The following is my response to an inquiry I received from a reader who was trying to better understand our economy and our economic policies in order to make better long term investments:
Hi, I share your concerns and appreciate your apprehensions. You are absolutely correct that investing in ways that increase the wealth of a nation is the basic element of a nation's prosperity.
But investment spending does not just happen because someone saves money. From Adam Smith to the Austrians to Keynes and today's modern macroeconomists and businessmen, everyone knows there is a "truth" that is self-evident: customers and borrowing are important. Employers, whether profit or non-profits, whether private or public, must take in revenues if they are to hire people and produce.
Those revenues primarily come from customers and borrowing. Without more money coming in there can't be more employment and production. Every businessman and economist knows this. It's the reality of the world even if politicians, pundits, and Federal Reserve governors aren't always worldly enough to understand it. The question then is - how does an economy get enough customer spending so its employment and production is maximized under today's circumstances?
Today the US is about $4 trillion short of the customer spending needed for business to fully employ all the Americans who want to work and our businesses' and governments' existing stock of capital.
In other words, we are leaving $4 trillion of value on the table and it will stay there and our economy and markets will continue to stagnate until spending is increased in one area or another - so that jobs and tax collections and output rise and trigger investments so that there is even more production capacity in the future.
The great English economist and hedge fund manager John Maynard Keynes said that under such circumstance one government policy that might work when all else fails would be more government spending.
Keynes' fiscal policy prescriptions apply and are reasonable for the UK. But they don't work for the US because of the long time delays inherent in our system of government compared to the UK where the leader of government is also the leader of the Parliament.
Also reasonable for the UK, but not the US, was Keynes' suggestion that a sometimes-viable alternative to fiscal policy is monetary policy wherein a nation's central bank lowers its key interest rate to encourage spending. It works in the UK because commercial banks can borrow newly created money at the key "bank rate" set by the UK's central bank and loan it out to borrowers who will then spend it. In effect, the "bank rate" is the wholesale price of money in the UK.
But again, Keynes' ideas aren't applicable to the United States -because monetary policy in the US doesn't work the way it does in the UK: we do not have a "bank rate" that is the wholesale price of money.
The only interest rate the Federal Reserve typically sets is the overnight rate for banks - and one must be either incredibly naive and unworldly, or a Federal Reserve governor or media pundit, to believe a commercial bank in the United States will loan out money it must instantly repay the next day. (The strange belief that the interest rate the Fed sets is important probably originates in the fact that years ago most macroeconomic books were written by Brits. It's an unworldly belief that still persists in 2nd rate economics departments and at the Fed)
What the Federal Reserve can do to increase spending is create new money and get it into the hands of potential spenders. The Fed can do this "quantitative easing" either directly or indirectly. (The lowering of the overnight rate is not totally meaningless - it is often used as a signal to the financial markets and banks that the Fed is, or will be, engaging in quantitative easing.)
Typically the Fed creates new money and indirectly gets it into circulation by using newly created money to buy assets, typically US bonds. The sellers sell their bonds and get the newly created money which they inevitably deposit into their banks - so that, as a result, the banks have more money to loan out.
In essence, the Fed creates new money and flows it into the economy indirectly via the commercial banks. The banks then loan it out and spending increases.
But that is not happening today - the banks don't have enough loanable funds to offer would-be spenders because they have been hit by higher reserve requirements and higher loan requirements. (which soaked up the Fed's QE1 and QE2 increases so there was no increase in the banks' supply of loanable funds - the Fed thought it was doing something significant. It wasn't - we're yet to have our first actual quantitative easing)
Worse, the Fed may have waited so long to finally start quantitative easing - the economy may be in such bad shape that the banks now won't be able to find enough qualified borrowers at any interest rate sufficient to cover their costs and risks. That appears to be the case.
That leaves the Fed's creation of new money and flowing it directly into the economy as the only viable alternative to getting enough customer spending under today's circumstances.
The Fed's governors have recently done that sort of thing - they have directly channeled newly created money to such needy beneficiaries as Goldman Sachs (NYSE:GS), Fannie Mae, and Deutsche Bank (NYSE:DB) (and lately the IMF and the ECB so they could bail out the European banks that made bad loans to the Greeks).
The Fed's governors obviously disagree, but in my humble opinion if the Fed has waited so long that its indirect flowing of newly created money via the banks will no longer work, as seems to be the case, it would be much better and much more effective to directly flow the newly created money to our social security recipients, rather than to Goldman Sachs, Fannie Mae, and the IMF, even if they won't have jobs to offer the President's appointees when they are replaced.
After all, a Social Security recipient is likely to have a higher propensity for consumer spending than recipients of Goldman Sachs or Deutsche Bank bonuses granted for successfully conning the Fed out of money.
In any event, something must be done. Until the Fed acts in some way to increase customer spending, we will continue to have massive unemployment, foreclosures, bankruptcies, low tax collections resulting in budget and social security deficits instead of surpluses, and no growth in the future because there is no reason for businesses to make investments in new plant and equipment because they have $4 trillion of capacity now standing idle.
If you can suggest a better way than flowing money directly to our retirees and disabled citizens who helped build this nation and earned a retirement we would all like to hear it. Any suggestions?
Note: Readers who believe the Fed's creating more new money to stimulate the economy means inflation should be aware that the goal of monetary policy is to create "enough" money to generate full employment - not too much so there is inflation from too much spending nor too little such that there is not such that unemployment results. If the Fed overshoots it can correct the situation within hours (yes, hours) by instantly selling assets and removing from circulation the money that is paid for them.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.