Trapped

What really is sustaining the North American economy and the financial markets?

When asked, everybody pulls out the same trump cards. Faith in the economy's superior qualities, but mainly in the "wisdom" of the central banks, notably the United States' Federal Reserve System. It is alleged that these constitute the definitive answers, with no further explanations needed.

All this rests on two assumptions. With signs of undesired economic weakness, the central banks will be prompted to cut interest rates. They will continue to do so, and financial markets will respond on cue to this monetary easing, that is, reduced interest rates.

At first, the stock markets will be pleased by lower interest rates. However, there is another market of crucial importance to the well-being of the world's economy and the entire financial network, namely the currency market. What is bad for the dollar, which is falling precipitously, and which is sure to continue to fall, is bad for capital inflows. What is bad for capital inflows is damaging for financial markets. They and the economy will lack the "fuel" to prosper.

The U.S. dollar is dependent on more than $2-billion coming in each day, because of the deficit in its trading account. In other words, that nation imports $2-billion more in goods and services every day than it exports. Hence, it would be necessary for the U.S. to trim imports drastically if funds from abroad were not available. Such circumstances would require an economic contraction of some magnitude.

The recent easing of interest rates may launch a temporary rally in the stock markets, and a minor uptick in the economy. Nevertheless, a declining U.S. currency that will result from less attractive interest returns eventually must scare off foreigners.

The theory has been that, facing a business contraction, the central banks, primarily the Federal Reserve, can pump up the money supply to provide the essential funds. Interest rates would decline over the near term, of course diminishing foreigners' predisposition to invest in the United States' currency.

As the U.S. dollar is being debased and loses more of its purchasing power, people then resort to speculating in other things, for instance, high-tech stocks in the 1990s, or, in the past decade, in real estate. Bubbles are created, which collapse of their own weight. The more the artificial stimulus is injected into the economy, the worse the outcome over the long term. Without doubt, the economy is trapped.

Clearly, optimism about the economy rests more on hope, less on the lessons of history.