The victory balloons still had air in them at many Republican campaign celebrations last week when Ben Bernanke and his colleagues on the Federal Reserve Board let loose with a heavy spray of cold water on all those candidates who have vowed to keep government spending under control.
In one fell swoop, the Fed released a chunk of new money into the economy by way of a $600 billion purchase of treasury bonds. While this action doesn’t result in immediate cash flowing into the economy, as the Obama stimulus act of 2008 did, the Fed hopes it will have the same positive effect, to wit: an increase in economic activity.
Okay, I know that any time mention of the Federal Reserve gets into a conversation (or a blog post) most people look for someone else to talk to (or something else to read). But hang with me on this one, because I’m going to make it easy to understand.
Let’s talk a little unadulterated Econ 101. You know, that course that you never took because it included too much math. Here’s the pared down version, without all those troublesome numbers.
And today’s lesson, since we are still suffering from the throes of it, is recession.
Recessions occur when the flow of money in an economic system is too slow (or the demand for it is too weak).
Think of the economy of a community as measured by the amount of money in circulation. Assume there is a fixed amount, that is, there is only so much, and everyone in the community has to get by on what there is.
Assume that in this community, as in all modern communities, certain members of the community (we’ll call them merchants) set up shops in which they sell goods that they believe other members of the community want and/or need. As goods are produced by these merchants’ shops, they are offered for sale to other members of the community who pay for those goods with some of the money they have.
The merchants then give some of the money they receive for the sale of those goods to their employees, the folks who actually got their hands dirty making the goods. Those folks, of course, then go and buy other goods from other merchants who also employ folks who make their goods.
Of course, the merchants keep some of the money they receive for themselves. They use some of it to buy goods for themselves and their families (just like all the other members of the community), but they also use some of the money to expand their own businesses. For example, they increase the production of their original goods so they can sell more of them or they expand the line of goods they produce so they can increase the market of potential buyers of their goods in the community.
In the meantime, the workers (employees) seek more money from the merchants so they can buy some of the goods they haven’t been able to afford before. The merchants want to keep their employees happy, because without them they won’t have anyone to make the goods their shops sell, but they don’t want to give them too much money, because if they do, they won’t have as much for themselves and for the expansions they want for their shops.
So the merchants work out agreements with their employees who then use the additional money they receive from those agreements to buy more goods from more merchants.
Now eventually, as more goods are produced that more members of the community want to buy, that fixed amount of money that the community has to pass around from merchants to employees to other merchants and to other employees and so on is just not going to be enough to keep everyone happy.
At that point more money is needed to keep everyone happy. So, the community creates a central banking system that is responsible for keeping enough money in the flow to keep everyone happy. And that, essentially, is the Fed’s job. (It’s also the government’s job, but in our story, we’re assuming the government of our community is impotent for reasons that we’ll call “gridlock”).
In a smoothly running economic system, the flow of the money in the community is at a pace that is just fast enough to keep everyone happy (and by happy, we mean that everyone has just enough money to buy the goods they need and want and that the merchants have enough money to pay their employees and to expand their own shops).
But sometimes things happen in the community that mess up that all-important flow of money. Sometimes, for example, natural or human created calamities occur that require everyone to give up lots of money to save a segment of the community. (For real examples of this phenomenon, see Hurricane Katrina, TARP and the Iraq and Afghanistan wars.) Then, after that calamity has passed the members of the community may feel (perhaps correctly) that they have less money to do the things they used to do.
Suddenly that all-important flow of money slows appreciably. Now the merchants aren’t selling as many goods because the employees of the other shops aren’t buying them. Now merchants are getting less money to pay their employees, and so they are laying off some of them.
Now with fewer people working, the flow of money slows even more, and before long a vicious cycle of less money being circulated in the community becomes an economic slowdown that is called a recession.
The government, if it weren’t in gridlock, could resolve the crisis by pumping more money into the community, perhaps by passing a stimulus bill, thereby increasing the flow of money. But with the government in gridlock, the Fed has to step in.
It can create more money, because the community has given it that power. And so the Fed creates more money in the hope the increase will stimulate the merchants to use more of it, which will then lead to more employees spending more and more merchants hiring more employees.
Eventually, the economy of the community will revive if enough money is pumped into it, because having money, as we all know, creates an inherent instinct to spend it (in one way or another). Individuals look for new things to buy/own; merchants look for new ways to grow their companies. That part of our story is called the human condition (greed might be another word for it) .
Recessions are part of the economic cycle. In time, they end, whether because of naturally evolving market conditions or because of Fed/government intervention. Doing nothing can work, but it can take a whole lot longer and be a whole lot more painful for just about everyone in the community.
Ben Bernanke understands this little lesson in economics, even if his Republican friends in government don’t.