American Economy: The Flooded Engine

The real estate market is collapsing, the dollar is losing value rapidly, the government is increasingly indebted (as are more and more of our citizens), companies are going bankrupt, unions are striking, and we're spending hundreds of billions of dollars a year on a wholly unproductive war, but the stock market makes new highs. Something just doesn't add up.

By Citizen Correspondent Josh Sidman

Date Posted: 10/11/07

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(WARNING: MIXED METAPHORS AHEAD. PROCEED WITH CAUTION.)

Anyone who has had the unpleasant experience of trying to start an old car with a faulty ignition will be familiar with the phenomenon of a flooded engine. When you're having trouble starting a car, it is usually effective to step on the gas pedal while turning the key in an effort to force-fire the engine. However, this procedure can become counterproductive if used to excess. Eventually too much gas is administered, and the engine will not start again until the excess gasoline has had time to drain off or otherwise dissipate.

The phenomenon of a flooded engine is an apt metaphor for the current state of the American economy. The engine of our economy has been run in such an irresponsible and unsustainable manner that the only way to keep it from collapsing is to continuously add more fuel to the fire. The only thing that prevented a crash in 1999 and 2000, when the internet bubble burst, was an extremely high dose of liquidity added to the financial system by the Fed. Short-term interest rates were slashed to one-percent – a measure that could only be considered "emergency medicine". The Fed's action succeeded in averting a crisis temporarily, but the real effect was simply to postpone (and magnify) the eventual reckoning. The medicine used to deal with the collapse of internet stocks only served to create an even bigger bubble in the real estate market.

Monetary policy is proven effective at influencing macroeconomic conditions in the short-term, but it is only a temporary remedy. If the long-term fundamentals of the economy are not addresed, a point will eventually be reached where the medicine doesn't work anymore. Similarly to how the human body becomes resistant to antibiotics if used to excess, each new injection of monetary stimulus, if not accompanied by real economic reforms, will become increasingly ineffectual. And, in both medicine and monetary policy, when effectiveness has been reduced, the short-term temptation is always to administer larger and larger doses, even if the long-term health of the patient is jeopardized. If the patient is fundamentally healthy, medicine can be used to speed the process of recovery and alleviate the suffering associated with it.