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Newsletter – September / October 2012 – Theories sometimes work; price always does

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Theories sometimes work; price always does

Economic Theory is very interesting stuff. It’s basic logic and it’s all about supply and demand. When a government increases money supply, it’s like throwing a log on the economic fire: it gets hotter. And when they indulge in tight money policy, it’s like choking off the air supply to that fire. When the theory works, it is a delight to behold.

Former Canadian prime minister Lester Boles Pearson once described this wondrous process: “Economic policy is the skilful use of blunt instruments.” Our American cousins are getting a serious up close look at the bluntness of their central bank’s instruments. And they would not use the words I chose: “delight to behold” and “wondrous process” are not in their economic vocabulary as their presidential election campaign heats up.

The problem stems from faulty mortgage lending in the first seven years of this century. The so-called subprime mortgage fiasco triggered a blow-off in the US housing market: too much easy money for US home buyers who could not afford to repay their mortgage loans led to a serious barn-burner in real estate prices. The home building industry turned to ashes. The US economy burned out along with the US manufacturing industry. There was a flame-out in the US finance business: bail-outs everywhere; foreclosures and bank failures everywhere. The problem was that billions of US dollars of American wealth had disappeared when house prices declined.

In the face of this disaster, US officials resorted to basic old fashioned economic theory: they flooded their country with easy money. They rolled out three plans: Quantitative Easing (QE) one, two, and three. Their goal was to stabilize US house prices, to re-inflate the real estate market. Yes, that’s right, their goal was to create inflation in the USA, particularly in the real estate sector.

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