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November 27th, 2010
Two office co-workers discuss the reasoning of newest round of quantitative easing by the U.S. Federal Reserve.
STEVE: So, it seems as though they have a new plan to save the economy.
SUVARNA: By saying "they" - do you mean the Federal Reserve?
STEVE: Yeah. They are going to stimulate the economy with another $600 billion over the next eight months. They say it will create jobs and kick-start the economy.
SUVARNA: I am not so optimistic it will.
STEVE: Why not?
SUVARNA: Last year, they created $1.5 trillion and what did it do?
STEVE: They averted a second great depression!
SUVARNA: No. All they did was delay consequences of an unstable system.
STEVE: What do you mean?
SUVARNA: Essentially what is happening, is a process of monetizing the debt. This is often a final phase before a currency collapses. The Federal Reserve creates electronic money to credit banks, which in turn use the money to purchase U. S. treasury bonds. In short, the central bank of the United States, is creating money to loan to the government, but is doing so through the banking system.
STEVE: And that is bad - why?
SUVARNA: Because the value for these new dollars comes from those already in existence. It is a tax or theft, maybe both depending on your view.
STEVE: But they say it's needed, to combat deflation.
SUVARNA: And what is so bad about deflation? But first, let me ask you a question, what is deflation?
STEVE: Deflation is falling prices.
SUVARNA: I disagree with that definition. Price changes are a consequence of changing money supply. But prices can also drop for other reasons, such as improving technology, or more efficient distribution. So instead of using the latest catchy phrase that the Fed is combating deflation through quantitative easing, let us cut to the chase, and just simply say that, the Fed is creating more money to make prices higher.
STEVE: Falling prices are bad for the economy.
SUVARNA: Are they? Combating deflation to help the economy does not make logical sense. If reduced prices were bad for an economy, please explain to me the purpose behind sales. Every store in America is battling with one another to hold the biggest sale. If it was bad for business, why would they engage this strategy.
STEVE: OK, so why do they believe deflation is so bad?
SUVARNA: Because of an archaic notion that declining prices lead consumers to hoard money, as their money will buy more later on. This is contrary to what we observe in the real world. Low prices result in more demand, not less. Anyways, it is complete nonsense to say that we are experiencing deflation now. Both money supply and consumer prices are increasing.
STEVE: So why are they doing it?
SUVARNA: The government has a $13.7 trillion debt and is running a $1.5 trillion deficit. Much higher interest rates would be required to entice foreigners to buy more debt. Higher rates would sink the already tapped out American consumer. So instead, the Fed creates money electronically to credit the banks which in turn buy the debt.
STEVE: And how does the Fed create this money?
SUVARNA: By entering numbers on a computer.
STEVE: That sounds ridiculous! What's backing this new money.
SUVARNA: They literally create it out of thin air. That wasn't always the case though. Up until 1971, the treasury had to honour its responsibility to exchange dollars for gold. At least to foreigners.
STEVE: Why only foreigners?
SUVARNA: It was illegal for American citizens to hold gold because of a law passed in 1933.
STEVE: What was that law for?
SUVARNA: Officially, it was declared necessary to prevent, an economic downturn. Eventually, this period of time became known as the Great Depression.
STEVE: That's ancient history. That period has been studied and they know how to avoid it from happening again.
SUVARNA: Oh? Are you so certain?
SUVARNA: I am not certain that they do. There are many parallels with today. Back then, collapsing banks in Europe were bailed out, but the strain resulted in Britain abandoning the gold standard, and subsequently losing much of its credibility as being a reserve currency.
STEVE: But, we don't have a gold standard today, so that won't happen again.
SUVARNA: We had, and still have, collapsing banks being bailed out. And the US dollar can still certainly lose its credibility.
STEVE: And what would take its place?
SUVARNA: That, is an interesting question.
STEVE: It can't be gold.
SUVARNA: And why not?
STEVE: Because for gold to replace all the money in the world, it would have to be much higher in price - there isn't enough of it.
SUVARNA: Is that an argument for or against gold?
STEVE: Whatever, you know what I mean.
SUVARNA: No, I do not. Why does gold have to be a particular price. If they continue to print more and more money, why should the price not be much higher? And not just gold, but everything!
STEVE: They won't let it get that out of control.
SUVARNA: Let us hope not!
STEVE: Anyway, I better get back to my desk. It looks like break is over.
SUVARNA: Yes. So should I. Enjoy the rest of your afternoon.
STEVE: You too!
ABOUT THE AUTHOR
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and I encourage you to complete your own due diligence when making an investment decision.
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