Some thoughts on the Current Economy

I’ve been following Peter Schiff, Jim Rogers, George Soros, Warren Buffett and Marc Faber lately.  I’ve also been watching Obama and Bernanke’s speeches.   And here are some thoughts about current state of the economy and where it is going:

The recession is deflationary because the current price levels are the results of the excesses of the consumption and credit bubble.   After the bubble busted, there are an over-supply and over-capacity of everything:  oil, houses, cars, cloths, over-paid employees.  Deflation is market’s way of getting rid of the excesses, punishing the debtors, rewarding the savers, making resources affordable for entrepreneurs who would re-allocate resources more efficiently.

Unfortunately, the government is the biggest debtor of us all.  Therefore, deflation would mean the debts the government owe would become more valuable in the future.   Considering that a large portion of the debt are owned by foreign countries and investors, it is in the best interest of the U.S. government to engineer inflation rather than deflation into the economy.   That’s why Bernanke and Obama keep telling us deflation is evil.

I can understand the government’s rationale that a deflationary spiral would be awful.  But if the government acts as the lender of last resort, new entrepreneurs would jump into the scene and snatch up these resources when they are cheap enough to justify a profible business.   I think here is where the government got it wrong.  Instead of allowing the market to spur new businesses, the government is trying to do it artificially by spending on energy reform, health care reform, education reform, etc, etc.  What the government fails to understand is that these investments would not be profitable because:

1.  If they would be profitable, the entrepreneurs would see the opportunities way before the government sees them.

2. The government has not run anything efficiently in the history of mankind.  It’s not the government’s job to run profitable businesses, and it does not know how to do it.  Government spending is more likely to be wasteful at best.

3. The government does not know where to invest and how to invest.  Central planning has never worked and never will.  Capital allocation are best done at the private sector.  One reason for this is that the government employee that makes decisions bears no personal financial risk should the investment go wrong.  On the other hand, an

entrepreneur risks financial losses should he makes a bad decision.

It is true that this country needs to produce more scientists and engineers.  Under market economy the shortage of scientists and engineers would reflect on their higher salaries, and therefore attract more students into these fields.   Obama’s education reform totally ignores this fact.  Students do not want to become scientists and engineers because the benefit does not justify the hard work one needs to put in.  In the past two decades the brightest minds have gone into the finance industry because that’s where the money is.  Since Obama is not letting the banks fail and bankers are still getting crazy salaries and bonuses, more bright students will get into the field and make crazy financial engineering feats that provides no value to society.  The whole financial industry is over-bloated and must be allowed to shrink.  The re-structure of the economy would depend on bright students going into industries that provide exportable goods and services.

From Obama and Bernanke’s speech it seems that their intention for the bank bail-outs are to prevent a financial meltdown.   The financial system is saved at the cost of tax payers absorbing the losses from bank’s bad bets.   Eventually these losses would have to materialize.  Obama’s only hope is that the economy would turn healthy enough (produce more) to pay off these losses over time.  It might work out if his plan actually will do what he promised.  But I am skeptical on that because government and bureaucrats are never good at allocating resources efficiently.  And Obama’s reforms and stimulus would not turn a profit, and would need subsidies by taxing profitable businesses in the economy, or borrowing more from other countries.

Many people are talking about a currency crisis for the dollar.  The dollar has not devalued in the past decades because foreign countries are buying U.S. treasuries.   Since the government would not allow deflation and encourages inflation, foreign countries are more worried about the value of these debts and the dollar reserves.  That would pressure the dollar to devaluate.   As a result, imported goods becomes more expensive and causes more inflation.  At this point the Fed would have to raise interest rate to slow down inflation, which will hurt the recovery, and drive the economy into stagflation.

So there are three scenarios:

1. Government allows deflation, which would make our exports more appealing and make our currency stable.  But deflation is devastating to all debtors, which includes most U.S. tax payers and the government.  So this happening is unlikely as it might result in revolts and social unrest.

2. Government does not allow deflation, hoping foreign countries will keep lending us money.  If this happens the economy will start to recover due to the injections of liquidity.   But the recovery would be a very slow process as the Fed will pull out money supply at any sign of increasing inflation.

3. Government does not allow deflation, and foreign countries stops lending to us.  The government then would have to increase tax, or print more money to fund its projects.   At the same time the dollar devalues and consumer prices rise.   The government might be force to choose war against other countries, social revolt, or hyper-inflation.