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How Politics Caused Fiscal Disaster

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And how central banks threaten prosperity by printing money backed by nothing.

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It goes without saying that believers in the elixir of counterfeit money and credit, which is to say Keynesians, monetarists, and Goldman Sachs (GS) partners, will dismiss all this as flat-earth doctrine -- fossilized ideas pre-dating the discovery of government's wondrous power to manage the macro-economy.

Still, a doctrine that holds out the state as an agent of economic betterment suffers from some deep flaws of its own. Decades of experience show, for example, that fiscal stimulus is an exercise by which one class and region steals from another. But the worse flaw is the hallowed central bank doctrine that deflation is always bad. In fact, wrong-headed deflation fighting is what generated the boom of the 1920s and the subsequent bust -- a scenario repeated almost exactly during the last decade.

The famous quote from "Bubbles Ben" about the Fed at Milton Friedman's 90th birthday is thus replete with irony. Said Bernanke in November 2002: "You're right. We did it. We're very sorry...we won't do it again." But the Fed did it again, generating the most massive speculative bubble ever. And this time the Fed even assured that if a bubble should ever break, it would stand ready to -- well -- rinse and repeat!

Here, the Austrians note that the central bankers' allergy to deflation is rooted not in sound economics, but in weak politics; in the catering to the pressures of promoters, speculators and borrowers. In fact, the Austrians showed that deflations owing to powerful secular cost-reduction trends -- whether based on new technologies, new economic geographies, or new forms of enterprise -- are healthy. They raise real incomes and wealth, even as they cause commodity prices to fall.

Thus, the East Asian export machine far outranked every other cost-crasher in recorded history. It bested the Internet, Walmart (WMT), Henry Ford's moving assembly line, central station electric power, the railroads, canals, the steam engine, the spinning jenny, and, while we're at it, let's throw in the wheel, too!

The Fed's strategy in the face of the Great East Asian Deflation, then, was exactly upside down. It should have raised interest rates and liquidated credit in order to encourage a deflation of domestic wages, prices, and corporate cost structures which were no longer competitive or viable in the new global markets. But by keeping interest rates absurdly low on the pretext that the "core" CPI Index was, as it was pleased to say, "well-anchored," the Fed thwarted the fundamental economic adjustments that were vital for the American economy to regain its footings.

The "panic of 2008," therefore, wasn't a random policy error, nor was it caused by the machinations of overly-bonused bankers. In fact, the massive quantities of unsupportable debt and the vast malinvestments in housing, banking, shopping malls, office buildings, and Pilates studios, too, which came crashing down last September, were rooted in history's other star-crossed rail car. That was the gilded club car which in November 1910, had secretly whisked away Senator Nelson Aldrich and his coterie of Morgan, Rockefeller and Kuhn Loeb bankers to a duck-hunting blind on Jekyll Island, Georgia.

The truth is, the monster that was hatched there -- the Federal Reserve System -- has always been an instrument of politics; that is, the politics of the speculative classes, whether domiciled on Wall Street, Main Street, or the Agrarian plains. Let the political chatter get fevered enough about unfairly "low" prices for goods, grains, or labor and there's invariably been a new theory and willing maestro at the Fed to print-up some easy credit.
No positions in stocks mentioned.

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