Despite 13 rate cuts from the Fed, tax cuts from the White House, and continued deficit spending from all corners of Washington, our economy has only sputtered toward recovery. Worse yet, for all the attention focused on a successful short-term recovery, there seems a real lack of concern for our economy's long-term health.
The Federal Reserve has pumped up the money supply with massive open-market purchases of short-term Treasury bills. The dual effect is to inject liquidity into the system, while at the same time, keeping a lid on short-term rates. Now, there's talk of the Fed extending its open-market purchases to the longer-end of the yield spectrum to keep long-term rates low. Unprecedented as that is, it's within the Fed's authority, and the Fed seems ready to consider anything to prop up housing and consumer spending.
At the same time, by depressing the yield on bonds and other fixed-income securities, the Fed's cheap-money policy has served to prop up stock market valuations. But what's the long-term cost of inflating stock and bond values (remember, bond prices move opposite of bond yields)? Or scarier yet, what happens to the prices of these assets when the cheap-money stimulus is withdrawn?
Add to this a Federal government back to its old tricks of running large budget deficits, and you've got a fairly potent mixture. After all, deficit spending is widely applauded for the stimulus it injects in the short term, but sooner or later, there is cost to paying down all that debt. Do people really think the government is offering us a free lunch?
Shedding light on tough economic questions
These are unpleasant (and on the surface, intricate) questions to be sure, but better to address them head on than to play the ostrich. Which brings us to Henry Hazlitt's classic, Economics in One Lesson, with its clarity of logic and knack for simplifying the seemingly complex. I only wish I'd had this as my textbook in college, instead of that mind-numbing "C + I + G - X" stuff invariably trotted out by stodgy professors.
Hazlitt's "one lesson" is that good economics demands consideration of both the short-term and long-term implications of any policy. He writes:
There are men regarded today as brilliant economists, who deprecate saving and recommend squandering on a national scale as the way of economic salvation; and when anyone points to what the consequences of these policies will be in the long run, they reply flippantly, as might the prodigal son of a warning father: "In the long run we are all dead." And such shallow wisecracks pass as devastating epigrams and the ripest wisdom. But the tragedy is that, on the contrary, we are already suffering the long-run consequences of the policies of the remote or recent past. Today is already the tomorrow which the bad economist yesterday urged us to ignore. ... The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups [emphasis mine].
From here, Hazlitt goes on to debunk countless widely-held economic fallacies, shedding light on the true ramifications of certain courses of economic action. Though written in 1946, Hazlitt's commentary is no less relevant today than it was 57 years ago. The following excerpts strike me as particularly pertinent. I hope the material is as enlightening for you as it's been for me.
On the fallacy that printing dollars creates wealth:
In our own day the most persistent argument put forward for inflation is that it will "get the wheels of industry turning," that it will save us from the irretrievable losses of stagnation and idleness and bring "full employment." This argument in its cruder form rests on the immemorial confusion between money and real wealth. It assumes that new "purchasing power" is being brought into existence, and that the effects of this new purchasing power multiply themselves in ever-widening circles, like the ripples caused by a stone thrown into a pond. The real purchasing power for goods, however, as we have seen, consists of other goods. It cannot be wondrously increased merely by printing more pieces of paper called dollars.
On the economic impact of keeping interest rates at artificially low levels:
If interest rates are artificially kept too low in relation to risks, there will be a reduction in both saving and lending.... The effect of keeping interest rates artificially low, in fact, is eventually the same as that of keeping any other price below the natural market. It increases demand and reduces supply. It increases the demand for capital and reduces the supply of real capital. It creates economic distortions. It is true, no doubt, that an artificial reduction in the interest rate encourages increased borrowing. It tends, in fact, to encourage highly speculative ventures that cannot continue except under the artificial conditions that give them birth. On the supply side, the artificial reduction of interest rates discourages normal thrift, saving, and investment. It reduces the accumulation of capital. It slows down that increase in productivity, that "economic growth," that "progressives" profess to be so eager to promote.
On the danger of a cheap-money policy:
The money rate [i.e., interest rate] can, indeed, be kept artificially low only by continuous new injections of currency or bank credit in place of real savings. This can create the illusion of more capital just as the addition of water can create the illusion of more milk. But it is a policy of continuous inflation. It is obviously a process involving cumulative danger. The money rate will rise and a crisis will develop if the inflation [that is, the inflationary policy of constantly increasing the money supply] is reversed, or merely brought to a halt, or even continued at a diminished rate.
On the fallacy that economic stimulus is only achieved by spending, not saving:
But let us see what Benjamin [the hypothetical saver] actually does with this other $25,000 [of hypothetical savings]. He does not let it pile up in his pocketbook, his bureau drawers, or in his safe. He either deposits it in a bank or he invests it. If he puts it either into a commercial or a savings bank, the bank either lends it to going businesses on short term for working capital, or uses it to buy securities. In other words, Benjamin invests his money either directly or indirectly. But when money is invested it is used to buy or build capital goods -- houses or office buildings or factories or ships or trucks or machines. Any one of these projects puts as much money into circulation and gives as much employment as the same amount of money spent directly on consumption. "Saving," in short, in the modern world, is only another form of spending.
On politicians' addiction to inflationary policy:
[From the afterword, written in 1976] Whenever there is any slowdown in business, the politicians now see the main cause as "insufficient consumer spending." At the same time that they encourage more consumer spending, they pile up further disincentives and penalties in the way of saving and investment. Their chief method of doing this today, as we have already seen, is to embark on or accelerate inflation. The result is that today, for the first time in history, no nation is on a metallic standard and practically every nation is swindling its own people by printing a chronically depreciating paper currency.
Obviously, the long-term questions I raised at the outset can't be answered with a few excerpts from any book, no matter how great. But Economics in One Lesson does a superb job of helping the reader think critically about today's economic problems.
What I walked away with was a much greater concern for the inflationary potential of the various stimuli now being used to jump-start our economy. Maybe global deflationary forces will offset the inflation spawned by the Fed's rate cuts and the government's deficit spending -- but maybe not. Either way, we must remain vigilant and think carefully about the long-term consequences of our government's economic interventions.
From the perspective of a stock investor, Economics in One Lesson only strengthened my conviction that the best investment strategy is to build a portfolio of deep-value equities. By virtue of their low valuations, stocks trading at less than 10 times free cash flow are inherently less prone to asset-value deflation. And should inflation become a problem, these companies would be able to hold their value simply by increasing the prices at which they sell their goods. In sum, deep-value stocks are the best bet against both deflation and inflation. (Where to find deep-value stocks? Tom Gardner's Motley Fool Hidden Gems is a great resource.)