Dinner with Mr. Keynes.

Now, I understand that a lot of people don't have a degree or any formal education in economics. I didn't know a thing until I started reading around, so what I've picked up isn't coming from some professor at Generic University, (beat Everyschool State!) it's coming from esteemed authors and economists, as well as a little bit from my own head. It seems that the current economic crisis has brought out everyone's inner Buffett, as ordinary pundits, as well as the everyday America, start pointing at GDP and the stock markets like they belong on the floor of the NYSE. The major point of contention that I've seen is the federal deficit.

Every time a new program is brought up, it's immediately denounced for raising the deficit, as if we'll have China's personal team of collectors banging on the White House saying that we're decades past due. For the normal day-to-day proceedings in our own lives, that may be true. Max out your credit cards with now with no way to pay them back, and sure you'll get phone calls all day. Blank out on the electric bill, and you'll be living in the dark. We like that. It makes sense. If you borrow money, you have to pay it back, that's simple enough. This is the way classical economists see things (as well as microeconomists.) However, like many things, once you draw back the zoom and start looking at the country as a whole, it gets a little different.

It gets a lot different, actually. In my last article, I said that one of the major advantages of the federal financial policy as opposed to that of the states' was the ability for the federal government to run a deficit. In fact, the federal deficit has pretty much become a way of life. Social Security, Medicare, all these programs have to be paid for by the federal government. And no, we cannot simply 'print more money'. We have to get it from somewhere, and that somewhere is China, the up and coming beast of the East. China is one of our largest exporters, something that nearly everyone knows about, due to the ubiquity of "Made in China". In exchange for all of their products, we don't head to some sort of international cashier and start rifling through our wallet, we issue them U.S. treasury bonds. These bonds represent a set amount of U.S. currency, and mature at a later date, usually 30 years from when they are issued. It can be likened to taking out a loan. China holds a huge amount of these bonds, $800 billion worth. (Other large holders are Japan at $600bn, and the UK at $123bn.) The reliability of these bonds depends entirely on the value of the U.S. dollar; if, when China tries to cash in, the dollar is about as valuable as the paper it's printed on, they're going to lose an insane amount of money.

On that topic, one of the words I hear being thrown about all too often is "inflation". I can understand why. It's a scary idea; that all your money starts turning into lumps of paper. This can get incredibly threatening, as in post World War I Germany, when the currency became, literally, worth less than the paper it's printed on. What many of these doomsayers don't realize is that the amount of pressure that it would take to cause the value of the dollar to plummet to disastrous levels would require a massive upheaval of not only the United States's economy, but the majority of the developed world. The same can be done for the idea that suddenly China will try to 'cash in' on the U.S. If China did call in America's debt, there is no way that the U.S. would be able to repay it, leading to an unprecedented economic catastrophe for their country, and China would lose it's biggest importer, leading to not only the nullification of it's billions of U.S. bonds, but eliminating a huge part of their economy. The relationship between the United States and China is a symbiotic one; each nation needs the other to survive.

Although inflation may be a red herring, many news stations aren't broadcasting what is a very real threat to our nation: deflation. As its name implies, deflation is the opposite of inflation; while inflation decreases the value of currency, deflation increases it. While inflation hurts the guy with his life's savings tucked under his bed, deflation hurts the business owner. Instead of encouraging people to go out and spend, deflation encourages everyone to clam up. An increase in deflation can lead a country into a deflationary spiral, just as it did during the Great depression, where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. Deflation can also cause an artificial increase in interest rates. If annual deflation is at 10%, as it was during the 1930s, even a 0% interest rate is a bad deal, as the initial amount must be repaid with money worth 10% more every year. This leads to a stagnation in business, as the economy grinds to a halt. As if the deflationary spiral was not bad enough, reduction in interest rates in an attempt to combat deflation can lead to the infamous liquidity trap, where interest rates have been lowered as far as they can go, but even that is not enough to stop deflation. This is where monetary policy falls apart.

In the early 20th century, an Englishman named John Maynard Keynes said that maybe, sometimes, the private sector doesn't lead to the best macroeconomic outcomes. In layman's terms, sometimes the bigger picture doesn't look so good, even if the little picture looks great. Keynes advocated what is now a mixed economy, with a predominately private sector, but a large role for the public sector and government. Under Keynesian economic theory, the way to combat deflation and a stagnating economy is to supplement the normal spending with increased government spending. When business slows, the government creates its own business. Another way of fixing the deflation problem would be to provide an increase in the supply of money, giving consumers that would otherwise be unwilling to spend incentive to buy and stimulate the economy. Sound familiar?

- Tom

N.B. As of July 31, the House of Representatives has voted to add another 2 billion dollars to the wildly popular "Cash for Clunkers" program.