Thursday, November 27, 2014

SQUEEZE THE BALLOON: Bursting Foreign Economies While Trying To Save Our Own

Our economy is like a balloon.  A balloon grows as air fills its interior.  Our economy grows as the number of business transactions increase within our borders.  Like a balloon, sometimes our economy seems to grow lopsided or in an irregular shape.  Sometimes even, the economy shrinks, and like a deflated balloon, it presents unsightly wrinkled patches.  These irregular shapes and wrinkled patches of the economy routinely become the object of attention of the media, the public, and policymakers.

I recently completed reading From New Deal Banking Reform to World Ward II Inflation by Milton Friedman and Anna Jacobson Schwartz.  Before your eyes glaze over in disinterest, let me say that it provided very relevant historical examples of economic manipulation that resonate with what we are experiencing today.  It also provided compelling examples of how actions taken by the Government and Federal Reserve laid the foundation for future problems. One of the most poignant examples cited was efforts to manipulate gold and silver markets.

As the Great Depression reached a trough in 1933, the Government and Federal Reserve were scrambling to find policy that could help lift the economy.  Commodity prices (i.e. wheat, corn, etc.) were very low.  The low prices were putting farms out of business and creating a crises in agriculture.  In an effort to stop this phenomena, President Roosevelt declared a bank holiday on March 6, 1933.  On March 9, Congress passed The Emergency Banking Act which gave the President power over all banking transactions and over foreign currency exchanges and gold and currency movements.

One of FDR's first actions was to institute a freeze on all gold transactions between banks.  All banks, persons, and institutions were ordered to surrender all gold bullion in their possession to the Federal Reserve.  The U.S. dollar at that time was based on a gold standard.  Shortly thereafter, the dollar was depreciated as its gold "content" was cut nearly in half.  Also, the U.S. set out on a policy of purchasing gold domestically and abroad to increase the metal's domestic supply and thus allow the supply of dollars to increase and thus allow commodity prices to inflate.  Again, the whole point of this program was to indirectly increase the price of commodities and help out ailing farmers.  In this, the programs succeeded.

Chinese line up to receive a stipend of gold during hyperinflation.

However, despite the success of the gold purchase program, it had the inadvertent affect of kicking other countries off the gold standard.  Even more so, it's sister program of purchasing silver left significant wreckage in its wake.  On May 22, 1934, the Secretary of the Treasury was ordered to purchase silver domestically and abroad just as had been done with gold.  One of the major unintended consequences of reducing the supply of silver in rest of the world was that it exported deflation to countries whose currencies were on the silver standard.  China was one of these countries.  The reduction in silver available to back its currency (since it was all being sold and smuggled to America which was willing to pay a premium for the metal) caused prices to decline in a disorderly way.  The Chinese government was forced to leave the silver standard and adopt a fiat paper currency.  But, when it did so, it began to print money to pay its bills and experienced a disastrous episode of hyperinflation.  The Chinese economy was wrecked from the chaos and Japan's invasion punctuated the misery of the people.  The economic woes followed by the hardships of war planted the seeds of discontent which led to the Communist Revolution.  America's silver purchasing program seemed innocuous enough here at home, but abroad it created more problems than it solved.

Federal Reserve Balance Sheet showing a spike upward in efforts to respond to The Great Recession.

We have seen similar episodes of unintended economic consequences in the recent past.  Following the Great Recession, our Federal Reserve has embarked on an ambitious program of market manipulation.  At first it purchased mortgage backed securities in an effort to bolster the mortgage credit markets.  Later, it began purchasing U.S. Treasury bonds en mass to help "quantitatively ease" market conditions.  This quantitative easing (QE) has basically been a money printing operation that has propped up markets through selective inflation.

As we saw during the Great Depression, the interventionist policies of the Great Recession have spawned problems abroad.  As QE pushed up our stock market, it also pushed up the price of food in other countries.  In places like Egypt, where the average person lives on less than $2 a day, this increase in food prices proved to be unbearable.  Hunger turned to anger and the ugly, yet U.S. friendly, dictatorship of Hosni Mubarak was overturned in 2011 and replaced with a very U.S. unfriendly and fascist regime known as the Muslim Brotherhood.  Libya, Syria, and Tunisia all experienced similar political revolutions stoked at the onset by the high price of food.

Tahrir Square Protests - Cairo, Egypt - 2011

While we may believe we can outsmart the natural laws of economics, our actions do not occur in a vacuum.  Squeezing a balloon on one end will only cause the other to bulge.  We need to be mindful of the fallout that comes from tinkering too much with the economy.  Natural laws of economics follow natural rhythms.  As a nation, we would do best to implement policy that adheres as closely to these natural laws as possible.  While short term gain may seem the order of the day, it nearly always comes at an expense.  May we have the courage to make economic policy with the long view in mind.      

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