• Home ::
• Fundamental ::
• Analysis Reports

• Send
• Print
• Add To

484c0926-be96-43fb-80f1-e4fe62922065

0

0

Uncle Sam Vs. The Market Process

Mon, Sep 8 2008, 12:59 GMT
by Jack Crooks

Money and Markets

In America, times like these don't come around often. Usually, Americans are blessed with economic prosperity. Enduring periods of stagnant or shrinking economic growth are exceptions to the rule.

There's a big reason we've been so fortunate ... something often referred to as the market process. Contrary to what the current Federal Reserve or U.S. Treasury might have you believe, it is this naturally occurring progression that keeps the markets functioning the way they ought to function — free of interference.

What better time than during a Presidential election year to discuss the role of government on the economy? Of course, I'm not going to tell you to vote Republican or Democrat. I just want to explain how I feel we should expect our government to behave with respect to the market process.

Government: Always Getting Their Hands into Something

The way I see it, our government officials create too many laws and spend too much money. It's all because they claim to have the best interests of the people at heart when in fact, knowingly or unknowingly, they do not.

And, for now, let's exclude taxes from the discussion. It was our ancestors' objective to rebel against British rule and escape the burdens of taxation, something that clearly impeded the market process. That was one of the ideas on which America was founded.

Instead, let me delve into another dynamic that interferes with the natural flow of markets — government handholding. For many years its impact has been immense. But where do we stand now? Has the government left us with more individual freedoms, fewer regulations, and a solid foundation from which to move forward? Not likely.

Enabling Bad Business With Easy Money

There are two important things that allow businesses to grow — money (credit) and ingenuity. Let's assume that the ingenuity exists and all that's needed to start up a new business is money. Where does one get money? Well, it's always good to dip into savings. But what if the savings aren't there? Then, if the business venture is deemed a profitable one, the other option is to borrow money.

But borrowing money to fund a new business can get sticky. Of course, new businesses create new jobs, and we've come to know that new jobs are good. But because the natural signals from the market are jumbled because of the government's manipulation of interest rates and loose credit, entrepreneurs often embark on expansion of their business at precisely the wrong time.

Normally unprofitable businesses would simply reach a point where they must close their doors. But often times, when cheap credit is readily available, these same businesses find ways to keep the doors open longer than they normally would. And because weak players are left standing, it tends to weaken the entire industry. This is what happens when the government tries to "do well" through incentives and bailouts. As the saying goes, "The road to hell is paved with good intentions."

Assume for a moment that the Federal Reserve is merely an extension of the government directly responsible for monitoring the economy, which is what this so-called private organization really is.

As we all know, the Federal Reserve is trying hard to keep the good times rolling for our economy. Amidst handing out money to any bank or institution that rolls up with a piggy bank full of any old structured debt products, the Fed has brought rates down to 2%.

Sure, such low rates encourage new borrowing and new businesses to sprout up, but do low rates encourage sensible borrowing and attractive business investment? Not usually.

If a project can be expected to yield 4% and money can be borrowed at only 2%, there's a good chance a whole lot of marginal business investments will emerge.

But when so many new businesses form, demanding assets and resources, what happens to the cost of those assets and resources? Those costs rise, and suddenly these business investments don't look nearly as profitable as they once did. That's when we're left with a heaping mess — artificially low interest rates fuel artificially valuable projects.

The Austrian School refers to this as malinvestment. And thanks to the massive amount of rocket-fuelled derivative credit and acquiescence by the Fed and an implicit weak dollar policy from the U.S. Treasury, dollar credit was cheap; it funded all sorts of projects around the globe that never should have happened and likely would not have happened, had the market pricing signals not been manipulated.

Now, a massive base of malinvestment abounds and the credit crunch is the market's way of trying to cleanse the system.

How About A Little "Tough Love?"

What's the solution then, if the government shouldn't be creating jobs out of thin air, or if the Federal Reserve shouldn't be opening up the money spigots for just anyone?

How about "no pain, no gain"? Or how about some tough love? We need to rid our economy of excesses, and malinvestment isn't the answer. It's not healthy. The market process is a bit like natural selection: The strong investments survive while the marginal investments are weeded out.

Granted, this "tough love" approach is becoming increasingly unpopular. No one wants to see their own economy struggle. No one wants spending to decline and jobs to be lost ... especially not their own. This idea of trimming the fat is a no-no for the socialist mentality Americans are coming to accept. They much prefer putting off long-term consequences if they can keep the party hopping right now. Americans now seem to prefer the Nanny State to rugged individualism in a big way.

However, to drive home this point, consider this excerpt from an essay by French economist Frederic Bastiat:

"In the economic sphere an act, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge on subsequently; they are not seen; we are fortunate if we foresee them.

There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

Yet this difference is tremendous; for it almost always happens that when immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil."

Restoring Real Value Through Deflation

Despite all the pot-stirring and visible-hand economics the government believes in, I think we could see the market process still hold the upper hand.

We first reached a point of saturation and now we're at a point of repudiation. That is, through money pumping and interest rate cuts money became cheap. American consumers and businesses stocked up on credit until they were up to their eyeballs in debt. But now the tides are shifting — debt saturation is becoming debt repudiation.

The Federal Reserve can dish out all the money it wants. But if banks aren't lending it or if no one wants to borrow it, then it's useless. It will not be used to invest in new businesses, it will not help to create more jobs, and it will not aid consumer spending patterns. It boils down to this: The market process is taking back control, and we can expect deflation.

But let's not be scared — deflation restores real value to its rightful place. It tends to boost the value of money relative to goods, i.e. increasing general purchasing power for those with cash balances. It allows the most efficient users of scarce capital to survive, and those propped up by artificial manipulation of the rate of interest and crony capitalism to die—as it should be.

Published on  Mon, Sep 8 2008, 12:59 GMT

• More Reports from this Contributor

Weiss Research, Inc  | 15430 Endeavour Drive. Jupiter, FL 33478-6400 - USA
http://www.moneyandmarkets.com | eletter@moneyandmarkets.com