YOU DECIDE: Will more money help the economy?

Date posted: October 29, 2010

Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

First there were the Bush tax cuts of the summer of 2008. Then there was the TARP (Troubled Asset Recovery Plan) of the fall of 2008. Last there was the stimulus plan in early 2009.

But still the economy struggles. The latest statistics for North Carolina for September do show a lower unemployment rate — at 9.6 percent — yet that same survey showed the number of jobs falling and the number of people dropping out of the labor force increasing.

Is the government out of ammunition for boosting the economy? The Federal Reserve doesn’t think so. Indeed, the Fed is planning its own stimulus plan that could be the biggest yet. The question is, will it work?

Before I answer, let me summarize what the Fed is and what it does. The Federal Reserve is the nation’s central bank. It has extensive regulatory powers and serves as a backstop to banks that get in trouble. It also controls the currency we use (the dollar) in day to day transactions.

The Fed has been charged by Congress with pursuing two goals: price stability and full employment. The Fed has two arrows in its quiver to deliver on these goals. The Fed has the power to raise and lower some key short term interest rates, thereby making it harder or easier for people to borrow and spend. It also has the power to both create and destroy money.

Since the recession began, the Fed, often behind the scenes, has been using both of its arrows to contain the recession. It has lowered its key short term interest rate from over 5 percent to near 0 percent today. And from the fall of 2008 to the summer of 2009, the Fed pumped an additional $1 trillion into the economy.

Late last year, it looked like the Fed’s efforts — and maybe those taken by the President and congress — had worked. Production in the economy was beginning to increase. Jobs also began to come back, and the unemployment rate dropped.

But this summer and fall it looks like the economy has stalled again. The stimulus plan is beginning to wind down, and it doesn’t look like it will be renewed. The Federal Reserve has pushed interest rates down as far as they will go. So there’s only one arrow left — the money supply.

Fed Chairman Ben Bernanke has indicated he is ready to turn on the money printing presses again. We don’t know how much more money will be printed — estimates range from $500 billion to $1 trillion — but it looks like it will be coming soon.

There are three questions about the Fed’s new rescue plan for the economy:  why is it being done, what are the risks, and will it work?

The answer to the “why” may be puzzling. The Fed will be printing more money because Fed officials are deathly afraid of deflation. Deflation is the opposite of inflation. With inflation, prices are rising. With deflation, prices are falling.

The big problem with deflation is that it makes debt and debt payments more expensive. Deflation means the value of the dollar increases. Therefore, anyone with debt or debt payments stated as a specific number of dollars sees the effective cost of their debt rise when deflation occurs. Inflation does the opposite; it effectively reduces the cost of debt.

Therefore, the Fed wouldn’t mind seeing a little more inflation created to help debtors. More domestic inflation would also help exporters of U.S. products and services increase their sales in foreign markets by pushing down the international value of the dollar. Many see increased exports to foreign buyers as the best opportunity for economic growth.

However, the Fed’s new money creation policy also carries risks. It could eventually send inflation too high and bring back the days of “stagflation,” sluggish economic growth with high inflation. It could motivate similar moves by other countries, thereby sending the value of all currencies down in a race to the bottom.

Lastly, many of the extra greenbacks could find their way to investment markets like stocks, commodities and bonds, potentially causing an investment bubble that could eventually burst and sink the economy.

So will the Fed’s new policy work? Most economists see it more as a backstop for the economy, preventing a further slide, rather than a move that will quickly turn the economy around. Chairman Bernanke is a student of economic history. He realizes the devastation deflation inflicted on the U.S. economy in the 1930s and to the Japanese economy in the 1990s. He thinks it’s an imperative to avoid a repeat today.

When I came to North Carolina in the late 1970s high inflation was the big problem. Now the fear is the opposite: deflation. Will we ever get price changes just right? You decide!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks.

Related audio files are at http://www.ncsu.edu/waldenradio/

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