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Economic Scholar: The Fed Won’t Let The Economy Heal

June 6, 2014 by  

This essay, written by Frank Shostak, was originally published at Mises.org.

Most commentators are of the view that the massive monetary pumping of the Fed during 2008 prevented a major economic disaster. The yearly rate of growth of the Fed’s balance sheet jumped from 3.9 percent in January 2008 to 150.9 percent by December of that year. The Federal funds rate target was lowered from 3 percent in January 2008 to 0.25 percent by December of that year.

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According to popular thinking, the Fed’s actions have bought time to allow the U.S. economy to heal — much like keeping a coma patient on life support. Consequently, popular thinkers are harshly criticizing commentators that advocate allowing economic recession to take its course.

Contrary to popular thinking, economic recessions or economic busts are not about the end of the world but about the removal of various non-productive activities, also labeled as bubble activities brought about by previous loose monetary policies of the central bank.

Observe that by means of loose monetary policy wealth is diverted from wealth generators to non-wealth generating activities. The stronger the pace of monetary pumping the stronger is the divergence of wealth. (Bubble activities, which don’t generate wealth, cannot exist without this divergence.)

Obviously then the longer the divergence of wealth takes place the weaker wealth generators become. Note that once the ability of wealth generators to generate wealth comes under pressure the so-called economy follows suit. After all it is the increase in wealth that supports overall economic activity.

It is increases in wealth that fund increases in productive and non-productive activities. So how then can aggressive monetary pumping by the Fed during 2008 have allowed the economy to buy time and to heal?

We suggest that the massive monetary pumping of 2008 has bought time for non-productive bubble activities. However, as we have seen, such activities undermine wealth generators thereby weakening the economy as a whole.

If loose monetary policy is enforced over a prolonged period of time it runs the risk of severely weakening the process of wealth generation. A situation can then emerge where the pool of wealth becomes stagnant or starts to decline.

Once this happens the economy plunges into a severe slump since there is now less funding available to support both productive and non-productive activities. In such a case, what is required to heal the economy is the fast removal of bubble activities.

This will leave a larger amount of necessary funding in the hands of wealth generators thereby strengthening the process of wealth generation — the key for economic recovery.

Again, we suggest that rather than healing the economy massive monetary pumping by the Fed during 2008 has strengthened bubble activities thereby weakening the economy.

To clarify our points further, consider a company that is comprised of ten divisions, of which six are making profits and four divisions are suffering losses. A responsible CEO would be expected to either restructure the four losing divisions or to shut them down. If he/she were to keep them going then this is going to weaken the company.

The profits from the six profitable divisions, instead of being used to strengthen the company’s ability to generate profits, will be employed to support the four losing divisions.

The longer this lasts the worse the fundamentals of the company become. At some stage, once the company’s ability to generate profits diminishes, it runs the risk of going “belly up.”

Would it be valid to say that by allowing the non-profitable divisions to stay longer the company buys the time in order to heal itself?

As we have seen, the longer the CEO keeps the losers the worse the company’s “bottom line” is likely to become. Contrary to popular thinking then, the sooner the cleansing takes place the stronger the company is likely to become and the better the shareholders’ interest is going to be served.

Obviously, the restructuring or the elimination of losing divisions is going to be painful for some of the individuals that are employed in these divisions. However, a strengthening in the company’s fundamentals is likely to increase their chances of being re-employed in other divisions. Likewise, with the elimination of bubbles in the economy individuals that were made redundant are likely to be re-employed in newly expanding wealth generating activities.

Summary and Conclusions

Most commentators are of the view that the Fed’s massive monetary pumping of 2008 has prevented a major economic disaster. We suggest that the massive pumping has bought time for non-productive bubble activities, thereby weakening the economy as a whole. Contrary to popular thinking, an economic cleansing is a must to “fix” the mess caused by the Fed’s loose policies. To prevent future economic pain, what is required is the closure of all the loopholes for the creation of money out of “thin air.”

-Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies.

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The Ludwig von Mises Institute

was founded in 1982 as the research and educational center of classical liberalism, libertarian political theory, and the Austrian School of economics. It serves as the world's leading provider of educational materials, conferences, media, and literature in support of the tradition of thought represented by Ludwig von Mises and the school of thought he enlivened and carried forward during the 20th century, which has now blossomed into a massive international movement of students, professors, professionals, and people in all walks of life. It seeks a radical shift in the intellectual climate as the foundation for a renewal of the free and prosperous commonwealth.

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