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A Message to Lawrance G. Lux 7/12/2003 11:14:55 PM
Originally posted at Roundtable as a response to LGL's comments, this short note touches on such economic issues as inflation, deflation, deficit spending, Keynesianism, Fed policy, the impact of war on the economy, as well as economic outlook for 2004, 2005 and beyond. Hi, LGL:
Yes, your mumbo-jumbo writing style is "as consistent as it possibly can". But your memories may not be as long as mine, so in your eagerness to attack my conservative views, you tend to forget what you have said before and inadvertently "swerve at times".
But are you telling me that you picked my brains and put my theory into your book in 2002 after reading my article "Economics and Politics"? If that's true, I'm glad you have developed a remarkable "intellectual open-mindedness and flexibility".
"Corporate monopolistic pricing power" can only exist in an environment of strong demand growth, which is not the case at this moment. Let's stop worrying about it for now. Rather, I hope there will be more industrial consolidation to allow corporations to regain some pricing power.
We need to fight deflation, not inflation. If prices move back up from low levels, it's price stabilization, not inflation. Rising prices plus corporate pricing power will convince companies to make new capital investments and hire more workers to increase production. This would boost both the stock market and the jobs market, thereby stimulating Consumer Demand.
When budget deficits emerge, the government is forced to pay some of its bills with money borrowed from the Federal Reserve, increasing the amount of high-power money in circulation. In theory, this would dilute the value of the currency, triggering inflationary pressures.
In reality, much of the money created by the Fed simply disappears into God-knows-where through wear and tear. As mentioned before, about 2/3 of the U.S. currency is outside the U.S., in Europe and many third-world countries where people hoard U.S. dollars as a store of value.
In life, anything can happen. This is especially true in the illegal drug industry where operators dare not deposit their illegal drug money in legitimate banks. What happens to the huge amounts of U.S. dollars they hold in cash when they get killed or arrested?
Billions of U.S. dollars went missing from Iraqi banks during the Iraq War. While U.S. troops may have recovered part of the money, much of it may have been burnt or otherwise destroyed during the 3-week long conflict and will never flow back to the U.S. to cause "inflationary pressures".
After all, paper money is printed paper -- a commodity to lubricate business transactions and the operation of the economy. It can only cause inflation if people use it to buy goods and services whose supply is smaller than demand.
If people don't spend, their money only represents a claim on goods and services, not a real demand for goods and services, and so can't fuel inflation.
As long as budget deficits are not excessive relative to GDP, as long as inflationary pressures are non-existent or moderate, there's no need to worry about deficits, and the Federal Reserve should keep its money supply growth steady.
In some sense, the federal government is actually having a free meal. Look at the process below:
(1) It pays some of its bills with money borrowed from the Federal Reserve (or the public).
(2) The Fed can buy back Treasury securities from the public, creating more high-power money in circulation, which commercial banks can deposit in Federal Reserve banks as reserves when they make loans to their customers.
(3) But part of this paper money disappears from circulation through wear and tear, allowing the Fed to create even more money without fueling inflation.
(4) On paper, the federal government carries an ever-growing National Debt, but don't worry because the Fed can create more money to lend to the federal government -- loans it needn't repay at all because Uncle Sam and Uncle Alan are twin brothers!
However, there is one important point: If budget deficits become excessive relative to GDP in percantage terms, exceeding the amount of currency that disappears from circulation through wear and tear by a huge margin, then, inflationary pressures would re-emerge.
But that is definitely not the case right now. We still face the possibility of deflation in the current recessionary environment.
Whatever you say about John M. Keynes, he was one of the greatest economists in modern history. His proactive approach toward economic management was an admirable supplement to free-market economic theories.
As to business-friendly legislation and tax policy, here's some news for you to read: Russia instituted a 13% flat tax rate on income in 2001. You might think this must have caused "an economic disaster" by reducing Russia's tax revenues.
Yet, revenue from Russian income taxes climbed by nearly 40% in 2002. Ironically, higher tax rates tend to diminish revenue returns, because they increase the incentive to cheat and create loopholes. Human behavior has its rules which apply to the entire mankind, you and myself included.
As to the sluggish GDP growth of recent quarters, the clouds of war must have played a role and may continue to do so in the coming months amid news about U.S. casualties in Iraq and comments from the anti-war camp about how Iraq could become a Vietnam-like quagmire.
Such anti-U.S. wishful thinking draws parallels between unequal historical events. The Vietnam War was an extension of the Cold War between capitalism and communism. North Vietnam received substantial material support from both the former Soviet Union and Communist China in the 1960s and 1970s, whereas Saddam Hussein was totally isolated.
Without extraneous material support, Saddam Hussein loyalists cannot sustain their insurgent activities for a whole decade as the Viet Cong did, though they can assassinate a few people. When U.S.-trained Iraqi soldiers and police take over certain security jobs, U.S. troops' exposure to danger will be reduced.
Saddam Hussein loyalists can intimidate some Iraqi people but can't stage a meaningful comeback. When this becomes clear to the U.S. public, Investor Confidence and Consumer Sentiment will improve markedly.
My guess is by 2004 America's overall mood will begin to turn for the better as the public sees hope that the clouds of war will lift at long last.
By 2005, I believe, America will shine in a glory of victory -- just as it did in 1945 when Japan surrendered. Take it from me history will repeat itself and the economy will boom beyond our expectations from 2005 onward.
