. The best thing the government can do for the economy right now is to quit trying to direct it and just sit back and observe for a while. Trust in the cumulative effect of individual decisions. You’ll be amazed at how efficient it really is.

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