Friday, May 01, 2009

The Law of Supply and Demand

The Law of Supply and Demand operates on competitive market places.  The basic idea is that price and quantity sold are determined by the intersection of the supply and demand curves for a given market.  In practice if you have a competitive market and demand increases with everything else held steady, prices will go up, as well as quantity sold.  If demand decreases, the quantity and price will go down when everything else held constant.  It makes sense if you think about it.  If you operate in a competitive market, and you lower your prices, you will earn some additional sales at those lower prices at the expense of those who did not lower their prices.

The Obama administration seems to believe that they can defy the law of supply and demand in a competitive market.  If this is true and the law of supply and demand can be violated, the Obama plan to revive the economy can work.  However, if the law of supply and demand holds, all of the actions that are being taken to improve the economy, can only hurt.

The heart of the problem is using government spending to stimulate the economy when the government does not actually have the money on hand to spend.  If the government must borrow the money used to stimulate the economy, the act of this borrowing will hurt the economy more than the spending can possibly help.  This is because of the Law of Supply and Demand.

In fiscal 2008, the USA had a deficit of about 500 billion.  To fund government operations about 500 billion in Treasury Bonds and Bills were sold on the open market.  The government also sold Treasury Bonds and Bills to cover refinancing any outstanding bonds that were coming to maturity (We refinance rather than pay down debt).  With the recession hitting in 2008, and the reduced revenues as a result in conjunction with the 700 Billion TARP passed in 2008, the budget deficit was expected to be 1.2 trillion in fiscal 2009 pre-Obama.  It is now looking like this one-off 1.2 trillion deficit left over from Bush will be expanded to about 2 trillion under Obama, and will not be a one-off anomaly.  Trillion plus deficits continue well into the future under Obama's own budget numbers.

So last year the USA needed to borrow 500 billion plus what was required to rollover and debt that came due.  In 2009 the Government will need to borrow 2 trillion to fund the deficit spending plus any rollover of existing debt.  So the supply of T-Bills and Bonds put to market in 2009 will be about 4x as large as in 2008.  This is not a small move on the supply curve.  This is a massive shift in supply, and if the law of supply and demand holds the prices of these bonds and bills must drop by a massive amount to get them all sold.  The USA desperately needs these funds to operate, and must set the price where all 2 trillion in bonds can be sold.  Since interest rates go up as bond prices go down, this will effectively mean a massive increase in short and long term interest rates for Treasury Bonds and Bills and as a result everything else.

Now remember that the premise here is that the bond market is competitive.  A bond or bill is really just borrowing money with the promise to repay.  Competing for money to borrow are other consumers, businesses, local governments, and international governments.  The USA competing so aggressively for 2 Trillion in borrowing this year vs. 500 Billion last year will crowd out the other competing borrowers.  We will get the funds because we will pay more in interest.  Interest rates for everyone must rise or all funds for lending will just go to the U.S. government. So we currently attempt to keep short and long term rates low to help the economy, and it is not really working very well.  As soon as rates start rising an economic recovery becomes even more difficult.  Some projects can still get done in weak economy, as long as rates are low allowing for a return on investment.  A bad economy with high interest rates is an absolute disaster.

We have really just began to borrow the 2 trillion for this year.  A good portion is set to go out over the next 3 months.  Rates are already headed up and are at 2009 highs.  I am expecting rates to start accelerating upwards soon.  The banks are sitting on TARP funds but not lending. I can see them being attracted to Treasuries with high yields, and lending to the government and not into the economy.  High interest rates will inevitably lead to high inflation rates. Stagflation could well be the economic buzzword in the second half of the year.

Countless third-world countries have destroyed their currencies through similar actions and we are not immune as we follow in their footsteps.

To solve this problem government borrowing must stop.  Taxing our way out can't work because it punishes the activities that grow the economy.  The government is simply vastly over sized and must be greatly reduced.  Bailouts and cash stimulus must end immediately.  Local, State, and Federal governments must be stripped down to where they only provide basic services as outlined in the constitution.  The only path out is via the free market, and that can only happen if the government gets out of the way and stops interfering.  The nations wealth is determined by the sum of goods and services that we can produce.  The government in general is not a producer of goods or services so it is a drag on the economy.  Bigger government is a bigger drag.  The founding fathers were very aware of this.  The United States was never supposed to have a large government.  We need to get back to our roots as soon as possible.

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At 11:56 PM, Blogger JD Schellnutt said...

Agree 100%!!! Excellent post.

At 12:35 PM, Blogger Dawood Mamedoff said...

Nice article!
For those who want to understand how the Law of Supply and Demand works I'd advice the following article:


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