Of Government spending, Interest rates, Bailouts and Prosperity

In order to live a prosperous life we need to have a strong economy.

That's obvious. But what makes a strong economy? I would say that it's an economy in which continuous higher value is created over time. This value translates into money and we have a higher standard of living every year. It's debatable what higher value means but for the sake of simplicity let's say it's higher purchasing power and a better variety of goods to purchase.

Purchasing power comes from either higher salaries (or revenues from stock appreciation / investments) and/or a stronger currency. What are the things that influence these levers? I would argue it's two things: government spending (and incentives for development) and interest rates. Here is my argument.

A PRIMER ON INFLATION:

What is money?
Money is a convention - an agreed medium of exchange between individuals. In itself it has no value. Its value comes from the agreement we make within society to exchange actual goods for it. Without money - If I sell pears you sell peaches and John sells apples it might be difficult to get what I want if we just bartered (I'd have to get the peach from you and give it to John for his apple if he doesn't want my pear but wants peaches). So instead we put all the peaches, pears and apples in a warehouse and create money in exchange for which I can get whatever I want from the warehouse. So all the money we have relates to all the goods that are for sale.

What's that got to do with inflation?

Imagine (again for the sake of simplicity) that all there is for sale on the market are two apples. And imagine that all the money that exists is two dollars. Then each apple will cost $1. If then I print another two dollars and put them in circulation there will be four dollars for two apples so each apple now costs $2. We now have inflation. Note that this can be reversed by growing another two apples in which case the cost will revert creating deflation.

So the more money we have on the market the higher the inflationary pressures (assuming that we do not make additional goods). In real life things are obviously more complicated but overall this is a good approximation of how things work.

Who controls how much money is on the market? The Fed.
How?

INTEREST RATES:

An interest rate is the cost of borrowing money.
The higher the interest rate the less money people borrow because there are less opportunities of making more somewhere else (it's expensive). They also are a lot more careful on how they invest it since this high price makes the practice much riskier.
The lower the rates the easier it is to make a profit elsewhere so people will borrow more form the low interest provider to make a profit in the market.

The Fed controls the amount of money on the market (by the way - this quantity is called M3) by controlling interest rates. The lower the rates the more people borrow from the Fed hence more money makes it to the market. Imagine if you will a faucet that pours out money. The lower the rates the more open the faucet is and it allows money to flow out of the Fed Reserves into the market.

Why is this relevant? Well easy money (through low interest rates) creates two problems.

First - because it's easy - it reduces people's incentive to make a good effort towards better smart investments. So the investments that are being made will likely be of lower quality.

Two - because there's so much of it around it bids up the price of everything there is for sale. For now let's look at securities. Higher stock prices could be a good thing if they were backed by a higher value of the underlying assets but this is not the case. Instead of real value being created there is a bubble being created because of too much easy money is being held by incompetent financial houses (i.e. WaMu, Wachovia, Aig, Fannie Mae, Freddie Mac etc) and thrown indiscriminately at poor investment choices.

OF VALUATIONS AND BAD INVESTMENTS:

An example of how it works - imagine there is a $100k house on the market. If there is only one bid on the house for $95k that's what the house will sell for. If all of a sudden there are three other higher bids the house will sell to the highest bidder although the underlying value of the house itself hasn't changed.
Within certain reasonable limits this process of bidding and asking is a healthy market mechanism that sets prices.
If all of a sudden an irresponsible trust fund kid shows up with $1M in easy money and bids it on the house it will sell for that much money. But the value of the house is not anywhere near that price. Probably no one else will pay him that money (only an even bigger fool) so he's stuck with it.

The same thing happened in the mortgage backed securities market. The investment firms were the crazy children with lots of easy money from the Fed. They all wanted to make a lot of quick profits by investing in these mortgage backed securities which at the time seemed fairly safe. So a lot of them bid on them and inflated the prices to unrealistic levels. A realistic price level is set by the revenues generated by the mortgages themselves (underlying asset) adjusted with some risk for default. They assessed the risk poorly and when the mortgages started defaulting all of a sudden no one wanted these securities any more. So banks are now stuck with them. Not only that but they are valued at unrealistic inflated values.

This is mostly why no one wants them creating a credit crunch. A sane way to solve this would be to admit the mistakes, take the losses (reduce the price for these securities) and start trading them at their real level. But no one on Wall Street wants to do this. They have gotten used to the idea of the higher price and selling them cheaper looks to them like a loss. The problem is that these valuations are FAKE. They were never there in the first place - only on paper. It's a story investors were telling each other. It's like the kid who bought the house for $1M and now doesn't want to admit that it's only worth $100k and sell it for that price in order to get some of his money moving. Instead he holds on to it and has no cash available to make other transactions.

WHY IS THIS IMPORTANT FOR US?

One word - BAILOUT.
What does the 700B Bailout mean? It means that the Fed is opening that faucet even wider to let $700B out on the market to purchase these failed securities off of the bank's back AT HOLD TO MATURITY PRICES. In other words at the inflated, unrealistic and unwarranted price instead of the discounted real and adjusted price.
Remember when we talked about the quantity of money on the market and how it creates inflation? Well this $700B goes directly into the market. So if you wonder why the price of eggs has gone up recently it's because there is more green paper bidding on the same amount of goods (of course things are a bit more complex as the market is such a huge beast but for the sake of simplicity this is how it works). This of course means lower purchasing power for us which in return means a lower standard of living. By the way - The Fed stopped publishing the M3 a few years back. We are not supposed to know how much money is floating around in the market any longer.

Not only that - but when investors realize that some of these assets are so inflated they dump the stocks of the banks that hold them - the market drops - everyone suffers.

To recap:

LOW INTEREST RATES -> EASY MONEY -> MALINVESTMENT -> MARKET CRASH / CREDIT CRUNCH -> BAILOUT -> INFLATION

So then it's simple you'll say - raise the interest rates and everything is solved. Well - here's where the government policies become a problem.

The United States currently consumes more than it produces. That means we are borrowing from other countries in order to finance our operations. How much?
$3 BILLION / day.
Every day we go into debt at the tune of $3B more that we owe foreigners (mainly China). And here's the trick - we pay interest on that money the same one that the Fed sets for banks to borrow. Currently about 2% (and dropping). If we let this interest rate adjust to realistic levels dictated by the market then we would have to pay the same interest rate on the $3B we borrow every day.

Just to keep things in perspective: we were in this situation before at the beginning of the 80s. Then in order to solve the stagflation of the 70s Paul Volker - the new chairman of the Fed - set the interest rates free. Guess what did they adjust to? Roughly 20%. By the way - this is also the interest you would be getting on your money deposited in the bank. A 3 years long tough recession ensued but the economy recovered enough by the 4th year to allow Ronald Reagan to be re-elected.

The difference is that at the time we didn't owe all this money to China. We could defer paying that interest rate as we owed the money to ourselves. Today we don't and we would have to pay an impossible interest on the money we borrow.
So the interest rates are stuck until we can reduce our spending.
Of course The Fed could just raise them anyways thus executing the mandate that they were created for (namely controlling inflation) and let the government deal with the consequences of their own spending. However I honestly believe that it is too late at this point as it could truly sink our economy.

What the government needs to do in the very short term in order to keep this economic boat from capsizing (let's hope it's not too late) is to reduce spending drastically (and one of the biggest expenditures right now - besides the bailout - is the war in IRAQ) while at the same time stimulating investment in real value producing industries (i.e. renewable energy technologies instead of plasma TVs). These technologies we could in turn sell to other countries for real money rather than debt. Of course a war with IRAN would be catastrophic from an economic point of view as it would only increase spending and deficits. We also need to close the corporate tax loopholes so that we create more income. If we manage to reduce our debt then we will once again be free to set interest rates more realistically.

So to complete the picture:

GOVERNMENT SPENDING (wars, larger beaurocracy, lack of corporate tax revenues) -> NEED TO BORROW (China) -> LOCKED LOW INTEREST RATES -> EASY MONEY -> MALINVESTMENT -> MARKET COLLAPSE -> BAILOUT -> INFLATION

Please remember that all of this has happened in the last 7 years. We went from one of the most prosperous times in the history of this country to the brink of collapse mainly because of government spending policies. In 7 years.