My New Blog

The recent massive spending bill by the Obama Administration is going to cost this country much more than it will provide. There will no doubt be some short-term relief. The extent of that relief has been widely debated. But whenever nearly 800 billion is injected into the economy something should happen. The real problem however is going to be what happens after the spending is over. The likelihood of the economy growing itself out of the huge deficit we have incurred is highly unlikely. We would have to grow at a rate unseen in the history of the United States. Here is what the likely economic scenario will be:

1) Interest rates will rise on everything, including mortgages. Mortgage rates are tied to Treasury securities. These securities are bought by investors to fund the spending of the government. They follow a supply and demand principle. If demand is stable and the supply goes up that means the value of the security goes down. The only way for the government to entice people to buy that security with all the other options for investments available is to raise the interest rates on the security. So instead of issuing them at a 3% rate of return, they must now issue them at 6%. Mortgage rates are tied to treasury rates. That means mortgage rates go up by 3%. Can you imagine what that would do to housing demand if mortgage rates went up 3% in this economy?

2) Inflation will go up. Inflation is simply too much money chasing too few goods. When the government injects money into the system through spending or printing money it creates a supply of money. If the supply of goods and services is not expanding fast enough that means people will be able to charge more for goods and services to absorb the money supply. Put it this way, if you know that someone is going to buy something from you and they have all kinds of money and they want it badly it that means you can probably ask more for it. When everyone does that it causes prices to rise, and it also cause the devaluation of our currency. That makes everything more expensive.

When inflation goes up that means banks will start charging higher interest rates on loans because they aren’t going to loan money at 5% if they know inflation is 5% a year. They wouldn’t make any money. So they’ll raise interest rates to make a profit after inflation. If interest rates get too high, then suddenly the people stop borrowing to buy cars, houses, and other durable goods. The result is another recession.

So it is my prediction that what we will see is a mild recovery from this recession, but due to the large amount of borrowing interest rates will go up. Since the government has increased the money supply this will cause inflation, which will cause even higher interest rates as the government tries to stop inflation by raising the Federal Reserve rate to contract the supply of money. The high interest rates will then cause another recession. The depth of the recession will be determined by how bad the inflation is.

How can this be averted?

1. Government will have to cut spending drastically at some near point to reduce the money supply and reduce the issuance of treasury securities. Borrowing and spending by the government will need to be drastically reduced at just the right time.

2. The supply of goods and services needs to be expanded to absorb the money supply without causing inflation. New businesses will need to grow and develop. We will need another industrial revolution, and the world economies will need to expand in order to buy those goods and services. The US can only consume so much.

The problem is that all of this is very delicate to control if not impossible because it is hard to know just exactly where things are at in the economy, and it is only after something happens that we know that it happened. That’s why often we don’t really know that we are in a recession until after we have been in it for three or four months. It is difficult if not impossible to predict when they will occur. Hindsight is 20/20. Foresight is generally blind.

I believe that it would be better to take the bitter medicine now. Consumption has got out of whack in the past decade as the savings rates plummeted. People have too much debt. Everything has to be back into balance. Monetary policy is the best way to get us out of this recession. The Fed can increase the money supply and keep interest rates low. The government doesn’t have to borrow large amounts of money and spend. This keeps inflation in check. Eventually things will come back to balance. Sooner or later people have to start buying cars etc. as things wear out. Eventually we work our way of this recession. Will it be painful? Sure. Just like a family that has incurred too much debt has to bite the bullet to get things under control so will we. But it will be less painful because once we come out of the recession we will be out. But what the government is now doing is setting us up for another recession in the next decade and that could be worse than the one we have now.

Pay me now, or pay me later.