Fed’s new monetary plan runs the risk of severely damaging the US economy

The US central bank announced on Thursday September 13, 2012 that it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month as it seeks to boost economic growth and reduce unemployment.

In his press conference, following the conclusion of a two-day meeting of the Federal Open Market Committee (FOMC), the Chairman of the Federal Reserve Board Ben Bernanke said the US central bank will continue buying assets, undertake additional purchases and employ other policy tools as appropriate if the outlook for the labour market does not improve substantially.

According to the Fed Chairman purchases of housing debt should help the housing market, which he called “one of the missing pistons in the engine”. Bernanke holds that mortgage backed securities purchases ought to drive down mortgage rates and create more demand for homes and more refinancing.

Some experts are of the view that the Fed could eventually buy more than $1 trillion in debt given the open-ended nature of its new policy.

The latest Fed policy is based on the work of Columbia professor of economics Michael Woodford regarding the policy options of the central bank when interest rates are near zero. Woodford argues that the best way to defeat stubborn economic weakness is to keep monetary policy very loose for longer than would otherwise be advisable under normal conditions.

According to this way of thinking, the open-ended purchases of securities should help bolster the confidence of American consumers and businesses by showing that the central bank is determined to stop the economy from weakening. This, according to Bernanke echoing Woodford, will make people more willing to invest, hire, and spend.

Note that what we have here is a suggestion of how to boost the demand for goods and services, which is seen as the stumbling block for the economic expansion. Note that all that is required here is somehow to convince consumers and business that the Fed has the tools and the knowledge of how to revive the economy and strengthen the labor market.

Even if Woodford is right and from now onward consumers and businesses will be willing to boost their demand because they now believe that the Fed is determined to stop the economy from weakening, this still may not work. We suggest that it is not enough to boost demand as such, what is required is the strengthening of effective demand. People’s demand must be fully backed up by previously produced goods and services.

According to James Mill,

When goods are carried to market what is wanted is somebody to buy. But to buy, one must have wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation that constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of its inhabitants? But if a nation’s power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation.

….

Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.[1]

In order to boost the demand for goods and services one must boost the production of goods and services. For instance, an individual can exercise his demand for bread by producing shirts, or a butcher can exercise a demand for potatoes by first producing meat that he can exchange for potatoes.

Furthermore, producers of final goods can also exchange them for various other goods such as tools and machinery in order to expand and enhance the existent infrastructure, which will permit an expansion of final consumer goods that promotes people’s life and well being.

The Bernanke-Woodford plan, which is based on relentless monetary pumping, will lead to a weakening of the economy’s ability to generate final goods and services in line with consumers’ preferences. Hence this will diminish rather than strengthen effective demand for goods and services.

Regardless of psychological disposition, if the ability to generate final goods and services diminishes it is not possible to boost overall demand for goods and services. We could convince individuals that the Fed’s monetary pumping is going to revive the economy and therefore it is in their own interest that they should start buying more goods and services. However, if the backup is not there i.e. if there wasn’t an increase in the production of real wealth (final consumer goods and services) it is not going to be possible to expand the overall demand.

If a baker has only saved ten loaves of bread he can only exercise his demand for other goods in accordance with the exchange value of the ten loaves of bread. In order for him to raise his demand he must produce and save more bread.

The question that one needs to ask is why after lowering interest rates to zero and pumping over two trillion dollars into the monetary system the economy remains subdued.

Most economists and other experts respond that we are currently in a unique situation brought about by various mysterious shocks. It is held that if it were not for the Fed’s aggressive monetary pumping the economy would have suffered a massive economic depression by now. Hence, contrary to various critics, if anything Bernanke’s policy has saved the economy and hence has been very effective.

(The Fed Chairman however is of the view that at this stage the effectiveness of monetary policy might be diminishing. He holds that we now require some support from fiscal policy. In particular Bernanke warned that US economic recovery could be in jeopardy if lawmakers can’t stop automatic year-end spending cuts and tax hikes from taking effect. The Fed Chairman holds that the new central bank stimulus efforts would not be enough to protect the economy from the twin-shocks).

We hold that it is a fallacy to suggest that Bernanke’s monetary pumping has prevented the US economy from falling into a severe depression. What Bernanke’s policy has done is to prevent the removal of various non-productive wealth destroying activities that emerged on the back of previous loose monetary and fiscal policies.

Obviously, if Bernanke wouldn’t have stepped in with massive pumping, a large number of bubble activities would have been liquidated by now. This would have provided more real wealth to wealth generators and would have set in motion a genuinely solid economic expansion. This would have strengthened the economy’s ability to generate real wealth.

By introducing another massive monetary pumping scheme Bernanke is running the risk of inflicting more damage to the process of real wealth generation. Consequently, this raises the likelihood that we could remain in depressed economic conditions over a prolonged period of time.

It must be realized that the damage inflicted on the economy by reckless monetary and fiscal policies cannot be fixed by further aggressive monetary pumping and by lifting people’s confidence in the Fed’s policies. What is needed to revive the economy is to stop the Fed and to cut government outlays to the bone.

Summary and conclusion

The US central bank announced last Thursday that it will undertake open-ended purchases of $40 billion of mortgage debt per month until the labour market improves substantially. The Fed Chairman Ben Bernanke, who has introduced the new policy, is of the view that this will revive the economy. It is questionable why all this pumping should revive the economy given that the zero interest rate policy and the over $2 trillion in monetary pumping since 2008 weren’t successful. We suggest that by introducing further massive monetary pumping Bernanke is running the risk of severely damaging the US economy. Consequently, this raises the likelihood that the US could remain in a depressed economic state for a prolonged period of time.