Here's what I've been able to figure out so far:
Conventionally, the Fed is said to be responsible for "regulating the money supply". Seems to me, though, that they can only have an marginal effect -"fine-tuning" on a day to day basis, but helpless before larger fiscal currents.
Money is created every time Uncle Sam writes a check, and it's destroyed every time he cashes one. By regulating how and where they spend money and how and where they take it in, the feds act as the "heart" of the economy, pumping money eveywhere it's needed. So in the Keynesian view, by "borrowing" money, the feds take savings out of the banking system (by excahngeing it for treasury debt) and pump it back in to the consumer economy by spending on salaryies, missile, etc.
But when the budget goes into surplus, this dynamic is reversed. The feds take money out of the consumer economy (through taxes) and pump it into the financial economy (through buying back treasury debt). Since most people who sell treasury notes don't go out and spend the proceeds, but rather turn around and put the money into other financial instruments, this leads to a financial bubble. But since the consumer economy is simultaneously being drained of funds, the real economy eventually cools off. This pricks the bubble, causing even more contraction of the money supply, and you have a major recession, if not out-and-out depression, on your hands. The fed can lower interest rates all it wants, but since there's no money to be lent, it won't help.
This leads to a few questions:
1.) Is this at all correct? Am I missing something obvious? (For example, I'm not sure how foreign exchange fits into this)
2.) If it is correct, than how come I haven't heard a any words of warning from any economists (even those like Krugman, who call themselves Keynsians) over the last few years amid all the crowing about the wonderful surplus?
3.) One thing I'm unsure about: when the bubble bursts is the money just gone? Is there some kind of "conservation of money" law, or is it possible for trillions to just vanish?
Jim Baird
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