Washington politicians are pointing the U.S. economy straight into a liquidity trap and instead of a bright economic future, the U.S. is looking at years of high unemployment, weak GDP growth and the possibility of widespread deflation.
When the economy is in a liquidity trap, monetary policy is ineffective because individuals and businesses hoard money rather than spend it. The more money the Fed makes available, the more consumers hoard.
Will I be able to feed my family and pay the bills? Is my job secure? Is my house worth less than the mortgage? Will the government help me when I am old or will Medicare be denied when I need it the most? Why is the school board cutting pay and firing teachers? Does a government shutdown mean that I won’t be paid? Is the Treasury raiding my pension to pay bondholders?
When ordinary people aren’t sure how to answer those questions, they become gripped by fear and uncertainty. To assuage their fears, they spend their time and resources getting ready for whatever bad news comes their way. They hoard cash and try to save for the rainy day that they are convinced will come. As a result, demand for goods and services falls causing prices, wages and living standards to plunge. Before you know it, we’re in the midst of what economists call a deflationary spiral with no end in sight.
Last week the Federal Reserve of Bank St. Louis published an update to its M1 Money Multiplier chart that shows ordinary Americans are holding on to cash. In the last six months the Money Multiplier has gone into a downward spiral. When the Money Multiplier falls, it’s tough for the economy to sustain growth.
It’s not just the M1 Money Multiplier that is falling; M2 Velocity is falling as well. M2 velocity is a measure of how fast broadly defined money supply turns over each year. When M2 velocity falls, consumers, businesses and investors are slowing the rate at which they spend and invest their money. Annual GDP equals the amount of money available to spend multiplied by the number of times the money turns over in a year. When velocity goes down it is a sure bet that a recession is right around the corner.As the below chart illustrates, M2 Velocity resumed its downward trajectory about six months ago after recovering a little from the 2008 financial crisis.
Beyond the obvious inclination to hoard, one of the side effects of falling monetary velocity is the tendency of investors to sell more risky and less liquid assets and invest in Treasury bonds which are considered “as good as cash.” Right on queue in the last two months, the stock market has been in decline while the Treasury market has been rising.
Confidence in the future is needed to get money turning over again. Yet, confidence is being destroyed by a lethal combination of natural and man-made disasters.
In the last six months there have been natural disasters of epic proportion, but the worst disasters are man-made and causing self inflicted wounds.
The earthquake and tsunami in Japan were natural disasters with wide spread economic consequences for both Japan and the global economy. Flooding in the Midwest and tornadoes throughout the East were no one’s fault, but still rocked the world of millions of Americans.
Even so, it’s man-made disasters that are hurting the most.
Conflict in the Middle East is a man-made disaster that has the potential to take a turn to the dark side with lasting consequences. Also, the European sovereign debt crisis is a man-made crisis that still isn’t under control.
However, by far the biggest economic disaster is being created in Washington and in state capitols. The deaf ear of politicians and policy makers to the unintended side effects of their words and deeds is almost beyond comprehension. Certain politicians seem to think that they were elected to play Russian roulette with the economy and don’t understand the consequences of their actions.
In the last six months investors, businesses and consumers have watched the U.S. come within minutes of defunding itself and shutting down.
This month everyone is wondering if Congressional leaders will commit collective suicide and fail to pass an increase in the debt limit. Every night on TV members of Congress seem almost giddy at the prospect of serving the U.S. economy cyanide-laced Kool-Aid.
Consumer and business confidence requires public sector certainty. It can’t be up for debate whether or not the government should honor its commitments.
Several state and local governments aren’t doing any better. Solving budget problems by going to war with workers and constituents is like pouring acid on confidence.
The Fed’s ability to help the economy is very limited when fear drains money from the productive economy. For better or worse, when the Fed can’t help, it’s up to our elected officials to fix the economy. Unfortunately, it’s these elected officials that led us into the shadow of the valley of economic death.
Despite evidence to the contrary, politicians continue to believe that their words and personal deeds don’t matter; that there are no consequences to creating uncertainty by threatening to unilaterally break contracts and bankrupt people that trusted the word of the United States.
Until our elected officials stop threatening an economic Jonestown, we are doomed for as far as the eye can see.