The Fed Can't Fix An Overtaxed Economy

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Monetary Policy: With the economy seemingly headed for a big slowdown or even a double-dip recession, it's tempting to demand that the Fed print more money. The only problem is, it won't work.

Fed chief Ben Bernanke, speaking last week at the central bank's annual Jackson Hole meeting, promised that the Fed would do "all that it can" to keep the economy from falling off the table and to stave off deflation.

But he fell short of promising concrete action. Indeed, he pointedly noted, "central bankers alone cannot solve the world's economic problems."

He's right. Still, there are those who think the Fed should do more - a lot more. For sheer impact on the economy, none of the things the Fed could do would have the impact or sheer size of what's being called "QE2" - which stands for Quantitative Easing, Part II.

"QE1" was what the Fed did from early 2009 to March of this year, during which it expanded its own balance sheet by about $1.4 trillion by buying government bonds and agency securities.

That added nearly $1 trillion to banks' reserves, an unprecedented flooding of the banking system with cash. How did the Fed accomplish this financial feat? By simply creating money out of thin air, then buying financial securities with it.

Money printing, pure and simple.

Did it work? That depends on what your definition of "work" is. True enough, we didn't collapse into a deflationary depression. But the money printing was meant to keep long-term interest rates low and asset prices high, in order to boost business investment and housing markets, and get the economy growing again.

Based on that, the printing spree failed. Following the expiration of the $8,000 housing credit this summer, July existing-home sales fell 27% and new-home sales plunged 12%. Meanwhile, fixed business investment is still 23% below where it was in late 2007.

Jobs? About 93,000 created per month this year - not even close to being enough to close the gap caused by 8 million jobs lost since 2007. In the second quarter, GDP crawled at a 1.6% annual rate.

Again, quantitative easing didn't work. But we knew it wouldn't from the experience of others, especially Japan. A recent paper by Bank of Japan economist Hiroshi Ugai, looking at Japan's experience, said QE's impact on total demand and prices was "limited."

In short, with interest rates already at 0% since 2008, there's not much ammo left in the Fed's arsenal. That leaves only fiscal policy.

No, we don't mean spending more money, as the government has tried to do and which failed horribly. We mean a fiscal stimulus from cutting both spending and taxes. At a time of low interest rates, such a policy would bring about a 1980s-style economic boom.

Bizarrely, the Democrats instead seem set on letting the Bush tax cuts of 2001 and 2003 expire - an effective $921 billion tax hike that will sink the economy and kill any hopes of a jobs-led rebound.

As the U.S. Chamber of Commerce recently noted, "Marginal income tax rates will increase for every taxpayer. Capital gains tax rate will climb 33%. Dividend rates for stockholders will jump as much as 164%. The child tax credit will be cut in half and the marriage penalty return." That's a recipe for economic depression.

Big spending is another economy-killer. A recent OECD study noted that for every percentage point increase in spending among the nations studied, per capita GDP fell by 0.3% and investment by as much as 0.4%. So more government "stimulus" cures nothing.

Even so, here in the U.S., federal spending as a share of GDP has surged from about 20% to 25% in just three years - and is on its way to 40% or more by 2040. That's why our private sector is ailing - we're diverting trillions of dollars from productive, profitable enterprises to big, sloppy, unaccountable government programs.

More Fed quantitative easing isn't needed. Research, logic and common sense instead suggest we'd be smart to stop feeding our bloated, inefficient government, and avoid tax hikes. If we don't, we may well end up writing an obituary for the American dream.

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