Thursday, November 4, 2010

The Folly of Our Economic Policy

"Paper money eventually returns to its intrinsic value—zero."

While Voltaire lived before Jean-Baptiste Say, the quote above implies that he had an understanding of Say's Law. Say's Law, simply stated, is that supply creates demand. However, that simple statement of it, doesn't really capture the whole story. A better formulation is "the demand for any commodity is a function of the supply of noncompeting commodities."

Within this context, think of dollars as a commodity with few competitors. As a result, the "demand for dollars" will go up if the supply of dollars goes up. This "demand for dollars" is what we commonly call the price tag on each of those noncompeting commodities. This is why debasing the currency/printing money/quantitative easing is inflationary.

Yes, I know the inflation hasn't shown up despite previous quantitative easing. I still expect inflation in the future.

Which brings us to QE2: the next round of quantitative easing. Earlier this week the Fed announced plans to print up $600 billion dollars. This round has made our trading partners nervous. Brazil's President elect had this to say: “The last time there was a series of competitive devaluations. . . it ended in world war two.”

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