AUSTRIAN ECONOMICS ADDICT

Blowing large bubbles  (Photo credit: Wikipedia)

THE WEALTH EFFECT.

Since the housing bust and the corresponding economic downturn in 08, the Fed has been trying to create the “wealth effect”, using its double-edged sword of near zero interest rates and injecting counterfeit money into the banking system. I don’t know if they realize it or not but this double-edged sword is what caused the artificial housing boom which collapsed in 08.

The wealth effect starts from the Keynesian belief that consumption drives the economy. A vast majority of economists, politicians, and bureaucrats believe that if individuals feel wealthier because the value of the stocks and bonds they own are increasing, and the value of their house is also increasing, they will spend more. This increase in consumption [aggregate demand] they believe, is  what drives the economy. Unfortunately if the policies they are implementing are based on a fallacy, the policies will also be  fallacious.

WHAT DRIVES THE ECONOMY SAVINGS OR SPENDING?

The truth is savings, capital formation, and entrepreneurial activity is what drives the economy, not consumer spending. Consumption is what happens after something is produced. ( Read here: What Comes First Consumption or Production) This process can’t happen in reverse order, at least not for an extended period of time. The Fed’s policies of low-interest rates and injecting counterfeit money, don’t take into account what borrowing and lending really represent.

If I borrow from you [the lender], you are transferring your purchasing power to me. You no longer have the ability to spend on consumption in the present, but I do, because of the exchange we made. Your purchasing power is returned to you incrementally over time as I slowly transfer my purchasing power back to you, through my payments plus interest. What is being borrowed is something that really exists. Its in the form of what has been produced and saved by the lender. Both of us can’t consume the same thing at the same time, but this is what the Fed is doing when it starts counterfeiting money and lowering interest rates.

HOW AN ECONOMY GROWS.

Here is the process of how an economy grows. 1)  Individuals produce; consuming some of what they produce and saving a portion of what they produce. 2) These savings, or present goods, are invested, and end up producing capital goods. 3) Capital goods allow us to produce more output with less imput [land, labor, time, resources, etc.] 4) These capital goods are used to produce future consumer goods. If there is no savings there will be no expanding economy. If the Fed tries to counterfeit savings via the printing press, it starts the process of different groups consuming the same thing at the same time, and this can only go on for so long before there is a correction. When individuals are presently consuming what they have produced, and at the same time other individuals are using counterfeit dollars to purchase the same present production, we start consuming more than we are producing. This makes us less wealthy, because every act of consumption is a destruction of wealth. (Read here: Consumption Depletes What Has Been Produced And Saved.)

CONCLUSION.

The present rise in the prices of housing, and the rise in the stock market over the last three years is a result of the Fed injecting counterfeit money into the market. The Fed is trying to create a new wealth effect. But no matter how much they try to dress up the fallacy that consumption drives the economy, the economic reality that production comes before consumption, always wins in the end. The price of relearning this lesson will be more costly than it was in 08, and it will be paid by all of us, either in taxes or through inflation.

Read this article written in 2001 by Gregory Bresiger at mises.org, titled Personal Savings Collapse. This is a great article about savings, consumption, and spending. It shows what happens when the people in power think they are smarter than the market. Their policies lead to unintended errors that the market tries to correct. The planners try to do the impossible no matter what the cost, or who pays.

Here are two articles that show what the interventionist are doing to reflate the housing bubble.

Keeping The ‘Recovery’ Dream Alive; Three Banks Halt Foreclosures In May, at zerohedge.com.

Chart Of The Day: Crushed US Consumer + All Time High New Home Prices = Record Housing Bubble, at zerohedge.com.

This entry was posted on May 29, 2013 at 2:45 am and is filed under Econ. 201. You can subscribe via RSS 2.0 feed to this post's comments.

Tags: Capital Consumption, Consumption, Counterfeiting, Fed, Housing Bubble, mises.org, Savings, The Wealth Effect, zerohedge.com