This is Not Good

Deflation is really not good.  Think about what would happen if suddenly, everything sold for less than it did last month. 

Krugman lays it out here in economics major detail: http://goo.gl/Wg7V.  But for the layperson, here’s the shtick.  First, if I build widgets and widget prices are going to be lower next month than this month, why would I invest money in building widgets?  I’m better off holding onto my money.  With lowered prices comes lower wage growth, especially in economies with unemployment.  Why pay more to people making widgets when there are a 100 people knocking on the door for a job?  Third, all of this is reinforcing.  Less spending begets less demand which begets lower wages which begets less spending.  Then suddenly, no one wants a widget.

I wasn’t really nervous until I saw this chart.  For those who didn’t watch Lost in Translation, Japan went through a housing boom in the 1980s to be followed by 20 years of economic funk.  Think Detroit with kimono robes and sushi. 

Two things compound the problem:

1. There’s a lot of pressure to cut government spending (ie trim the deficit).  Since we’re a borrowing country, this deficit money is a net flow into the US economy.  Cut the spending and you cut the flow.  Cut the flow and suddenly there’s $1 trillion less demand in widgets.  Dōmo arigatō.

2. Tea Partiers are throwing stones at the Federal Reserve’s action to inject $600 B into our economy.  In the Tea Party thesaurus, “central” and “reserve” are synonyms with Hitler and Maoism (or something).  See this comic:

But the Federal Reserve’s actions are to prevent the chart (above) from becoming reality.  What does a Japanese-style 20 years of non-growth look like?  Well, think close up of Bill Murray and a world where Scarlett Johansson doesn’t wear makeup.  It’s that bad.

I Thought the QE2 was a Boat

Michelle, my sister, once had me draw out a chart on how the Federal Reserve worked so she could pass a High School Economics test.  So I drew it out on the back of a paper bag.  I thought I’d draw it again for the Moogaz world.

1. The government can spend money by collecting it through taxes or taking on debt.  It takes on debt by issuing Treasury department notes.  No new money is created or destroyed in this process, only moved around.  In this way, the government operates like you and me.  
2. Central banks aren’t really banks.  They print money.  This is not like you and me.
3. When a central bank wants to print money, it buys things.  Hmmm… say what.  Pretend you had the ability to create money out of the thin air.  What would you do first?  Sure, you’d go somewhere and spend it.  Central banks spend their new money buying debt.  Literally, in their accounting books appears the ledger term “ex nihilo” (out of nothing).
4. The central bank can buy lots of things.  At the beginning of the Great Recession, it bought toxic mortgages from banks.  This was known as QE1.
5. Now, it’s buying new US treasury debt.  This is QE2.
6. Just like anything else in the economy, when everyone is buying the price goes up.  Well, if the Central Bank spends too much, too fast interest rates go up.  Print too much money, and you have hyperinflation.
7. But right now, there’s not enough people buying things so even with the Central Bank buying $600B worth of things, there’s little cause for concern.
8. Unless you’re a foreign country.  China, Brazil, Europe – they all don’t like the QE2.  Because the Central Bank can create money out of nothing, it makes what’s already out there a little less valuable.  This makes the US Dollar a little less valuable.  Thinking about vacationing in Europe this summer?  Maybe not so much now that your London latte will cost you more.  And this is why the EU and China are complaining.
9. But all of that said, the Central Bank just printed $600B worth of money.  And this all but paid for the $800B in Stimulus money spent earlier this year.  What? How?   Well, since the Central Bank bought the debt, we don’t have to pay interest to anyone else.  The debt … disappeared.
10. Boy, that was easy. Why can’t we do that all the time?  Besides inflation, there’s suppose to be independence between a central bank and it’s government.  Obama and Bernanke aren’t suppose to coordinate printing of money and issuance of debt. 

So in a nutshell QE2 is a good thing. It helps the economy by injecting capital.  It gets rid of $600B in debt.  And it helps exports. 

So don’t let the nut head Tea Partier tell you the whole world is falling down.

And banks, how about lending some of this money instead of hording it.