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The United States economy has been expanding since July of 2009. However, economic growth has been mediocre at best. Consumer spending has supported the expansion, but the all-important investment in capital goods -- the investment in plant and equipment, inventories, and housing -- has been sorely missing.

The Federal Reserve has, seemingly, done almost all it can to stimulate the real investment in capital goods, yet businesses have not responded to this stimulus and, consequently, any multiplier to economic activity has been absent.

The problem is that a large part of the stimulus is, and has been, going into financial investment. And, as long as this diversion continues, real investment in capital goods will be modest and the subsequent economic growth will continue to be feeble.

The argument is that businesses and (wealthy) households have learned over the past fifty years or so that when the federal government creates an environment of credit inflation, greater wealth can be created by investing through the financial opportunities available than by investing in the physical opportunities available.

One reason for this is that during a period of credit inflation, the monetary authorities as well as the fiscal authorities, protect the downside of financial investment to a greater degree than they protect the downside of physical investment. The Greenspan "put" is just one example of this. Inflation as it is generally perceived occurs in the flow demand of goods and services being produced. We buy food, we buy clothing, and we buy other items that are primarily consumed within the time period they are produced.

Credit inflation has to do with the price of assets -- items that have a lifetime that exceeds the time period in which they are produced. Houses are such an item -- the ownership of physical capital represented by common equity -- assets in which price "bubbles" can be created.

What have we seen happen in the economy over the past fifty years? Well, as the United States government has attempted to maintain high levels of employment, the monetary policy and the fiscal policy of the United States has been aimed at providing sufficient stimulus to the economy so as to keep unemployment at low levels. In doing so, the monetary base that is supplied to economy by the Federal Reserve System increased at a compound rate of growth of about seven percent from the early 1960s up until the beginning of the Great Recession. The outstanding debt of the United States government has risen by about a compound rate of ten percent during this time period.

These growth rates far exceed the rate of growth rate of the real economy over those roughly fifty years, which was in the neighborhood of three percent. During this time period the American economy experienced some price inflation, especially in the earlier years. However, credit inflation took over in the last twenty-five years or so and this is what really produced distortions in the United States economy.

People and businesses responded to the credit inflation by taking on riskier assets. They also increased financial leverage and, more and more, financed long-term assets with short-term liabilities. Finally, people and businesses enhanced returns even further by producing financial innovations that allowed them to be even more efficient in supporting the first three responses.

And, in all of this, the federal government, in essence, placed a "put" under all this risk-taking. Although the "put" covered real investment as well, the "put" was much more effective in protecting the downside of financial investment.

Of course, people and businesses were very responsive to this. As housing prices went up and up and up, many people increased their wealth by getting into houses. Then into second homes. Then into art. Then into gold. And then into other commodities or physical assets that appreciated in price.

Businesses did the same thing, but they also moved into financial businesses. At the start of the 1960s could you imagine that General Motors (GM) and General Electric (GE) would earn more than fifty percent of their profits from their financial wings? In the financial sector, financial innovation came to dominate the structure and business of banks and other organizations.

But, as people and businesses moved relatively more and more of their wealth into financial investment economic growth began to slow and the employment of labor became less robust. Under-employment grew and labor force participation dropped! This is where we find ourselves now.

And, while the U.S. Congress remains deadlocked and any coherent fiscal policy remains absent, the Federal Reserve has taken upon itself the responsibility of the sole source of governmental stimulus to the economy.

The economic models of the Fed contain two prominent channels through which monetary policy works on the economic to produce growth. First, low interest rates that keep the cost of business borrowing low is one of these channels. Second, the models contain a wealth effect that impacts consumption. As household wealth rises, consumption expenditures rise.

The current problem is that people and businesses have learned well the lesson of the last fifty years. They have learned that in a period of credit inflation, the easiest way to increase wealth is through financial investment and not physical investment. So, those economic units that are able to, invest in financial assets and not physical assets. And there is relatively little physical investment.

If you look at the record over the past four years you see that financial investment has done very well, for businesses as well as for individuals. Headlines in business publications over the past week or so ask the question, "Why are business profits doing so well when there is so little business investment taking place?" And, for all the government's talk about supporting the middle class, the policies of this government have done an excellent job in creating an environment in which the income/wealth distribution of the people has become even more skewed toward the top ten percent.

Our basic economic models are built on the premise that more and more economic stimulus will solve all our problems and put people back to work again. It seems as if the past fifty years of pursuing expansionary policies like this have produced just the opposite result. Maybe it is time to review the results of this time period and create some new models that can account for the ways people and businesses behave when governments engage in a sustained period of credit inflation. Maybe it is time for our government to learn that more and more money and debt may actually produce the opposite of what they are hoping to achieve.

Source: Where Is The Physical Investment?