In Case of Economic Collapse: How to Fix the Economy

Every one seems to agree: the economy is in a ditch. Agreement on a solution, however, is less than unanimous.

The first problem is knowing what to call the current situation. Selecting the right solution requires knowing what's going wrong.

Although it may not be a textbook case, our situation could be considered 'deflation.' I base this on duck theory; that is, if it walks like a duck and quacks like a duck, then it is a duck. The symptoms that we're experiencing seem to be symptoms that reveal themselves during deflation.

In a previous article we discussed what is deflation. In short, deflation is widespread falling prices caused by people's falling expectations.

In 1929, during the kick-off of the last economic crisis, stock prices (as measured by the Dow Jones Industrials) fell 50%. The deflationary period that followed lasted ten years.

In the most recent shock, from late 2007 to early 2009, world stock prices (as measured by Wilshire 5000) fell over 68%.

Then, something occurred that made all the tell-tale signals of deflation disappear: on the brink of a total economic collapse, governments increased spending and added to the money supply to prop up economic activity. Depending on who you are, you might not have felt the shock at all.

In the US alone, $11 trillion dollars in spending and backstops -- including 1.2 trillion 'stimulus' commitments, a $700 billion TARP backstop from the Treasury and $6 trillion from the Federal Reserve -- were added to help mute the blow to the country's $15 trillion economy. [Source: CNN-Money]

In addition, the Fed was able to effectively double the amount of money in circulation by claiming it held an additional amount on behalf of its member banks. [Source: Fortune ]

So, basically, there was a lot of new money added to the US economy to mask the trillions of value that was lost in 2007-2009.

Indeed, in terms of prices in the US stock market, by the middle of 2012 values have nearly fully recovered.

All this is wonderful news, except that pumping money into the economy is not the cure for deflation.


The leaky bucket model
The leaky bucket model

Pumping Money into a Deflationary Economy

It sure makes sense that if the value of everything was falling, you'd simply give people more money, which they'd spend, and the economy would be saved. Right?

The problem is 1) that you can't force people to spend the money you give them and 2) you haven't addressed the root cause of the deflation -- that people's expectations about the future is falling.

Until the root cause is resolved, people will take the money you give them and pay down their loans, or save it for a rainy day, rather then spend it.

Just take a look at some recent headlines to see how people are thinking of the future:

Bloomberg: Recession Generation Opts to Rent Not Buy
Kiplinger: Businesses Hoarding Corporate Cash

The current situation is tantamount hiding a hole in a bucket. By keeping a constant flow of water flowing in, most would never realize that water was escaping.

The moment you shut off the life support -- that is, stop throwing money into the system -- the economy is likely to fall again.


Government: The Answer? [image: yourdchotels.com]
Government: The Answer? [image: yourdchotels.com]

What Can Government Do to Fix the Economy?

Liberal governments often promote spending as an economic solution. To fight deflation their answer is: stimulus, bail-outs, government guarantees, and more regulation to ensure economic protection.

Conservative governments usually promote the opposite. To fight a downturn, they promote austerity, tax cuts, deregulation and trickle down economic theories.

To be fair, when the panic of deflation actually hits, both conservative and liberal governments use the other's bag of tricks to attack the problem. The conservative Bush government turned away from austerity and introduced stimulus. The liberal Obama government allowed tax cuts.

The dirty little secret that both liberal and conservative parties don't want you to know is this: deflation can't be fixed by government.

Both parties want you to believe that each has the answer -- that they just need your money, and your vote, to make things right. Nothing mobilizes a political base, and a nation's electorate, like an economy that needs to be fixed.

The problem is that, for liberals, pumping more water into a hole-filled bucket will not work forever.

And for conservatives, curing a downward economy with an austerity diet might theoretically pay off in the long run, but could kill the patient in the short run.

Both parties have found scapegoats to demagogue: banks, labor unions, illegal aliens, high taxes, government mismanagement, imports, politicians, etc. But these issues are props for political theatrics -- they cause a sensation when they're used, but they have no relationship to the real problem, or the solution.


Source

So How Does the Economy Get Fixed?

The short answer is: the economy needs to fix itself.

The economy is a system, and like any other system, it's always looking for balance.

In this case, an economy is a system of values, as measured in prices, of the resources we collect and the work we produce.

At the core of it all is the process that the system uses to determine the value of everything.

In this dynamic system, the value of things will fluctuate, always searching for equilibrium. The value might be based on the work you'd have to perform to create the resource yourself, say, to grow the food to feed your family. Or what value (price) you might give to another, to provide you that food, while you do some other, more productive effort.


Understanding How We Set Values

At any given time, the value of any particular item will be effected by the supply of that item, the demand for it, the future value (based on our outlook for its future supply and demand) of it, and how fast the whole economy is expected to grow in the meantime.

So part of value is determined by pretty stable things like: the quantity of an item and the current demand for it.

Another part of value, is less certain: the future value of an item. This component of value can be all over the map, depending on our mood.

In a growing economy, we tend to look at things from a forward perspective, and invest in current resources and work based on a belief that we will be in a more profitable position in the future. We'll live with a positive outlook that values will keep growing, that the loans will be repaid, that our work and ideas will continue to have value for others. With a positive (some might say 'greedy') outlook, we'll tend to value things more.

In a shrinking economy, we'll see things from more of defensive perspective: we'd rather sell our resources and wait for prices to fall to safer levels before buying anything again. We'll tend to fear losing our job, missing a mortgage payment, seeing our investment lose value, laying off our employees. With a negative (aka 'fear') outlook, we'll tend to value things less.

This seems to be the state of our economy today.

The system of values constantly readjusts as we people pass through the human phases of positive and negative outlooks. The economy grows while we are in our positive outlook and contracts once we feel we have overestimated.

At any given time, the value of any particular item will be effected by the supply of that item, the demand for it, the future value (based on our outlook for its future supply and demand) of it and the expected rate of growth of the economy in general.

An economic jolt takes place, not because of current supply and demand issues, but because the future value component changes. When we go from growing values to shrinking values, prices can go quickly from upward to downward.


Falling Prices Meet the Falling Multiplier Effect

An economic jolt is magnified because of the way our banking system works, using the money multiplier.

When prices go down and people start reducing their bank accounts, the money supply is reduced by tenfold (or more) based on the money multiplier phenomenon.

The result is that we feel the economy is in free fall, because it essentially is.


Falling Prices
Falling Prices | Source

When Do Falling Prices Stop Falling?

Prices stop falling when they reach a new equilibrium -- where the supply, demand and our future expectations all line up again.

The solution has nothing to do with stimulus or tax reform.

It's about the economic system taking us from a period where we overestimate and over-compensate, through a period where we re-estimate with more attention paid to risk and the downside.

How far down will prices go?

No one has a crystal ball, but it's conceivable that, as far we let things become overpriced, prices could become just as under-priced eventually.

That's how the economic cycle works, because that's how we humans work -- going from greed to fear, and back to greed again.


Mr Fix-it
Mr Fix-it | Source

Where's Mr Fix-it?

Unfortunately, we humans seem to share a common trait: we tend to believe that we can 'fix' our surroundings. This leads us to believe that we -- or our leaders -- can fix a deflating economy.

But, just like we can't fix the weather, we're probably out of our league when it comes to reversing deflation.

But didn't Franklin Roosevelt implement a New Deal that cured us from our last bout of deflation? Not really. The natural growth that occurred after the industrial base was blown to bits during World War II was a much bigger factor.

Certainly, the New Deal's process of keeping people active in programs like the WPA helped many folks stay out of trouble. But it wasn't until after the War, and the world decided to invest and rebuild, that we realized a full recovery.


Practical Solutions

Government can serve a useful purpose during the downward episodes -- not as an economic manipulator -- but merely to provide a safety net for those who are bound to become displaced.

Unfortunately, there is no silver bullet solution to cure deflation. When experiencing an economic downturn, the most practical solution is to learn how to wait it out.

It's the same advice you'd receive if a large winter storm was heading your way: do your best to anticipate it, prepare for it and cope with it until it's over.


For more about deflation and what you can do to protect yourself from it, see my hub/article on deflation.

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