Monday, September 29, 2008

"Massive liquidity": Is the American economy too dependent on monetary policy?

US Dollar index, 1998-2008. Source:

From this morning, reporting new Fed actions:

The Federal Reserve and other countries' central banks have announced fresh steps to battle a worsening credit crisis that threatens to unhinge the U.S. economy.

The Fed said Monday the action is intended to "expand significantly" the availability of cash available to squeezed banks and other financial institutions in an effort to provide relief to the worst credit crisis since the Great Depression.

The Fed cited "continued strains" in the demand for short-term funding.

I overheard Steve Liesman (an economics reporter with seemingly close ties to the Fed and Treasury) on CBNC in a conversation with others trying to describe the actions the Fed is taking today. He was saying things like "massive liquidity" and "flood the system with dollars to force the credit organizations to lend" and "as much as needed."

I see the logic of the monetary action. Or rather, I recognize the fear of a further shutdown in the flow of credit, and the notion that loose monetary policy might spark greater lending. America is a country with an economy that is dependent upon a wide extention of lending/credit. The national economy is proving unable to absorb the current housing and financial collapse because the credit we need to support economic activity has become more limited. With about $1 trillion in questionable loans, America's collective creditworthiness has been significantly dented. We are seeing a limited amount of credit flow our way as a result.

That said, the Fed's monetary policy (however reasonable) is not without its own structural difficulties. Here are three questions regarding the Fed's continued actions to flood the world economy with dollars.

1. Can the dollar survive these actions? Take a look at the image above. The value of the dollar is already weakened. We must ask, Can it withstand a limitless expansion of its supply? If not, what is the dollar's limit?

2. What kinds of inflationary pressures will these actions produce?

3. What kinds of distributive effects will these actions produce? Will they reverse, neglect, or reinforce the flow of wealth and economic power outside the country?

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