from Independent

Once again, Anon makes an important point about the core workings of our economy. When I was in college, my professor took the class to Sturbridge Village to make this same point. Like the little town in Texas, it is a microcosm of the broader economy.

Economists call this concept the “Velocity” of the money supply - the speed at which money moves through the economy is as important as the total supply of money in the economy. So, “Moneterists” traditionally believed modulation of the cash supply is a sufficient tool to expand or contract growth in the economy, as needed, depending on its Velocity.

“Fiscalists” or “Keynesians” traditionally believed that it is the total amount of spending that matters, and that growth must be modulated through the expansion or contraction of government spending.

The “ISLM Framework” resolved this theoretical divide in the 1960’s, providing a hybrid theoretical framework that accommodates both concepts. This common ground was generally supported by both sides.

What changed beginning in the 1980’s was the rise of classical economists and their theory of pure free market principles to the securities markets; i.e., the belief that all security prices were by definition priced correctly in an open market. The theoretical work of these academics was picked up by key players in the capital markets and politicians and policymakers who favored government deregulation. This became the basis for deregulation of the financial markets and the failure to regulate new financial instruments like derivatives.

This utterly naive belief, of course, ignored ingredients necccesary to free market principles, including the extreme complexity of the instruments; the blind greed of investors that has always been the basis for the boom/bust speculative nature of financial markets; and the lack of availability and comprehension of information. There are a lot of free market academics out there who have run like hell away from their own teachings after this debacle.

So keeping money supply (M-1) growth consistent with economic growth to provide price stability is the primary role of the Fed. Modulation of M-! and interest rate adjustments can expand or contract cash and credit in the economy to smooth out expansions and contractions at the margin. Fiscal policy is a blunter, broader tool and can be used to counter either a too-rapid expansion or, more likely, to counter a recession.

In the last 18 months the Fed and Congress have used all of these tools to get the financial system, the capital markets and the economy under control. This is major surgery for sure. But the basic productive nature of our system; our educational system; our system of technological innovation; our entrepreneurial spirit; and (once properly stabilized and regulated) our capital markets system has not and will not dry up and blow away. We have a tough couple of years - and the need to address our entitlement programs in the out years is critical - and we will be on our way again.

Just as we have done over and over through our modern history.