Pushing on a string?

If you've ever water-skied, you know you must keep slack out of the line to stay on your feet.  If the line loosens, you have little time to take out the slack or you'll be swimming.

The Federal Reserve, too, must keep the line tight.  Otherwise, it finds itself pushing on a string.  And, as any water skier knows, pushing on the string is of little use.

Why is the Fed pushing on a string?  Because it--like a boy with a hammer--has only one tool at it's disposal: creating money out of thin air.

When the economy slackens, the Fed reduces interest rates (by printing or threatening to print money).  This is supposed to encourage borrowers to borrow, thus increasing economic activity.  As long as borrowers think they will get higher returns on the money they borrow than the interest rate they owe, they'll borrow. 

But, a problem occurs if borrowers either can't or don't think they can get good enough returns on the money they borrow.  When that happens, the Fed can lower rates and print money all they want and the economy won't improve.  That's when the Fed finds itself pushing on a string.

There are serious questions about the U.S. economy being at this point.  Very smart people are concerned the Fed can't get the economy going again, and they have powerful historic examples like the Great Depression and Japan to support their thesis.

During the Great Depression, the U.S. experienced a huge drop in economic activity, high and sustained unemployment, and significant deflation. Shrinking money supply was one of the things blamed, and so most economists have taken that as the solution to a similarly deflationary scenario like now.

Japan has been in a 20 year on-again/off-again recession.  Over this time, its stock market is down 75% and its economy hasn't grown.  Its central bank, like the Federal Reserve, has tried lowering interest rates and quantitative easing (a euphemism for printing money).  These solutions have kept unemployment from spiking, but have done nothing to improve economic growth and have left the Japanese government with a huge load of debt.

I think these two examples are important in understanding our present situation, but most analysts and commentators miss the point.  I do think the Fed is pushing on a string, but not for the reason that most suggest.

Borrowers will only borrow if they think they can get good returns on capital.  Such lending will only be effective if positive returns on capital are earned.  For the economy to grow and standards of living to improve, you need positive returns on capital. 

The issue is not employment, nor printing money, nor interest rates, nor fiscal stimulus.  The issue is positive returns on capital.  Without that, there is no growth, only decline.

The U.S. government tried all sorts of things during the Great Depression to improve employment and get the economy going (both Hoover and Roosevelt).  The result: the worst economic decade in U.S. history.  The U.S. economy finally started growing again during World War II.  Was that because killing people and destroying property is growth?  NO!!!  It's because the government boondoggles finally ended and individuals were able to get positive returns on capital.

Japan will not improve until positive returns on capital becomes its focus.  As long as employment and consumer demand are the focus, Japan will not grow.  Only when the Japanese economy refocuses on generating positive returns on capital will it grow again.

The same is true here in the U.S.  Printing money, lowering interest rates, giving loans to negative return on capital projects, and creating boondoggle employment will not create growth. 

The Fed is pushing on a string, but that's because it doesn't understand where growth comes from.  It doesn't come from creating money or lending, it comes from positive returns on capital, and there's nothing the Fed can do to bring that about. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.