Sunday, February 22, 2009

It's Economics Silly!

Last night I had some friends over for our regular nickle-ante poker game. As the night went on, comments were made about how bad the stimulus package is and how all of this is going to cause rapid inflation.

Of course, the guys saying this stuff were just parotting what they heard on television or the radio. Honestly, do you really think that Rush Limbaugh understands macroeconomic theory?

So what is the effect of the stim and how will it affect the broad economy? To understand this, we must first look at where we are now. In October, the money market pretty much siezed. This caused a ripple effect that quickly caused the failure of Lehman Brothers. Once that hit, then the Treasury Department got involved and pushed through the Toxic Asset Recovery Program (TARP).

After everyone saw that the economic meltdown was underway, then there was a rush to liquidity. You can tell this by looking at the 3 month treasury bills which went to almost 0%. When there is a rapid movement away from leveraged investments to cash, you will see asset prices drop. In other words, lots of people who had stuff that they owed money on sold that stuff at a reduced price. That is part one.

Part two is the forclosure issue. As homeowners go through foreclosure, they lower the value of their homes and their neighbor's homes. This is because when you have an appraisal done on your home, the appraiser looks at the comparable home sales in the area. If Joe down the street sold his home for 30% off then it will affect your home and subsequently what you can borrow against it. This is part two.

Put parts one and two together then you get deflation. Deflation, the opposite of inflation, means that asset prices are moving lower, consumer prices are moving lower, wages are moving lower. It is very, very bad. If you get into a deflationary spiral, then people will hoard money because it will be worth more later. If people don't spend money, then the demand continues to drop and prices keep droping. If prices continue to drop, then deflation increases and people don't spend. I think you get the idea.

So back to the stimulus plan, anyone who understands these forces knows that you cannot let the market fix this on its own. Will the market correct eventually? Sure, but at what cost? This mess will cause massive unemployment, loss of capital, bank failures, hoarding, and eventually price fixing.

As for what it will cost the taxpayers, the choice is simple: either invest in something now, or face lower revenues which will cost the taxpayer just as much.

Here is how it all works:

1. Prices are falling, demand is off causing the risk of a deflationary spiral.
2. The government prints money then uses that money to buy bonds from the government.
3. The money is then spread across the country and is spent. (it really doesn't matter where)
4. As the new money is introduced into the economy, it causes inflation.
5. The inflation counters the deflation which as discussed above is very very bad.
6. Because the treasury actually printed the money, the real national debt does not really increase.

Any questions?

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