When the Fed Stops the Music

Why has the Fed been able to print so much money without igniting inflation?  That's what Larry Kudlow is asking today.  The answer is that people are carrying much higher cash balances.

Michael Darda argues that Fed reserve creation and its unemployment target (the 6.5 percent Bernanke-Evans rule) has only partially offset a negative velocity shock of historic proportions...

Economist Scott Grannis... argues that consumers have increased their cash balances and that banks are holding onto extra reserves in order to avoid risk following the financial meltdown. As a result, the M2 money supply has been growing at a fairly steady rate of 6 to 7 percent. Not an excessive pace.

OK.  What does this mean?  It means that that the Fed is eating up the seed corn but people are trying to save seed corn at the same time.

But let's lay out some bullet points to understand what has happened since the Crash of 2008.

• All debt is an anticipation of future income.  The consumer says: I can buy a house now and pay for it out of my improving income stream in the years ahead.  Government says: I can fight this war now, or promise this glorious entitlement now, and pay for it out of the abundant tax revenues that will accrue after we have won the war.
  
• A big financial meltdown like 2007-2009 means that the consumer's assumption of future income and the government's assumption of future taxes is over confident.  There will be less income and less taxes than we thought.
  
  
• So the right thing to do in 2009 would have been for consumers to deleverage their debt, responding to the fact that they weren't going to get the income they thought.  And the right thing for the government to do would be to cut future spending.  Maybe government keeps going at full for today, but government cuts its promises for the future in e.g. entitlements.  Because there were not going as much tax revenue as we thought.
  
  
• All this would start after the financial system was stabilized, which occurred at the latest in the summer of 2009.
  
  
• What has happened is that consumers have deleveraged, but government has not cut spending.  This has worked so far because government has borrowed the money that consumers have saved, increasing its own debt as consumers have decreased theirs.
  
  
• So the result is a sluggish economy as consumer savings does not get recycled into good investments in the future but wasteful government transfers in the present.
  
  
• If the government had been cutting spending then we would now be looking at a reduced deficit and reducing borrowing and a growing economy, and the Fed could look to stop printing money and to allow interest rates to rise.
  
  
• But in fact the government has done nothing to reduce its future promises and instead has piled on a new entitlement with unknown present and future costs.  It is, in essence, doubling down on its bet that there will be plenty of revenue in the future to fund its debt.
  
  
• So at some point in the future we Americans will have to consume less.  We can do it with higher taxes or more likely by inflation.  Because there is just less to go around than we thought.  That's what happened to Germany and Austria after World War I.  The nations were much poorer but they kept spending the same.  It took a ruinous hyperinflation to persuade the low-information voters that their government stipends couldn't continue.  Later on they took their revenge on the political establishment by electing a charismatic chap that we have all grown to know and love.

It's possible that no president in 2009, Republican or Democrat, could have summoned the political will to cut back on the promises of future spending.  Certainly Democratic politics is based on the notion that "we are owed" irregardless of the economy.  Republicans, supposedly the Sensible Party, are usually embarrassed to talk about economic reality.  You can see the problem as it is working out in Cyprus.  Given the situation of a banking meltdown the policy of giving bank depositors a haircut is probably the least bad option  from a technical point of view.  But who is going to agree to that, especially after the world has been told that deposit insurance takes care of the bank failure problem for all time?

But sooner or later we will have to go under the yoke.  If we increase taxes to maintain the spending we will be reducing the future potential of the economy by wasting it on government spending.  If we cut spending we will infuriate all the people that say that they contributed to their Social Security and Medicare all their lives and now they want the money sitting in those trust funds.  Ah yes, the Trust Funds.

The Cypriots are raging against the six or ten percent haircut on their bank accounts.  Bully for them.  So now probably Cyprus will have to devalue by 50 percent and go off the Euro.  The same thing will happen with the entitlements.  Democrats will rail against cuts until the government goes broke and their voters are reduced to eating the paint off the walls.

Really, government should spend nothing except on wars.  Then a reasonable revenue could be used to fund and pay off the war debt.  And all the essential social functions of any society would be handled by people in their day-to-day lives instead of by rigid, unaccountable, un-adaptable, unreformable, unaffordable government programs.