The Governments Dilemma – Is there a Way Out or is it a Catch 22

WHERE  HAS  COMMON  SENSE  GONE, No. 18, Thomas Paine – March  2011

Economists have a well recognized axiom used to describe one aspect of production activity. It is called the “Law of Diminishing Returns”.

The law states “that we will get less and less extra output when we add additional doses of an input while holding other inputs fixed. In other words, the marginal product of each unit of input will decline as the amount of that input increases holding other inputs constant.”

What does this axiom really mean? A simplified example can be used to illustrate what is meant.

Suppose a farmer has typically harvested 100 units of crop for every 100 pounds of seed he has planted in his field. This ratio has held steady for years with only minor variances due to generally benign weather conditions year to year. The 100 units of crop can be considered the economic production. The inputs are the amount of seed sown, the available amount of land, the amount of fertilizer applied, the number of days of sunshine and normal temperature and the amount of rain that falls.

Now suppose the farmer wants to increase his crop yield. Some of the inputs are under his control and some are not. It is pretty clear that fertilizer and seed are under his control while the amount of land is fixed and the weather is not under his control. He looks at the cost of additional seed and at the cost of additional fertilizer. Seed being by far the cheaper of the two, he decides to sow more seed without adding more fertilizer which is very expensive. The farmer then proceeds to double the amount of seed he sows. He does not really expect to get twice the crop yield but any increase in yield even close to double will have made a dramatic improvement in the units of crop he produces for negligible increase in cost.

Now suppose the weather remains unchanged from the norm. The farmer is delighted when he sees that all of his seed is growing and the weather is cooperating. Then somewhere between planting and harvesting things take a turn for the worse. It becomes clear the crop will be stunted. The seed is experiencing too much self-competition for the other available units of input. The farmer doesn’t like what he sees but there is no way to effectively remove every other plant in order to achieve normal crop density. He is not too worried though. If he only gets ten percent more yield the extra seed has been more than paid for. As the growing season progresses it becomes increasingly clear that the crop is not doing well at all. Over abundance of seed has increased the number of plants trying to occupy the same space and all plants suffer the consequence of poor decision making by the farmer who was looking for an easy way to prosper with minimum additional effort.

Alas, the crop is harvested and the farmer finds that his field has produced less crop yield than if he had not planted extra seed at all. Once again the law of diminishing returns has been validated!

Now let’s see if we can use the law of diminishing returns to construct a simplified version of what is going on in the economy. We will have to resort to a much simplified version since the factors of improved production (economic expansion) are manifold. These factors are numerous and they are complex. Complex enough to keep an army of economists occupied just in trying to understand what is going on in the economy. There seems as yet little consensus.

Let’s look at what we can now see as actual events following the bursting of the housing bubble. We might want to recall the term “seed money” while remembering what happened to the farmer in the previous example. We won’t refer to seed money again but the reader may wish to recall the term every time he sees money related terms in the following narrative……….

Initially, the economy started to feel the effects of the bursting of the housing bubble. The Federal Reserve reversed track and lowered interest rates and congress flooded billions of extra dollars into the economy.

Unemployment started to increase!

The Government subsidized new homes through tax credits.

Builders kept building and the inventory of unsold homes increased even as house prices continuously decreased!  Economic productivity declined!

The Government launched a full suite of tax credits and subsidies.

Unemployment Increased!

The Government spent more billions keeping insolvent business afloat.

The gross domestic product declined!

The Government lent money to the large market center banks at almost zero interest rate to stimulate their lending and the resulting economic activity that lending would promote. The banks instead used the money to buy “risk free” Treasuries in order to improve their profit margins on a no risk basis! Besides, most business entities did not want to borrow their way into more debt. They were already too traumatized by the huge suite of Government regulations being promulgated by administrative decree.

People began to wonder, what is going on? The banks have lowered the interest rate on money they borrowed from me (my deposits) to the same rate they can borrow from a willing Federal Reserve, and they are using that money, conveniently multiplied by a fractional banking system, to buy even more Treasuries which further enhances their profits, at the same time giving the Government ready cash to spend on anything it wishes no matter how bizarre. This is a wonderful arrangement for the big banks, which by now also own the largest defaulted mortgage lenders. Why make any problematic loan to anyone in the housing sector when the Government is standing by with risk free Treasuries. But how did the banks, which were so recently in dire straits, initially come up with the money to start the Treasury buying process? Oh, I forgot the Government had already handed to banks billions of dollars and received mostly worthless paper in return, called TARP.

Unfortunately the economic units of production continued to decline. The Government decided to accelerate spending to stimulate the economy.

Now the banks started to worry. What if the Federal Reserve printed so much money the dollar would start to decrease in value causing commodity prices and most everything else to rise. If this price movement became acute enough, the Federal Reserve would be forced to raise interest rates on the money the Government had borrowed from it. But wait, if interest rates should rise the Treasuries the banks are holding will fall in price and the banks could lose much more than they have gained since that same fractional banking system which served them well on the way up, works against them on the way down. In fact they could lose so much money they once again might become insolvent. Diminishing returns one might say!

The banks started to lose their appetite for more Treasuries and actually started making a few conventional loans. This loss of appetite by the banks is not good for the Government since it is spending so much money it literally cannot stop the process. If it did stop spending, the thousands of newly hired government employees will have to be terminated and the unemployment rate will shoot up again. Besides, under the existing arrangement, it is mostly Government spending that sustains the economy.

The public has by now become wise to the sweetheart deal the Government has made with the Money Center Banks. The public now starts to understand the tax-paying public will be the ones who will have to pay the bill for excess spending no matter whether they pay for a Government bailout or a bank bailout.

Enter QE1.  The Federal Reserve ramps up printing money (electronically) and uses it to purchase notes directly from the Treasury. This is a good deal for both of them. The Government gets oodles of cash to spend and the Federal Reserve gets to keep interest rates low, which it hopes will stimulate economic activity sooner or later. At the same time the Federal Reserve does not have to rely on  those pesky banks which are more interested in making money than actually promoting increased economic activity.

What a great deal. The Government gets to do what it does best, spend money inefficiently for everything except the inputs to increased economic productivity. The Federal Reserve gets to inflate its balance sheet with unimaginable amounts of Treasury paper that everyone knows is “risk free”. Even better, the persons making the decisions at the Treasury and the Federal Reserve are not elected and therefore not answerable to the taxpayers. They serve at the whim of the person most needing the appearance of robust economic activity if he is to be re-elected, the President of the United States. The elected representatives of the public, the same public which will ultimately suffer the consequences of this corrupt arrangement, are not even allowed to audit the balance sheet of the Federal Reserve because they are so economically illiterate they might jump to the wrong conclusion. Also Congress is excluded from any Federal Reserve oversight, the reason given being Congress cannot be trusted to behave in a nonpolitical manner. (Some truth to this, but even biased oversight is better than none at all).

But wait, in our analogy everything was supposed to stay fixed in the rest of the world while we solved our own problem. However it starts to appear many other developed countries have been playing the same game the United States has played. They have also spent too much money. Money they had to borrow from somewhere.  Un oh!  Many of them cannot just ask their “federal reserve” to print them some more money, since much of Europe has gone to a common currency. This is a problem. In the absence of more revenue, or borrowed money, they must cut spending or default since their tax rates are so high it is literally impossible for them to be raised. This is not going to be fun for them.

“Fortunately” the United States does not have this constraint. It can still print money, and none of the other nations will object too much since the U.S. dollar is the reserve currency for the world. This is good for our Government since it allows the United States to continue spending in a way the rest of the world is unable to do. Besides no one knows for sure how many dollars are sloshing around out there since there is no way to accurately measure them. It might be good for Government but it is bad for the people. However, in a time of stress this doesn’t matter. After all the people are not the ones trying to get re-elected. Prices might go up in dollars on a global basis as the value of the dollar sinks but, what the heck, things will surely pick up soon. Besides the Federal Debt Limit is still relatively far away.

Enter QE2. One might think the Government is like a poker player trapped with a bad hand after having put too much money into the pot. But this isn’t poker; the Government can’t just fold its hand, because it would not be allowed to participate when the next hand is dealt. The Government has started this process and it will have to play the hand out.

Economically things may be getting a little better though. True the price of houses, that started all of this, has not quit falling, and the price of food is starting to move up strongly and most commodities are experiencing substantial price increases, but, hey, this could be the sign of an improving economy. When the cost of everything bought rises the Gross Domestic Product calculates out at a higher rate giving the Government something to point to and say its policies are working. Inflation could remain low, especially since the Government has caused food and fuel to be eliminated from the calculation. The slump in housing cost, while actually hurting the people helps the Government since it stays in the calculation. This gives the government another “positive” marker to point to. Isn’t it strange how the entity that gets to provide its own performance metrics always seems to have the best results? After all the Government has hired enough public sector workers to cause the unemployment rate to fall by 1/10 of one percent.

But wait; do these thousands of new government employees not want to be paid?  Doesn’t the Government not have to spend still more money to pay them? Not necessarily. The Government would be paying them extended unemployment benefits if they were not working, and if they had not previously been working the government would be giving many of them a myriad of support payments. Of course, the public has now learned that the average government worker earns thirty-four percent more than the average private sector worker while also enjoying substantially better benefits. The public may not like this but the public should take heart in knowing that much of their Government business will now be handled by persons unskilled and formerly chronically unemployed. And, oh yes, for the most part government employees are not engaged in any activity that enhances national economic productivity.

Not to worry, the Government can likely work all this out somehow if the other productivity inputs would just stand still and give all that Government spending a chance to work. But the value of the dollar keeps going down, just as the price of oil goes up. Surely this can’t be good for our current account deficit.

There must be some solution! Possibly the Government in a flash of inspiration will introduce QE3. After all QE2 is scheduled to end in June of this year. But wait the Government has reached the national debt spending limit much more quickly than originally anticipated when QE1 was introduced. The Government must find a way to increase its debt limit quickly or stop the unproductive spending. What if the Government was able to classify the Treasury borrowing as non-debt? Stranger things have happened! There must be some way for all of us to escape this debt trap without any pain or suffering.

Sorry to say folks, the answer is no. There is no painless way out. We are in too deep and it appears the Government is willing to go even deeper. Now is the time we really need some leadership in Washington. There are two basic options. Unfortunately they sound like a “Catch 22”. (1) accept some considerable pain now as the Government quits the wholesale printing of money, interest rates are allowed to rise and the government has to cut spending and raise taxes just to pay the increased interest due on our national debt, or: (2) keep printing and spending money to support  uneconomic activity until it is too late to avoid a general collapse of any remaining productive activity and the nation becomes totally divided into some haves but mostly have not’s, a much more painful and destructive option than the one proposed in (1).

So there you have it; a considerable amount of pain now, failing businesses, people out of work, or, an unbearable amount of pain later. This prospect is not what we have become used to and it is not going to be fun, but astute leadership can guide us through a very difficult few years so that we can come out on the other side bruised but not broken.  It would behoove us all to identify, empower and then work hand-in-hand with an astute leadership to promote only economically productive activity while eliminating government support to any vestige of uneconomic endeavor, letting the chips fall where they will. Really tough medicine, but consider the alternative.

Time to put a little Common Sense back into Government.  Remember this the next time you vote.

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