Does the economy need to get stoned again?

Photo of Paulson & Bernanke by Shawn Thew/EPA file

This piece out of the Associated Press concedes that the bailout package won't work right away. Why? Because, it is argued, in order for banks to start lending to purchase homes again, housing prices must rise. Sadly, this thinking is typical and is reflective of the myopia that has engulfed central economic planners, such as Ben Bernanke.

Americans are mortgaged up to their eyeballs, and housing inventories have piled up. If houses can't clear the market as is, and the loan market is underwater, does it make sense to believe that higher prices is the answer? In other words: supposedly, the answer is to reflate the housing price bubble. We are supposed to believe that the inflationary bubble was "normal," and that the economy needs to get doped up with an inflationary drugging.

By looking at this as a problem of falling asset prices, this begets the idea that more inflation is the solution. Thus, reason the central planners, if the Federal Reserve can inject liquidity into the loan market, keeping interest rates low, this will stimulate lending, thus giving rise to economic growth. However, this isn't case.

Credit can't be extended beyond the real pool of savings. The Federal Reserve injecting liquidity into the market does nothing to increase savings. All the Federal Reserve does is trick people into believing they are wealthier and more solvent than they really are, engendering artificially low rates of interest (both nominal and real). People are then tricked into malinvestment and malconsumption. This is why the loan market is now insolvent and inflationary credit expansion came to a halt.

It is economic growth that gives rise to savings, and savings that gives rise to credit. The Federal Reserve can do nothing to stimulate the loan market by creating inflation. That Americans are mortgaged to their eyeballs, coupled with the government running huge deficits, tells us that the country is insolvent. Thus the bailout will be ineffective not because housing prices aren't rising, but because the collateral isn't there (especially for such artificially high prices). If the collateral isn't there, the collateral isn't there. Collateral can't be created on a printing press. What the Federal Reserve will do is siphon labor away from productive channels and into the loan market itself.

This isn't about the loan market not wanting to extend credit to purchase homes due to falling asset prices. Banks already have inventories that they need to sell. No matter how hard Ben Bernanke & Co. try, the loan market will not be resuscitated by creating more liquidity.

Ben Bernanke has demonstrated that he has no grasp of the fundamentals. He said, based upon movements of commodity prices, that inflation isn't a problem, thus announced plans to try to drug the economy with even more cheap money.

The problem here is trying to measure inflation by measuring changes of prices in a price structure that isn't intact. Inflation is an expansion of the money supply. The real question is: what would prices otherwise be without Ben Bernanke creating liquidity?

By creating liquidity and holding interest rates artificially low, this both siphons scarce resources away from productive channels and prevents the market from functioning and setting market-clearing prices. If asset prices fall in nominal terms, but the government and its central bank prevent prices from returning to normal (i.e., the pre-bubble bottom), while incomes are simultaneously declining, it would be foolish to say there has been a deflation in real terms.

The trouble, then, is not that asset prices are falling, but that nominal prices - as well as nominal wages which are more rigid than ever, thanks to unions and government intervention - are still too high.

It was artificially low interest rates brought on by the Federal Reserve creating liquidity that precipitated this mess to begin with. We do not have a credit crunch. We have a savings crunch. The only way we will ever bring capital back into the U.S. is to let interest rates rise again. The government needs to dramatically cut back on spending, and all of the talk about the government buying up bad debt with more inflation is downright criminal. Every policy being advocated by central planners is tantamount to dousing a fire with gasoline, and will engender even greater problems.