The Federal Reserve announced yesterday that it would make over $900 billion available to financial institutions instead of the $150 billion it had said it would make available previously. (This is in addition to the $700 billion pledged to Wall Street for the bailout.) It appears that the Fed has abandoned its fight against inflation and has decided instead to inflate the currency.
There should be little question among those who understand the implications of infusing huge amounts of cash into a failing economic system. Without an increase in GDP, or more goods and services to purchase with all this money, there will be an increasing amount of cash chasing a stagnant amount of things to purchase. This must inevitably lead to higher prices for the average American.
Fed officials claim that without such an increase in the money supply credit markets will fail. The commercial paper market, short term loans that companies take to make payroll and short term commitments, has lost almost a trillion dollars, about one-third of the total market value of commercial paper outstanding, over the past couple of weeks and there is fear on Wall Street that credit will dry up even with the government intervention that has already been announced. It is feared that without this liquidity, major corporations will be unable to borrow money for their short-term needs. This might lead to bankruptcies of major US and international corporations unable to meet their short-term obligations.
The stock market should continue to decline as this credit crunch begins to work its way through the economy. The problem that the Fed faces now is how it will be able to infuse such huge amounts of cash without creating a runaway inflation. The only way it can do this is to create massive unemployment. This is a perfect example of how not to run an economy.
Allow me to explain. The one thing that drives the US economy is new housing starts. If you think about all the items, other than bricks and mortar that go into a home, you begin to get the picture. When housing starts begin to decline, as they have been for some time now, the rest of the economy suffers. Companies then lay off workers as orders decline and unemployment rises. With a lack of spending on the part of the average American, the “velocity” of money, or how many times a dollar changes hands over a certain period of time, slows down. The worse the recession, the more money the Fed is able to infuse without being concerned about inflation.
The problem now is that the Fed wants to infuse huge amounts of money to bail out Wall Street without a commensurate increase in unemployment. What this means is that a dollar will travel faster though more hands as it chases the same amount of goods and services, thus creating a rise in prices. If GDP declines, this is an even more serious problem as the amount of goods and services produced is actually reduced at the same time cash is being infused. Unless there is a significant decline in GDP, a decline steep enough to throw millions of Americans out of work, the dollar will lose its value.
What this means to the average American is complex. If the government decides that saving Wall Street is worth massive unemployment we don’t have to worry about the value of our currency. If, on the other hand, the government wants it both ways, to save Wall Street and maintain employment levels, retirees living on fixed incomes will watch their retirement funds erode. The Treasury will decline in value as interest rates rise, the result of a combination of an increase in the supply of Treasuries worldwide and a stagnant demand for them, and the Fed will be forced to raise interest rates to curb inflation. Anyone who has watched the markets for the past 35 or more years has already seen this cycle.
None of this had to happen. When currencies are backed by nothing more than promises to pay in a currency that retains its value, and those promises begin to wear thin, currency suffers. This was the lesson learned by the Continental Congress during the Revolutionary War, thus the phrase “not worth a continental”. One of the first things the fledgling government had to do was to borrow hard currency from European countries in order to get the economy going. This is the reason the US currency was backed by precious metals prior to the 20th century. One could always convert paper currency into gold or silver. It might be worthwhile to consider holding only “tangible” assets for the coming months.