Friday, November 21, 2008

Did the trade deficit cause the economic collapse?

Was it a policy matter beyond the Fed's control? I don't buy it. If the Fed had simply stood pat with the money supply, the newly-opened markets would have drained dollars, causing a stable deflation resembling the situation of the late 1800s. Dropping American prices would have increased exports, while resource competition would have inflated commodities and choked off excessively fast growth in imbalance. The arrangement is reasonably self-stabilizing.

The losers would have been those who had borrowed lots of money for enterprises with thin profit margins. But on a long-enough time scale they are doomed anyway—an inevitable market fluctuation will eventually wipe them out—deflation just blows them up a little sooner. They can only survive with eternal credit expansion. Naturally, this is what the Fed did. The mistake was not treating Chinese goods as a windfall, but propping up marginal enterprises and mistaking the results for efficiency. The more they inflated the money supply, the more illusory "efficiency" sprang out of the woodwork.

Take a look at these charts of the monetary base, the denominator of our fractional reserve monetary system.

Look at the bottom chart. In 1985, the monetary base was growing on a dead steady exponential curve: fractional reserve banking was causing inflation, but the system was net profitable, and the profits were being reinvested in the basis of the system.

Now look at 1995. The monetary base jumped off the tracks as the effective reserve fraction was dialed up. Money was being created fast, but not producing profits fast enough to maintain the new rate of creation. The dot-com bubble promptly inflated and burst from the pressure of all that money creation.

That should have been a wake up call to dial up the effective reserve fraction, but Greenspan decided to try it again, only harder this time.

Now look at early 2008, the last data on the graph. The monetary base actually shrank ever so slightly! Malinvestment was finally destroying money faster than it was being created. That marks the point where our economic system went off the edge of the abyss. The Fed has since manipulated the system so that the graph went vertical, but it is far too late to avoid tremendous destruction of productivity.

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