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Withholding credit to derail the Democrats
By Byron A. Ellis - September 20, 2010

It has been argued that flexible prices and technological progress cause income growth. However, if we assume a closed economy with a fixed real money supply M, flexible prices and technological progress could not increase M and therefore could not cause income growth.

However, if the central bank and the banking system increase M, flexible prices and technological progress could create additional jobs. Although, technological progress could also eliminate existing jobs by making old technologies obsolete. Nonetheless, in the absence of increases in M, income growth will not occur.

Furthermore, if the central bank reduces M, even with technological progress and flexible prices, income would decrease.

Some economists have argued that money is neutral. According to this view money is merely a medium of exchange and does not affect productive capacity. As a result, they proclaim that central banks are incapable of facilitating employment by increasing the money supply.

On the other hand, these same economists argue that increasing M causes inflation. Inflation occurs when the demand for goods and services exceed the supply, thus prices are bid up.

The money supply increases when the central bank (Federal Reserve) increases bank reserves through open market operations and financial institutions use the excess reserve to provide loans.

Therefore, if the economy is operating far below full employment (potential output), as it is now, increasing the money supply by providing loans to entrepreneurs and consumers would increase private investment and personal consumption, and hence production and employment.

Note that monetary expansion requires more than increases in banks' reserves by central banks. It requires credit creation by the banking system; by making loans banks create deposits. And, deposits   are a component of the money supply. Therefore, banks credit creation implies money creation.

So, if economic theory and history validates the relationship between increases in M and increases in effective demand, why havenít the Federal Reserve and the banking system increased the money supply?

Moreover, why are Democratic policy makers silent, if expanding the money supply would restore effective demand, and hence production and employment?

It appears that partisanship within the financial system prevents monetary expansion. If monetary expansion had occurred, production and employment would have increased and the Democrats would be poised for greater political gains. Greater political gains for Democrats, however, could have led to more financial regulation.

Thus, it appears to be in the best interest of the banking system to prevent increases in effective demand by restricting monetary expansion to ensure public dissatisfaction with the Democrats. Public dissatisfaction provides political advantages to the Republicans, who are in favor of less financial regulations.

The Democrats appointed Republicans to control the economy at Treasury and the Federal Reserve. Therefore, the only strategy available to them for restoring the economy is the blunt instrument of fiscal policy: government spending  and/or tax reductions.

However, government spending is incapable of expanding the money supply; rather, it often crowds out private investment. Furthermore, the multiplier for tax reduction is less than for government spending.

Given our understanding of economic history, it appears that withholding money creation is a deliberate strategy by the banking system to punish Obama and the Democrats, without any regard to the disadvantages imposed on the American public that rescued them.

Obama and the Democrats, however, could have avoided this financial trap by giving the keys  to the American economy (at Treasury and the Fed) to Democrats. Moreover, they could have escaped the trap by reverting to history and bypassing the private financial institutions with federally sponsored credit agencies that could modify mortgages and provide credit to small businesses. 

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