14/01/2011 – Understanding the Federal Reserve Bank

Jaguar Inflation
Excerpted from Robert Prechter’s February 2004 Elliott
Wave Theorist

I am tired of hearing people insist that the Fed can expand
credit all it wants. Sometimes an analogy clarifies a subject,
so let’s try one.

It may sound crazy, but suppose the government were to
decide that the health of the nation depends upon producing
Jaguar automobiles and providing them to as many people
as possible. To facilitate that goal, it begins operating
Jaguar plants all over the country, subsidizing production
with tax money. To everyone’s delight, it offers these luxury cars for
sale at 50 percent off the old price. People flock to the showrooms
and buy. Later, sales slow down, so the government cuts the
price in half again. More people rush in and buy. Sales again
slow, so it lowers the price to $900 each. People return to
the stores to buy two or three, or half a dozen. Why not? Look
how cheap they are! Buyers give Jaguars to their kids and park
an extra one on the lawn. Finally, the country is awash in
Jaguars. Alas, sales slow again, and the government panics.
It must move more Jaguars, or, according to its theory — ironically
now made fact — the economy will recede. People are working
three days a week just to pay their taxes so the government
can keep producing more Jaguars. If Jaguars stop moving, the
economy will stop. So the government begins giving Jaguars
away. A few more cars move out of the showrooms, but then it
ends. Nobody wants any more Jaguars. They don’t care
if they’re free. They can’t find a use for them.
Production of Jaguars ceases. It takes years to work through
the overhanging supply of Jaguars. Tax collections collapse,
the factories close, and unemployment soars. The economy is
wrecked. People can’t afford to buy gasoline, so
many of the Jaguars rust away to worthlessness. The number
of Jaguars — at best — returns to the level it was before
the program began.

The same thing can happen with credit.

It may sound crazy, but suppose the government were to
decide that the health of the nation depends upon producing
credit and providing it to as many people as possible.
To facilitate that goal, it begins operating credit-production
plants all over the country, called Federal Reserve Banks.
To everyone’s
delight, these banks offer the credit for sale at below market
rates. People flock to the banks and buy. Later, sales slow
down, so the banks cut the price again. More people rush in
and buy. Sales again slow, so they lower the price to one percent.
People return to the banks to buy even more credit. Why not?
Look how cheap it is! Borrowers use credit to buy houses, boats
and an extra Jaguar to park out on the lawn. Finally, the country
is awash in credit. Alas, sales slow again, and the banks panic.
They must move more credit, or, according to its theory —
ironically now made fact — the economy will recede. People
are working three days a week just to pay the interest on their
debt to the banks so the banks can keep offering more credit.
If credit stops moving, the economy will stop. So the banks
begin giving credit away, at zero percent interest. A few more
loans move through the tellers’ windows, but then it
ends. Nobody wants any more credit. They don’t care if
it’s free. They can’t find a use for it. Production
of credit ceases. It takes years to work through the overhanging
supply of credit. Interest payments collapse, banks close,
and unemployment soars. The economy is wrecked. People can’t
afford to pay interest on their debts, so many bonds deteriorate
to worthlessness. The value of credit — at best — returns
to the level it was before the program began.

See how it works?

Is the analogy perfect? No. The idea of pushing credit
on people is far more dangerous than the idea of pushing
Jaguars on them. … I hate to challenge mainstream 20th
century macroeconomic theory, but the idea that a growing
economy needs easy credit is a false theory. Credit should
be supplied by the free market, in which case it will almost
always be offered intelligently, primarily to producers,
not consumers. Would lower levels of credit availability
mean that fewer people would own a house or a car? Quite
the opposite. Only the timeline would be different. Initially
it would take a few years longer for the same number of
people to own houses and cars — actually own them, not
rent them from banks. Because banks would not be appropriating
so much of everyone’s labor and wealth, the economy would
grow much faster. Eventually, the extent of home and car ownership
— actual ownership — would eclipse that in an easy-credit
society. Moreover, people would keep their homes and cars because
banks would not be foreclosing on them. As a bonus, there would
be no devastating across-the-board collapse of the banking
system, which, as history has repeatedly demonstrated, is inevitable
under a central bank’s fiat-credit monopoly.

Jaguars, anyone?