Sunday, November 4, 2012

Then What...?

Money is a factor of production; it is the lube that keeps economic engines running smoothly. As of right now we have low output, high unemployment, and low interest rates. The Federal Reserve is trying its hardest to get unemployment down by making lots and lots of money available to be used in production. The disconnect is created by banks however, who borrow money from the Fed but then in turn don’t lend to businesses and investors [who to a certain extent are not borrowing as much either, due to lessened demand from high unemployment]. If we keep along this road, eventually over time (I know that sounds like a long time, and that’s because it is) consumers will slowly start consuming more and more. This new found demand will come from either a small savings that has developed or a better debt-to-income profile that leads to increased access to credit. Either way, Americans will find a way to do what Americans do best, and that is to consume beyond their means.

A key assumption in this drawn out scenario is that money will be easily accessible when consumers can qualify for credit and when businesses and investors start truly demanding more capital investments to meet new consumption demand.

If for any reason however, interest rates have to start rising prematurely, the gradual transition back to growth will be abruptly interrupted. If we start with rising market rates, which represent the costs of borrowing in the secondary [financial] market, we would see businesses and investors start requiring more and more projected growth and return from their capital investments to compensate for the increased cost.
Businesses would have to in turn charge higher prices on their goods and services to be able to recoup to higher costs of production. As one good or service [with a higher price tag] is used in the production of another good or service, the higher price gets passed on and on until it gets to the consumer. We as consumers would start feeling the impact of the higher production costs as we shop and so would experience a cost-of-living increase, which would inspire us to demand higher wages. This further increases the cost of production for businesses as they have to pay their employees more and so they have to raise prices further and so on.

In the time it takes for wages to adjust to the point that producers can charge and receive a higher price for their goods and services in general, they would see a decrease in demand as strata after strata of the socio-economic spectrum is priced out of consuming. This will lead to a slowdown in production output to help match the slowdown in consumer demand. The outcome of which is simply higher unemployment and price inflation due to a general fall in production ahead of the falling demand from consumption.

If the Fed were to get in-front of the rising market rates by increasing the Fed Funds rate [bank borrowing rate], that would slow down and eventually reverse the price increases and stay inflation. It can do this because at it raises the cost for banks to borrow, the banks simply borrow less and lend less, and so the money in the economy starts to dry up. This has the detriment of slowing both inflationary spending and core investments [both usually funded by borrowing], which also means less jobs as businesses don’t have funding to invest in new production capacity and new employees; and in some cases have to start firing.

This will have the benefit of undoing all on the drawn-out, hard earned progress that we have been making since mid-2009, and take us at least one step back for our two forward.

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