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Steve Saville: Withdrawing the Stimulus

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August 11, 2009 – Comments (7)

Another fanastic must-read article by Steve Saville. It dispels the whole "gas-pedal" analogy that the Fed often uses with respect to controlling inflation.

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Withdrawing the Stimulus - LINK
by Steve Saville
August 11, 2009


There has been a lot of discussion in the mainstream financial press about how and when the Fed will withdraw the "monetary stimulus" it has provided over the past year. Also, Ben Bernanke has recently gone into considerable detail about the methods he will use, once the economy is on stronger footing, to gradually remove any excess money before an inflation problem arises. Unfortunately, these discussions and Bernanke's detailed plans betray a terrible misunderstanding about how money-supply changes affect the economy.

Most people who publicly comment on such matters appear to be labouring under the misapprehension that growth in the money supply has the potential to cause only one problem: a broad-based increase in prices. And, therefore, that injecting new money into the economy will not be a problem until/unless the general price level begins to rise at an undesirably fast pace. However, the reality is that growth in the money supply never has an evenly-distributed effect on the economy; rather, the money enters the economy at specific points and therefore affects different parts of the economy in different ways at different times. (As an aside, this is why monetary inflation is such a popular policy. If increasing the money supply caused all prices to immediately rise by a similar amount then nobody could benefit from the inflation, but the way inflation actually works is that the first receivers of the new money obtain a benefit, at the expense of everyone else, by getting to spend the money before it loses purchasing power. The first receivers of the new money tend to be the government, the banks, and the supporters and pet projects of politicians.)

In addition to understanding the non-uniform effects of newly created money, it is important to understand that creating money out of nothing TEMPORARILY makes it seem as if the economy-wide level of savings is higher than is actually the case. The result is lower interest rates and widespread investing in projects that would never see the light of day in the absence of the distorted monetary signals.

The non-uniform way in which new money enters the economy combined with the false impression created by lower interest rates leads to the large-scale transfer of resources and re-distribution of wealth. That is, injecting new money changes the STRUCTURE of the economy, not just the general price level. As a consequence of the monetary inflation, activities will occur that would not otherwise appear economically viable and these activities will collapse once the flow of new money is curtailed. Furthermore, a lot of the resources that get transferred to these inflation-sponsored activities will end up being lost to the economy and many of the businesses that spring up to support the projects that have been "stimulated" by the money creation will end up in bankruptcy. In other words, rapid monetary inflation leads to wastage on a grand scale.

The boom and bust of 2003-2008 is a classic example of what we are talking about. In response to the rapid monetary inflation and artificially low interest rates of 2001-2004, many projects were developed, businesses were started and investments were made that naturally collapsed during the years after the central bank tried to restrict the supplies of money and credit. Moreover, had the central bank not acted to curtail the boom then prices would have begun to accelerate upward throughout the economy and a different form of collapse would have eventually occurred.

The main point we are leading to is that the damage done by injecting a lot of new money into the economy cannot be undone by subsequently removing money from the economy. With regard to the current situation, the monetary profligacy of the past year has propped-up many businesses that should no longer exist and prompted investments that would not have been viable in the absence of the "stimulus". These businesses and investments will inevitably fail after pressure is applied to the monetary brake. And if the central bank refrains from tapping on the monetary brake then an inflation problem will emerge that even the Keynesians can recognise.

 

7 Comments – Post Your Own

#1) On August 11, 2009 at 4:01 PM, anchak (99.86) wrote:

Excellent article!

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#2) On August 11, 2009 at 5:23 PM, binv271828 (< 20) wrote:

Yeah, This is a good one!. Saville still continues to be my favorite analyst (which is why I guess I have been preferentially reposting mostly his stuff) :). Thanks man :)

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#3) On August 11, 2009 at 10:17 PM, dbjella (< 20) wrote:

Good post.  I always find it interesting how central planners can "figure" this out with the math formulas.  Give me a break!  If they knew what they were doing, then this recession is a planned event!!!!!!!!!!

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#4) On August 11, 2009 at 11:11 PM, StopLaughing (< 20) wrote:

Hey   I could use some help. Bob Prechter is calling the bottom in the $ and precicting a collapse in Gold, Silver, Oil, and Commodities. He is basing this on EWT. I took a cursory look at his count and don't agree with it, but I am no EWT expert.

I am trying to get a handle on all of the real variables that drive a currency up and down. I understand the simplified monetarist explanation but what I really need is an explanation of all of the variables and how they interact and an understanding of the conditions that would change the weights or underlying relationships among the variables. 

If this were a time series regression with strenght/weakness of the dollar as y, what are the xs and how stable are the weights or betas?

If any of you can help it would be greatly appreciated. 

The above article is timely and very useful as it deals with the linkages and side effects and both short and long run consequences. 

Very helpful post. 

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#5) On August 12, 2009 at 2:57 AM, uclayoda87 (29.33) wrote:

Decreasing the money supply is politically impossible, since this would mean all those green jobs would have to be sacrificed.  Therefore, the Fed may talk about the possibility, but he won't do it.

The green jobs will have to die of natural causes, from the mega-stagflation which will make the Jimmy Carter years look pretty good.

dbjella brings up a good point.  With the series of bubble/busting economies that we have had, it raises the question:   Is the Fed this incompetent or just malevolent?

And why are other economists supporting Bernanke reappointment?  Are their lives that dull that they need an economy in crisis to make life worth living?

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#6) On August 12, 2009 at 7:06 AM, binve (< 20) wrote:

dbjella, Thanks!

If they knew what they were doing, then this recession is a planned event!!!!!!!!!!

LOL! That is *priceless* !. Couldn't agree more :)

StopLaughing, I started writing my response to you for this, and then it just sort of turned into a blog post :)

First, if you have not done so already, read this post of mine: Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog.

Next, here is the direct response to your question: USDX Count Update and Thoughts.

Thanks for the questions and the comments!!..

uclayoda87, I agree. Any talk about decreasing the money supply now is just that: Talk. The Fed made a deal with the devil when it stated QE. All those Treasuries now have proof they won't buy themselves. Monetization of the debt has now become the norm.

Malevolent or Misguided + Incompetent. But this pargraph right here tells you why inflation is the "preferred Keynesian policy"

If increasing the money supply caused all prices to immediately rise by a similar amount then nobody could benefit from the inflation, but the way inflation actually works is that the first receivers of the new money obtain a benefit, at the expense of everyone else, by getting to spend the money before it loses purchasing power. The first receivers of the new money tend to be the government, the banks, and the supporters and pet projects of politicians.)

Thanks man :).

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#7) On August 12, 2009 at 11:17 AM, awallejr (76.71) wrote:

". . . but the way inflation actually works is that the first receivers of the new money obtain a benefit, at the expense of everyone else, by getting to spend the money before it loses purchasing power. The first receivers of the new money tend to be . . . the banks, . . . .

Yet another reason why I like some of the financials ;p

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