Feeding Chickens with Fish
"The mystery of government is not how Washington works but how to make it stop."
- P. J. O'Rourke
Scott, great thanks for a very detailed response. It is hard to disagree with you as government is simply terrible at allocating capital. As P.J. O'Rourke also said, "giving money and power to government is like giving whiskey and car keys to teenage boys". Only the invisible hand can facilitate an efficient allocation of capital. So as I mentioned previously, I am THE capitalistic pig.
I lived through a miserable experiment of government trying to allocate capital. I don't know how my parents managed to feed me and dress me in Russia - I am sure it was a miserable task. The place where I grew up (I will not disclose it at this point, as Mr. Collins promised to make it a future trivia question) had an abundance of fish, but little vegetation. Thus, chickens were fed fish powder and chicken tasted like fish. To this day I am still not a big fan of chickens. A lesson in economics here: if the invisible hand was "in charge" of the Russian economy, fish would have been bartered or exported to any developed nation in exchange for enough chicken food to feed the whole chicken population of Russia.
I think there is a place for a Federal Reserve in the economy. The Federal Reserve should not try to micro-manage the economy on a constant basis. However, I truly believe it should play a role as the lender of last resort and provide stability to the banking system.
It is hard to argue with the moral hazard argument; it is a very important risk. And your argument is well supported by what transpired in Japan over last decade, where government altered the formula of capitalism (remember: the creative destruction) by not letting companies go out of business. Thus maintaining many should-be-dead companies on life support and creating a zombie economy. We are in agreement that Federal Reserve or any other government agency should not be bailing out companies when they make bad investments or are simply mismanaged. Even if General Motors (GM) (being a somewhat important to the economy, though to a lower degree than ever before) goes bankrupt, the Federal government should let it fail.
Capitalism is Darwinism at its best (or its worst depending on ones perspective); It is about survival of the fittest, not survival of whoever employs the most. However, capitalism doesn't exist anywhere in its pure form. I believe it existed for a little while in the beginning of 20th century in United States, but it was gradually diluted with socialism as unions gained more power.
Every developed country aims to strike a balance between capitalism and socialism. Though some will not agree with me, the United States has done the best job doing that in my view. I am not saying we have a perfect balance but it is the best there is. Canada and most of the Europe have failed miserably at striking the balance and now they are gradually trying to rebalance it, tilting towards capitalism (latest developments in Germany come to mind when I am writing this).
I digress, back to your argument. By creating liquidity Federal Reserve doesn't give free money, it creates cheap money, and cheap money is not free. Banks when they loan (cheap) money still expect to receive a coupon (interest) payments and repayment of principal, thus I don't think your analogy holds here.
I am not honestly sure what school of thinking I belong to. But after your comments, I bet Austrians will not accept me into their school. So I'll remain school-less for now, or I'll start a new school (open for suggestion on this topic).
Federal Reserve Banks may play a certain part in political process, but transformation from the gold standard to a fiat money has not just happened in United States, it happened throughout the developed world. It was initiated in Great Britain in 1930s, so arguably the US followed the UK's lead. Thus, I would not necessarily blame the Fed for the inflation that is caused by fiat money. Also, the Federal Reserve was set up to be an apolitical government body (maybe that is an oxymoron in itself), similar to the supreme court it is very independent.
I listened to many of Uncle Al's testimonies to the Congress and he kept his political views to himself. I think your distaste with Federal Reserve goes far beyond the Mr. Greenspan, you have an issue with the institution itself. Thus even if the John Maynard Keynes or Adam Smith, or whoever is their equivalent in the Austrian school of thought was running a Fed you would still have a problem with that person.
Now, let us get back to bubbles. Bubbles are created by many different factors but there is a common element at the core of any bubble - human psychology. (I wrote an article on that topic that should appear some time next week in Financial Times). Your argument that all major wars in the last 300 years were preceded by inflation may not be accurate. WWI was preceded by inflation but WWII was not. Germany was already out of hyper inflation by the time WWII started. WWII pulled the US out of deflation. The great Holland Tulip and Florida swampland bubbles (though were not wars) were not preceded by inflation.
Your argument on inflation robbing people is well taken, and you would be pleased to know (and I am sure you know) that Mr. Buffett supports it as well. But the world has adapted to a very mild inflation: it priced into bonds (most of the time), companies raise prices based on the inflation expectations, and employee wages are adjusted for inflation as well (arguably with a lag, I think that is the argument you are making).
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