Why government interference may failFebruary 19, 2009
Let me try again to explain, more clearly, why government interference may fail. There are people who believe we have entered a new long wave cycle of increased savings and decreased consumption that may last a generation. If people are determined to save, the government can not force them to borrow. If we are entering a new savings paradigm to balance the previous few decades of excessive debt, which the evidence currently supports, government interference, both monetary and fiscal, will not only fail but significantly intensify the crisis. Failure of easy money Enticing savers to borrow with low interest rates will not succeed; instead of encouraging more borrowing it will encourage savings in another form. Without interest there is no reason to hold cash in a savings account. With no borrowing and now decreasing capital the banks risk insolvency, and in such circumstances savers are better off withdrawing even more cash from the bank or buying gold and other more reliable assets with no counter-party risk. Easy monetary policy could cause bank failures by eliminating the incentive to maintain a bank balance, and thus encouraging bank runs. This is often called a liquidity trap. It may appear deflationary at first as people stubbornly refuse to borrow, but ultimately fear of bank failures will cause the velocity of money to increase rapidly as cash is withdrawn. There is little difference between $10 spent and $5 spent twice in the same time frame, so deflation is really irrelevant to the debate. Such changes in psychology can occur much quicker than any central bank’s ability to react, causing the value of paper money to drop with frightening speed. Ask anybody who survived the Wiemar Republic, the process of moving from deflation to hyperinflation is stunningly quick. Governments can insure everything in sight, but insure with what? Such promises are no better than credit default swaps issued by AIG. The government has nothing to back such claims other than a printing press and there is no higher authority to bail them out. With economic activity declining, so does tax revenue. Failure of stimulus Distributing dollars directly to a business with no customers will not create more customers, it will merely buy time, allowing fear to spread as employees are shifted to make-work projects and losses mount, increasing dependence on further government bailouts. There is no reason to produce a product that will not be consumed, if employment is to be maintained either the excess production will stop regardless of any bailout, or it will sit idle in warehouses forever. Either way, profitability will not improve and there can be no recovery. Everybody will have a job, but everybody will be broke as both income and productivity plummet. If employees are released from their positions, stability may return at some point, but in the interim consumption will decline even further causing general living standards to follow. Whether politicians can stomach such events despite massive bailouts remains to be seen. Distributing dollars directly to consumers will merely facilitate a flight away from dollars by giving people the means to diversify their savings, causing asset prices for gold and other instruments of savings to rise. Hope? I believe the only salvation lies with technology. Many of these problems would have likely occurred years ago if not for the “productivity miracle” resulting from personal computers, high-speed internet , mobile telecommunications, etc. We need a similar new paradigm shifting invention, probably in some other sector like energy or agriculture, to take us forward. However, unless such an invention is coupled with a more sustainable financial system we will likely return to this place again in the future. That doesn’t mean I support government funded research, but it certainly would be the least offensive of all the bailouts I’ve witnessed so far. I would rather the entire $800 billion be spent on R&D than mortgages. However, we should appreciate the extent to which such policy is a gamble. If it succeeds everybody looks like a genius. If it fails, the end result could be equally catastrophic. Capitalism generally doesn’t work when people risk other people’s money. No related posts.
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I think Darryl Shoon said it best, not that you
didn’t cover many results of this:
“All managed markets—whether managed by government allocation as under Communism or by government sponsored central bank credit as in Capitalism—are doomed to failure.”
I love your last sentence. That’s one of those that I need to remember.
I would have to agree that your last sentence is the most poignant. Don’t they say “scared money seldom wins”. It is most certainly a valid concern.