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: Nothing.
STEVE: Nothing?
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?
STEVE: Yes.
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!
