The Opposite Effects of Current Interventionist Policies of the Fed

•February 23, 2011 • 2 Comments

This is a really quick blog post, and I will probably return back to this topic as market conditions change and new information is available.

I’ve been doing some research about why there is still a liquidity trap in the loans market. It’s still impossible for people to get loans.

In normal economic conditions, banks hold around .02% of excess reserves. They hold on to the required 10% by the Fed, but loan out anything that is left. Because of the money multiplier, this is actually the main way money is created (only holding 10% in currency, and lending out the other 90% and treating it as real “funds”). According to the latest Fed report, as of January 2011, banks are holding an unprecedented 51% of excess reserves! Remember Obama’s empty rhetoric about injecting money into the economy through bailouts so that banks could start lending out money again and the credit freeze would be solved? Those billions of dollars have ended up in the excess reserves of the banks.


I have found 2 reasons why this money isn’t being lent out.. I found them in reports published by the New York Fed in 2009, which is fairly ironic because their own actions to “stimulate” the economy have provided incentives for banks to not “stimulate” the economy!

1. The opportunity cost of lending is too high. With short-term interest rates driven down to almost 0% through open market purchases, banks can’t make any money off their investments, even if there is minimal risk involved. This means anyone trying to get a loan for any kind of entrepreneurial project is definitely out of luck. People who have steady income, excellent credit, and want a basic car/house loan can’t even get it. The central banks are paying interest on those excess reserves that banks hold, and it looks like those rates are higher than the rates the banks can get loaning out the money to entrepreneurs.

2. Remember how I mentioned open market purchases and bailouts? The reason why we haven’t seen any inflation from billions of dollars in money creation through those activities is because the banks are keeping them in excess reserves. The Fed report I mentioned earlier warns of the possible danger of massive inflation if banks lend out these 51% of excess reserves. So it looks like the Fed is in a sticky situation. Their 2 goals are inherently conflicting. They can’t keep price levels stable (control inflation) and also promote conditions for maximum GDP output. They want to thaw the credit freeze by injecting money, but don’t want inflation. It makes no sense.

Basically, the Fed has completely messed with economic incentives. Banks are now in a corner as well. It will be interesting to see what happens with these billions of dollars in excess reserves.

Advertisements

The Ricardian Equivalence Proposition

•February 14, 2011 • Leave a Comment

Ever since Reagan’s trickle-down economics was established as a legitimate fiscal policy in the ’80s, there has been a constant debate about the effectiveness of tax cuts. The simplest and most common argument for more tax cuts is that they will put more money in the hands of consumers, raise total consumption, and ultimately raise aggregate demand. Unfortunately, it isn’t that simple. If it was, George Bush would be a hero.

Yeah.

David RicardoAnyway, a 19th century economist by the name of David Ricardo (1772-1823) developed a theory that addresses this very issue. His theory (later dubbed “The Ricardian Equivalence Proposition”) says that tax cuts don’t directly affect consumption because consumers internalize the government’s budget constraint and therefore plan for future tax increases. From the government’s viewpoint, when it comes to financing government spending, they have to choose to “tax now or tax later.” Financing the spending through bond sales would require a “tax later” policy to eventually pay back the debt (assuming the government doesn’t continue to raise the debt ceiling and just borrow itself into oblivion).

What I find interesting with this theory is that it assumes the complete rationality of consumers. It also assumes consumers have keen financial foresight and will act accordingly. We all know both of these are not true for the majority of Americans. How can we assume that people internalize the government budget constraint when most people don’t event know what the government is doing?

I think the relationship between tax cuts and consumption that the Ricardian Equivalence Proposition presents is flawed because of the lofty assumptions attached to it. David Ricardo eventually went back and criticized his own theory, and he probably didn’t support it anymore by the time he died.

The marginal propensity to consume (MPC) most likely determines the effectiveness of tax cuts. If the MPC is 0.9, consumers will immediately spend $0.90 for every $1.00 they receive in tax cuts. Other factors that affect MPC and the effectiveness of tax cuts is whether the tax cut is a fixed payment or a continuous tax cut.

But that isn’t the main point I am trying to get at.. (yeah it’s 1 A.M. right now, so this may sound a bit A.D.D. so far..)

When investigating this theory, it made me think of a peculiar trait of human nature in regards to money and economics: once there is a tax cut, people won’t put up with a tax increase in the future. Basically once you give them a tax cut in the name of “temporary stimulus”, people are not willing to give that up with a future tax increase. If the government tries to increase taxes, people will instinctively oppose them or just move away from the area that is being taxed. That is exactly what is happening in historically liberal states such as California, New York, and Michigan. Years of reckless spending through wasteful government programs left them with massive deficits that had to be funded by new taxes. The 2010 census revealed that people just decided to move instead of enduring a tax increase in these economically collapsing areas.

I think this all ties back to the fundamental economic law of incentives. Incentives are what drive consumer choice.

Another place where this applies is in the realm of government agencies/organizations. They are allotted x dollars every year to carry out their activities. When was the last time you heard of a government agency telling Congress that the money appropriated for their agency was TOO MUCH? Never! Because if they ever revealed that to Congress, they would receive less money in the next year’s appropriation. This is the major cause of government waste. There is no incentive to be efficient and cut costs.

Once people are given tax cuts, they refuse to give them up. Once agencies are appropriated funds, they refuse to accept anything less in the future. This is why I don’t think the Ricardian Equivalence Proposition is valid. It neglects to consider the most important economic assumptions of all: the fact that incentives drive consumer choice, and that people are instinctively going to make decisions that provide themselves with the most resources—because economics is all about how we allocate resources, and humans will always choose themselves over others when deciding who gets them.

The Bastardization of Capitalism

•February 8, 2011 • 2 Comments

I have been meaning to write something about this for awhile now, but seeing this video of Obama speaking to the Chamber of Commerce made me stop studying for my macro test on Wednesday and quickly respond to his comments.

The first words that come out of his mouth are full of arrogance and show a lack of understanding of a market system (most likely because of his hatred of the market system). “But we have to recognize that some common sense regulations often will make sense for your businesses, as well as your families…”

He is basically telling business executives/investors that the government knows better than those who are actually taking the entrepreneurial risk, and then making strategic decisions (through “common sense regulation”) for those executives/investors. In a true market economy, consumers will consume products from the firms that produce the highest quality products for the lowest price. Firms that fail to do so will fall by the wayside and will no longer be able to compete (in the absence of bailouts, of course). Therefore it is in a company’s best interest to fulfill the demand of the consumer. When miles of red tape are wrapped around their legs due to government regulation, companies instantly become more inefficient and cannot serve their customers as well as they could have otherwise. In the end, companies that are not dictated by the government will make better decisions. These decisions will be a true definition of “common sense”, because they will make or break the success of the company, which is dependent on the happiness of consumers.

Consider this:

With the recent move towards environmentalism, conserving resources and protecting our fragile ecosystems, firms are faced with a new challenge: produce for cheaper while potentially harming the environment, or incur higher overhead and variable costs to ensure the minimization of their environmental impact. This shift in consumer attitude has forced companies (at least the smart ones) to cater to consumer demand, which is to stop destroying the environment. The power of true incentives and consumer demand is much stronger than any government rule or regulation could ever be.

Obama goes on to say, “…the benefits can’t just translate into greater profits and bonuses for those at the top. They have to be shared by American workers…”

Investors and leaders of these firms have two possible outcomes of their actions: profit and loss. When capitalism is bashed for producing exorbitant executive bonuses, billions of dollars in profit, and multi-million dollar mansions for business leaders, the other side of the coin (loss) is disregarded. These people took risks that could have just as easily wiped out their personal assets or got them fired by their organizations. While American workers are vital to the production process, they do not incur as much risk as those at the top (by not spending thousands on college, first and foremost), and therefore are not entitled to as much reward/loss. This system spurs innovation, increased efficiency, and the possibility of achieving what we call “the American Dream”.

A true capitalist structure provides an environment where good ideas and innovation are rewarded with success, and inefficiency, laziness, and satisfaction with the status quo are rewarded with failure. Mr. President, please stop bastardizing capitalism, and let firms take responsibility for their own actions and deal with the consequences of those actions.

The Government Budget Constraint: Something politicians don’t want you to think about.

•January 13, 2011 • Leave a Comment

We all see the political rhetoric especially around election season, and we all grow sick of it very quickly. The attack ads, smear campaigns, and “analytical” talking heads fill our media outlets, and our brains whether we want them to or not. Buzz words like tax cuts, financial assistance/relief for group x, and stimulus, are thrown around more often than Brett Farve returns to football from retirement. Most uninformed voters soak up this rhetoric and vote accordingly.

The politicians fail to recognize (or at least intentionally do not mention) the other side of the story: how will we pay for it? With over $14.3 trillion in national debt, this practice has gone on far too long.

One of the most fundamental principles of macroeconomics and therefore public policy is the Government Budget Constraint (GBC). As an interesting and somewhat frightening side note, I was not formally introduced to this principle in class until last week in my intermediate macro course (ECON 332 here at JMU). Even more frightening, my professor notified the class that he had only seen one macro textbook ever mention GBC. How could college graduates with a degree in economics never learn about one of the most fundamental principles of economics? Want the simple answer? Because the bias of most college professors doesn’t want them to. This law of economics demotes the government from its prior status of being the “all-powerful, able to do everything for everyone who wants/needs it and not having to worry about spending” body to an entity just like all of us. We all have to balance our finances, pay our debts, and earn money first in order to spend it.

So after all that, you probably want to know what GBC actually says.

The government budget constraint says that government expenditures must be identically equal to government revenues. (Simple enough right? That’s what I thought too. But why is it not taught in most macro books? Fishy, if you ask me.) Here’s the equation:

G + TR = T + BS + MC

G = government spending

TR = transfer payments (unemployment benefits, social security, etc.)

T = revenue from taxes

BS = revenue from bond sales

MC = revenue from money creation

All changes on the left side of the identity must be financed by a change on the right side. This law CANNOT be violated. It is impossible. So let’s look at a few applications of this law.

You want to build a new highway interchange in a metropolitan area with gridlock problems. This project is contracted at a cost of $200 billion. That means government spending is going to increase by $200 billion. According to GBC, we must finance an increase in G. We have 3 options: 1) Reduce TR 2) Increase T 3) Increase BS 4) Increase MC.

No one will want a reduction in unemployment benefits or social security, so that excludes Option 1. Tax hikes aren’t popular either, so there goes Option 2. This leaves Options 3 and 4 as the “only” alternatives. And this is what the government is doing (and doesn’t want you to think about it). Option 3 issues new government debt at fairly high interest to mostly foreign nations (China holds around 20% of our debt). Option 4 is basically printing money. That leads to inflation, and possibly hyperinflation if Option 4 is used often.

It is the constant use of Option 3 to pay for government spending since FDR that has left us with $14.3 trillion in debt. And the people to blame aren’t just Democrats or Republicans, it is all of us. We rely too much on the government to solve our problems and then don’t think about things like GBC that say that we will all have to pay for it one day.

Think about this the next time politicians campaign for more government projects or tax cuts. There is no such thing as a free lunch. Someone will eventually have to pay. And it looks like it’s going to be my generation.

Cheers.

I guess a formal introduction is in order…

•January 13, 2011 • Leave a Comment

Well, hello there. My name is Ryan Freeland, I am nineteen years old, and I love photography, cars, guitars, liberty, and most importantly, economics.

Many of you reading this probably already know that I am a second-year finance and economics major here at James Madison University, but for those who don’t, it’s nice to meet you.

I’m not exactly sure what this blog will become. I guess it’s just a place for me to organize my thoughts, discuss what I have Penlearned (in class and on my own), and ultimately to promote a common sense understanding of the laws of economics and our current market structure. After every econ class period or after finishing a chapter in the variety of economics books I am working through, I find myself comparing the new information to current events. Far too often there is a logical disconnect between the two. This is why I write.

I am by no means an expert—just a student excited about the implications of my newfound knowledge. But I refuse to be silent or too shy to share my thoughts even though I am still early on in the life-long process of true education. So with that, I welcome you to read what I write, respond, inquire, agree or disagree, walk away in disgust, praise me for being the greatest thing to ever happen to you, etc. I just hope this is interesting to some people, and if it isn’t, at least it is fun and helpful for me.