“When new money enters into an economy, it is not evenly distributed. Those closest to the source receive the first and highest benefits.”
Scenario for simplicity:
A stable economy has $10 and 10 widgets. (A widget is any object or resource in the economy including assets like equities or real estate.) All things being stable and equal, each widget is worth $1.
Inject another $10 into the ecosystem. Now there is $20 in the economy, but we still only have 10 widgets. You would THINK each widget is now worth $2, but that’s not what happens!!
The people close to the source (banks, governments, asset managers) have access to use the new dollars BEFORE the lower general population. The first thing they do with their new money is start purchasing the widgets that currently cost $1.
Problem #1: Price Distortion
How much is a widget worth now? $2? $3? The early people are buying the widgets with their new money, prices are rising, so not really sure…
Problem #2: Asset Bubble
The price of widgets is going up! Increasing value! Stock market and home values are at an all time high! Hooray!! People can’t miss out so they start piling in. The price gets way too high and someone starts to sell. Price crashes back down, financial wreckage, lots of people suffer.
Problem #3: The Poor Get Poorer
The poor general population raises their hand: “Excuse me! Prices of widgets are going up and I did not receive my extra dollar yet. Everything is now more expensive, but I still only have $1.” (Wages are always the LAST thing to adjust.)
Problem #4: The Elimination Of The Middle Class
People in the middle of this are caught in a binary trap. They may have some widget assets that are increasing in value, but their expenses are also increasing. If they have enough widget assets to escape, they can ride the wave of the new money and benefit from the increasing value. However, if they don’t have enough widget assets, they will be forced to sell them to cover their expenses. When they are forced to sell their widget assets or can’t afford to buy more, they fall to fate of Problem #3. This is effectively one of the primary causes of the destruction of the middle class. Also known as a “K” shaped economy.
A typical conversation that burns me:
Lower Class:
“Excuse me! There is new money in the system, but I didn’t receive any yet. The early people are buying widgets before I am able and everything is getting more expensive for me.”
Top Class:
“You need to buy and own assets like stocks and real estate!! See how they are rising in value!!”
Lower Class:
“Buy assets with what? Food, gas, insurance, childcare, and rent make up 87% of my income. Now they make up 93% because of the recent price increases. My wages are not going up. This sucks.”
Top Class:
“You don’t have enough money because you are lazy and not working hard enough. Sorry, I don’t have time to listen to you because I’m very busy watching my assets grow in value. I don’t see any problems with this system.”
Besides creative government stimulus programs, banks also create money when new loans are initiated.
This is why the federal funds interest rate matters to those closely watching the economy. It’s a delicate balance that has critical impacts on the economy.
Lower interest rates:
Encourages more loans which introduces more money which effectively creates the new money scenario. Juice the economy!! However, this leads to the problems outlined above.
Higher interest rates:
No new money, slow, or no growth. Our current financial debt based system requires growth to function. No growth means no economic expansion. No ability to meet credit and debt obligations. Can result in cascading loan defaults.
Our entire economy is dependent on this growth expansion of ever-increasing debt. To repay those debts, U.S. dollars are printed into existence. This printing results with the consequence of inflation.