Interesting read in the FAJ

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benjamen

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The FAJ is the Financial Analyst Journal. It is essentially a bunch of the top math/stat/econ/finance nerds rolled into one, like me!

I found an interesting section in a May 2012 edition...

"Litterman: What impact will the big expansion in the Federal Reserve’s balance sheet have on the markets?

Fama: It has basically rendered the Fed powerless to control inflation. In 2008, when Lehman Brothers collapsed, the Fed wanted to get the markets moving and made massive purchases of securities. The corollary to that activity, however, is that reserves issued by the Fed and held by banks exploded. An explosion in reserves causes an explosion in the price level unless interest is paid on the reserves. So, the Fed started to pay interest
on its reserves, which means that the central bank issued bonds to buy bonds. I think it’s a largely neutral activity. Before 2008, controlling inflation was a matter of controlling the monetary base (currency plus reserves). But when the central bank pays interest on its reserves, it is the currency supply that determines inflation. But banks can exchange currency for reserves on demand, which means the Fed cannot control the currency supply and inflation, or the price level, is out of its control. The Fed had the
power to control inflation, but I don’t think it does under the current scenario.

Litterman: How does that relate to the debt issues that the United States is facing?

Fama: The debt issues are entirely different. The debt issues are about how much we want to sacrifice the future for the present and whether we
get anything in the present for the future we’re sacrificing. This has been the big debate between the Keynesians and the non-Keynesians since 2008.

Litterman: But isn’t one way out of our debt problem to inflate it away?

Fama: Yes, that’s one way to handle it, but it’s far from a great solution. If the Fed were to stop paying interest on its reserves, we’d probably have a big inflation problem. The monetary base was about $150 billion before the Fed stepped in in 2008. Currency plus required reserves are still in that neighborhood, but the Fed is holding $2.5 trillion—trillion!—worth of debt financed almost entirely by excess reserves. The price level could expand by the ratio of those two numbers, and that translates into hyperinflation. Economies typically do not function well in hyperinflation. The real value of the government debt might disappear, but the economy is likely to disappear with it.

Litterman: What would your suggestion be for monetary or fiscal policy at this point?

Fama: Simple. Balance the budget. I heard a very prominent person say in private that we could balance the budget by going back to the level of
government expenditures in 2007. The economy is currently about the size it was then. If you just rolled expenditures back to that point, I think it
would come close to balancing the budget."
 
Source: http://www.cfapubs.org/doi/pdf/10.2469/faj.v68.n6.1

~~~

...
Fama: Simple. Balance the budget. I heard a very prominent person say in private that we could balance the budget by going back to the level of
government expenditures in 2007. The economy is currently about the size it was then. If you just rolled expenditures back to that point, I think it
would come close to balancing the budget."

Basically what Ron Paul was campaigning on. So sad that our political class cognoscenti refuse to hear the message. :flushed:
 
I thought I would pass on a portion of an email I received from a well respected PhD of Finance concerning the above article...

"With regard to economics, the use of federal debt to support the spending levels in this country is unsustainable absent some incredible increase in productivity that grows the tax base. I think nearly all economists would agree on this point. The alternatives are to increase tax revenues, cut spending, or both. The long-term impact may be open to some disagreement, but I think it would lead to a decline in the US economy with slower growth, higher unemployment, and a lower standard of living.

Politically, the debate is over raising tax revenues by reducing deductions or loopholes, raising marginal tax rates on upper incomes, and cutting spending. Once citizens receive a particular service from the government, they generally do not want to give it up. Social Security, Medicare, and Defense comprise most of the spending. No one wants to pay more taxes. So the real question is whether the American people have the will to address the problem? When you further consider that voters who comprise base voting blocks in the two parties are very polarized with regard to what needs to be done, It stands to reason that this would reduce the political will of politicians to address the problem.

How do I see this playing out? I believe that over the next 10-20 years, our economy and social safety net will come to look a lot more like what we see in European countries – lower growth, higher unemployment, a larger social safety net, and higher tax rates. The question is whether we look like Germany, the UK, or Greece? "

:popcorn:
 
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