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Epic Economic Battle Being Waged Between Friedman and Fischer Theories

Economics / Economic Theory Feb 08, 2009 - 09:32 AM GMT

By: Money_and_Markets

Economics

Best Financial Markets Analysis ArticleJack Crooks writes: There is a battle being waged now in the world of economics. This battle is fierce. And no matter who wins, the impact will be felt far and wide. I dub this epoch struggle: “Godzilla vs. King Kong

I'm not sure who will win, but I do have a favorite.


What I'm talking about is the intellectual and tactical battle concerning the best way to deal with the nasty recession engulfing us from a monetary and fiscal policy perspective.

There Are Two Basic Schools of Thought Here …

King Kong School — Intellectual Leader is Milton Friedman (Money Supply Theory)

Milton Friedman believed that the government should flood the economy with massive amounts of money to enhance and increase consumer demand.
Milton Friedman believed that the government should flood the economy with massive amounts of money to enhance and increase consumer demand.

Basic Premise: In order to keep the current recession from turning into a depression as we witnessed in 1929, the government must stimulate the economy with massive amounts of money so that we can enhance and increase consumer demand.

This is where Mr. Bernanke and President Obama's advisors reside.

Godzilla School — Intellectual Leader is Irving Fischer (Debt-Deflation Theory)

Basic Premise: In order to keep the current recession from turning into a depression as we witnessed in 1929, the government must step-back and let the invisible cleansing hand of the market wash away the debt before any real economic growth can again take hold in the economy.

Here is the outline for this theory:

Irving Fischer's Debt-Deflation Theory holds that the government must let the invisible cleansing hand of the market wash away the debt before economic growth can resume.
Irving Fischer's Debt-Deflation Theory holds that the government must let the invisible cleansing hand of the market wash away the debt before economic growth can resume.
  1. Debt liquidation leads to distress selling
  2. The amount of deposit currency falls and the velocity of currency in circulation slows
  3. Prices plunge and the dollar rises
  4. Business values fall further
  5. Corporate profits tumble
  6. Output, trade and employment take a header
  7. Pessimism and loss of confidence spread like wildfire
  8. Hoarding becomes commonplace and the velocity of currency circulation comes to a standstill
  9. Complicated disturbances erupt in the rates of interest: a fall in the nominal rates and a rise in the real rates

My Favorite — The Good Old Godzilla

And for this primary reason …

When debt levels reach such huge proportions in an economy, pumping more money into the system is ineffective because the velocity of money declines.

Let me explain the term “monetary velocity” and how important it is:

Monetary velocity means how fast money is circulated in the economy — the speed in which it is spent. And it is a key measure in the definition of economic growth.

Now stay with me … while I explain this simple equation:

M x V = P x O

M = Money Supply

V= Velocity

P = Price Level

O= Economic Output

Ben Bernanke and those in control of U.S. economic policy believe that if the “M” in this equation is lifted, it will impact prices (reduce the deflationary scare) and output (economic growth) accordingly.

But here's the rub: When debt levels become so huge, people get scared. They save, hoard and use their money to pay down debt. They don't take on more debt or run out and spend more just because the money supply has been increased by the government.

In fact, more money pumped into the system only adds to the total debt in the economy, and therefore prolongs the downturn.

The practical policy is to accept the fact that “V” shrinks dramatically at times like these — thus we have the big dip in “O” (output) and “P” (prices).

Here is How the Market Cleanses the System …

Debts get paid down; reserves are rebuilt with increased consumer and institutional savings. This provides the eventual pool of capital for fresh growth.

At a time of major risk aversion, the world will flock to its reserve currency — the U.S. dollar.
At a time of major risk aversion, the world will flock to its reserve currency — the U.S. dollar.

And once the debt is removed, monetary velocity “V” increases to more normal levels; therefore tinkering with money supply isn't necessary.

Sadly, I think, all governments are on the side of King Kong. And their flood-the-market monetary policies may make this global recession a whole lot worse.

So from a currency perspective I think it means this: We will be locked in a sustained period of risk aversion (rising unemployment, deflation, and sovereign debt defaults) as this crisis plays out. And in a world of major risk aversion, that mantle rests at the feet of the world reserve currency — the U.S. dollar.

Best wishes,

Jack

P.S. Are you hungry for the latest on what's going on in the currency markets? Then be sure to check out my blog .

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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