Stop the Press: More Fiscal and Monetary Stimulus won’t fix the ailing American Economy

The traditional response to financial problems by Latin American, African and other third world countries has often been to print more and more money on their printing presses, which then unleashed enormous inflation and devalued their currencies. University of Chicago economist Milton Friedman gained worldwide acclaim by proclaiming that central banks must carefully control the growth of money in every country, or else the economy will suffer and stagnate. The Government of Chile imported his theories and gradually transformed their ailing economy into the most successful economy in South America; other countries later followed this proven model.

Surprisingly now however, the Government of the United States is behaving like a 3rd world country in choosing high monetary growth plus record fiscal deficits, desperately hoping to avoid a looming inflation. I believe these policies are a recipe for disaster.

Imagine a patient who goes to his doctor and says: “I want you to keep me healthy and to make me feel good all of the time. The way I know that I am healthy is by always feeling good. So never let me feel bad.”

The doctor obliges this unreasonable patient and at every visit prescribes more and more pills, but ultimately the patient becomes chronically ill. The patient has also stopped feeling good, a long time ago.

The doctor is the American government (Dr. Bush and Dr. Bernanke) and the patient is the American population who elects their government. The pills are fiscal and monetary stimulus.

This is not a perfect metaphor, but it comes close to the actual situation. The doctor has erroneously come to believe that with increasing doses of pharmaceuticals, no patient should ever get unhealthy or need to feel bad. So the doctor has prescribed these magic pills in ever increasing doses; regrettably, the patient is now looking and feeling just awful.

These expansive economic policies are not entirely new. They started gradually under Doctors Clinton and Greenspan at the beginning of the 1990’s. Since then, America’s trade (or current account) deficit went from a balanced position to an annual deficit of $850 Billion. The American federal deficit widened to over $400 Billion, partly to pay for the Iraq war.

A lot has been written on this distressing topic, particularly in one of my favourite economic newspapers, The Financial Times (http://www.ft.com/home/us). Regrettably, the American press is strangely silent about this potential economic nightmare.

Presidential candidates left and right are rushing to join the Stimulus Parade. The exception is Ron Paul, a little noticed Republican candidate, who seems to better understand this evolving economic crisis.

The real issue is no longer how to avoid a major recession in America – that recession regrettably is already inevitable, and it will be a worse one due to these ignorant doctors. The American population had been lulled into a comatose complacency by the previously escalating stock market and huge increases in house prices, which had made Americans feel rich; that false contentment has now given way to fear as housing prices and stock markets are falling.

Meanwhile, inflation has gained momentum and this unchecked rise of inflation will bedevil the US Government and US Federal Reserve years to come. We should pity the winner of the 2008 election, because he or she may get the worst economy since the one President Roosevelt inherited after the 1932 election.

But how does this all relate to the Big Debt Crisis? Very simply, when so much new money was created during the past 5 years at very low interest rates, lenders felt pressured to find a home, any home, for this ocean of excess liquidity. Credit standards were thrown out the window (e.g. subprime loans), since loans against houses were thought to be always collectible, even if the borrower was unable to pay. Now these bad loans are defaulting in catastrophic amounts and the entire financial system is in deepening danger.

Unfortunately, official government statistics are so distorted (please see my blog of June 9, 2007) that it will take a long while to unravel what has actually happened to the American economy. But at a minimum, the mighty American Dollar has been permanently devalued and de-throned as the world’s leading currency. America is now the world’s largest debtor nation, when a few decades back it was the world’s foremost lender.

Lowering interest rates and decreasing taxes will not stop this economic freefall for more than a brief time. The “doctors” are just printing more money and devaluing their currency still further. A far better course would be to take the painful medicine of an economic correction bravely and then to return to more disciplined economic practices.

Sound economic management would involve strictly controlling monetary growth, as has been done in Europe and elsewhere. It would mean encouraging higher personal saving for Americans, who have long had the lowest savings rate among industrial nations. It would also mean reigning in federal deficits. Balanced budgets these days are only political slogans; government projections always show the deficit disappearing in 5 – 10 years, but every year in fact the deficit continues to worsen.

Finally, the international trade balance really matters a lot. It is not good enough to blame this problem on lower wage counties like China and Mexico. Advanced nations have always needed to compete with poorer nations. America should stop whining and start producing goods and services that the world wants to buy.

There is much more to be said about sound management of an economy, but these are some of the core points. These structural changes could take up to a decade to accomplish. But unlike excessive monetary and fiscal stimulus, they would eventually produce a healthy economy.

(Note to readers outside of the USA: while the American recession will affect the whole world, it will not be nearly as intense in Canada, Europe and other soundly managed economies. But we should wish America well, since we will share some of its pain.)