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On Tuesday, December 16, 2008 the Federal Open Market Committee ( FOMC ) lowered the federal-funds-rate target from 1% to between 0.25% and 0%. According to the FOMC statement,

The Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Another main reason behind the massive reduction in the federal-funds-rate target is the suppression of emerging price deflation. The consumer price index (CPI) fell by 1.7% in November from the month before. This was the biggest monthly fall since 1947. (In July 1949 the CPI fell by 0.9%.)

Most commentators regard deflation as a terrible thing that must be countered as soon as possible. This is also the view of Federal Reserve policymakers, in particular Fed Chairman Ben Bernanke. To counter a possible deepening in price deflation the US central bank—in addition to lowering the fed funds to zero—is pursuing aggressive monetary pumping. In December the yearly rate of growth of the Fed's monetary pumping stood at 151.7% against 141.3% in November and 2.6% in December 2007. As a result of the Fed's pumping its balance sheet jumped to $2.238 trillion from $0.9 trillion in December 2007.

According to the latest FOMC statement, the US central bank is likely to raise its balance sheet further in the months ahead.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Is so-called deflation such a dreadful thing as most commentators imply? In the present case, the emerging decline in prices is the outcome of a severe weakening of various nonproductive bubble activities that have emerged on the back of past loose monetary policy of the Fed.

Thus between January 2001 and June 2004 the federal-funds-rate target was lowered from 6% to 1%. It is this aggressive loose stance that gave birth to various false activities.

The reversal of this loose stance from June 2004 to September 2007 — when the federal-funds-rate target was increased from 1% to 5.25% — started to undermine various false activities. (False activities cannot survive without the support of monetary pumping; they cannot secure goods and services without money out of thin air. In contrast, various wealth-generating activities do not require loose-money policy to secure goods; wealth generators acquire other goods — real wealth — by means of the real wealth they have produced.)

"If it were possible to lift real economic growth by means of money pumping, world poverty would have been eradicated a long time ago."

As a result, the ability of false activities to increase the rate of price growth has weakened. Consequently, their ability to divert goods to themselves from wealth-generating activities by bidding prices higher has also weakened. (Remember that a price of a good is the amount of money per unit of a good. Also remember that false activities divert goods to themselves by means of money that was created out of thin air.)

This is good news for wealth generators since less diversion of wealth strengthens wealth generators.

From this we can infer that pushing massive amounts of money to counter price declines serves to prop up various false activities and weakens wealth-generating activities. This delays sustainable economic recovery.

As things stand at present, on account of banks' reluctance to expand lending, most of the Fed's monetary pumping ends up within the banking sector and doesn't spread to the rest of the economy. In this sense, this is positive for wealth generators.

For the time being, it seems that banks are not keen to lend, preferring instead to sit on large amounts of cash. In the week ending December 17, 2008 banks' cash reserves jumped to $774.4 billion from $604.7 billion in November and $2.39 billion in December 2008. In early December the yearly rate of growth of commercial bank loans fell to 3.5% from 4.8% in November and 10.2% in December 2007. (The data are adjusted for large commercial bank acquisitions of nonbank institutions in the week ending October 1, 2008.)

Banks are reluctant to lend and have significantly tightened their lending standards, due to the large amount of bad assets that they have accumulated. According to the Federal Deposit Insurance Corporation (FDIC), equity of commercial banks and savings institutions fell by $44 billion in the Q3 2008 after declining by $10 billion in the previous quarter.

The rising level of bad loans, particularly in real estate, has led many banks to increase their level of provisions for loan losses in Q3. Loss provisions stood at $50.5 billion, more than three times what the banks put aside in Q3 2007.

Now, the essence of credit is not about lending money as such but actually lending the real stuff — real savings. Without real savings no lending is possible. The fact that banks have accumulated a large amount of bad assets may indicate that the pool of real savings is in trouble.

If this is the case, it will be futile to try to boost lending by pushing more money into the banking system. If the pool of real savings is falling, this means that the percentage of false activities exceeds the percentage of wealth-generating activities out of total activities.

Consequently, banks are likely to remain reluctant to lend regardless of the Fed's pumping; this in turn will continue to undermine bubble activities. As a result the growth momentum of prices will continue to weaken.

The Fed could bypass various lenders and hand money directly to people in order to boost spending and reverse the decline in prices — via "helicopter money." Such a policy is likely to severely damage the real economy.

If it were possible to lift real economic growth by means of money pumping, world poverty would have been eradicated a long time ago. Real economic growth requires real savings to fund various activities that support and promote it. (Remember that money is just a medium of exchange and cannot grow anything. Money is employed to exchange goods of one wealth generator for the goods of another wealth generator.)

Can fiscal policy revive economic activity? At the G20 summit on November 15, 2008 leaders stressed that fiscal policy — strong increases in government outlays — will have a bigger role to play in reviving economic activity. US President-elect Barack Obama has suggested that one should not worry about budget deficits — what matters, he said, is to revive the economy.

But how can an increase in government outlays kick-start the economy? Any activity that the government would initiate requires funding. (Various individuals who will be employed by the government will expect compensation for their work.) The government as such doesn't create any real wealth, so the only way it can pay these individuals is by taxing others who are still generating real wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic recovery. (We ignore here borrowings from foreigners.)

As in the case of money-printing policy, if the pool of real savings is declining, massive government outlays cannot revive the economy; on the contrary, they will make things much worse. The only way fiscal stimulus could "work" is if the pool of real savings is still growing. The increase in economic activity when the pool of real savings is expanding is erroneously attributed to the government's loose fiscal policy. If the pool is shrinking, real economic activity will continue to decline — regardless of any increase in government outlays. Again, government is not a wealth-generating entity; the more it spends, the more it takes from wealth generators, thereby weakening any prospects for a recovery.

In his various comments, US President-elect Barack Obama has suggested that the aim of his economic policies would be to create employment. He has also reiterated that various job-creation projects under his administration will not amount to a reckless spending of taxpayers' money. According to the president-elect, he will spend money wisely by undertaking only essential projects such as fixing roads. But this is no different from what a centralized system like the former Soviet Union attempted. The collapse of the Soviet Union's system is the best testimony to the impossibility of replacing the market economy — as far as the best use of scarce resources is concerned.

Contrary to President-elect Obama's assertions, what is required is a rapid buildup of real wealth. What is the point of employing people in jobs that the free market would not endorse? Does it mean that fixing infrastructure such as roads is a bad idea? Not at all. However, given the present lack of real wealth, Americans cannot afford to improve the roads. There are more important priorities.

One could argue that it would be a great idea for every individual in the United States to have a luxury car. However, if the level of real income cannot support this, then bicycles may be all that Americans can afford. If the government were to push for a universal-luxury-car plan, there would not be enough means to produce more urgent needs — such as food.

By focusing on creating employment rather than real wealth, US policymakers are likely to further undermine the process of real wealth formation — and cause economic impoverishment.

Does this imply that we shouldn't be concerned with growing unemployment? Not at all. Once the focus becomes wealth generation, then by implication this will lead towards a less-controlled economy. In a true free-market economy, unemployment is never an issue.

At present both the US central bank and the US Treasury are pursuing knee-jerk policies. The aggressive policies of the Fed and the Treasury are an attempt to suppress the symptoms; no attempt is made to logically evaluate the true causes of the present crisis.

For most experts, in particular Ben Bernanke, the causes of the current crisis are of a complex nature — i.e., they are mysterious. This is why practitioners of the mainstream methodology treat symptoms rather than causes. The outcome of such an approach is to inflict ever more damage on the economy.

It has not occurred to Bernanke that a massive amount of money cannot replace nonexistent real savings. If pushing money is going to fix the problem, why is a country like Zimbabwe in total ruin after doing just that? Since we do not believe that Bernanke will cease his massive pumping, Congress must act as soon as possible to stop it. Failing to do so runs the risk of severely damaging the US economy.

Conclusion

The current policy of fighting price deflation is a recipe for economic disaster. What is required is purging the economy of various false activities that severely undermine its ability to generate real wealth. Various policies aimed at fixing the symptoms rather than addressing the true causes are only making matters worse. The fall in the prices of goods and services is in response to the weakening of false activities. This means that so-called price deflation indicates that false activities are in trouble. This should be seen as great news since it means that the process of purging the economy is in force. The sooner the economy is cleaned up, the sooner wealth generators can start making real wealth — the key for the economy's revival. To prevent a further destruction of the American economy, Congress must stop the reckless policies of the Fed and the Treasury as soon as possible.