What is going on with the world of finance, and how do you fix it! (Update 1)

Just after I wrote my blog, with the above title, Martin Wolf, of the Financial Times wrote a blog analyzing each major sector in the US economy, in terms of surplus and deficit.  Not surprisingly our analysis is identical, in terms of the US Federal government and its massive deficit.  What Mr. Wolf lacks in his blog is my theoretical construct on the Solvency ratio and Solvency curve, which I reproduce below.  However Mr. Wolf does ask the $64 million dollar question.  Mr. Wolf writes;

The question is, of course, how the government should respond to its sudden shift into massive deficits.  That depends on how the economy best adjusts to balance-sheet adjustments in the private sector.  If the government is to move back into balance, by cutting spending and raising taxes, how would the private sector respond to being forced  [sic] back into balance?  Would it spend more, because of a sudden surge in confidence about fiscal prospects?  Or would it cut back more, so driving the economy into depression, thereby at least partially defeating the effort to improve the fiscal position?

Notice how Mr. Wolf, and probably others in the economic profession, use the term “forced” in terms of individual categories moving “UP” the Solvency curve – the right side of the curve.  As the US Federal government outlines and executes drawing down its deficit, businesses, households, and other categories (as well as banks leading excess reserves) will be spending their surpluses because it will be profitable to do so – in my mind there will be no “forced”.  Demand will be there.  This process will be slow moving at first, however as the US Federal government sticks to its plans to bring its deficits under control the more confidence the private sector will become in spending its surpluses.

How do I know this?  We, as Canadians, experienced this from 1995 to 2002.  Our Federal government outlined and implemented a credible deficit reduction plan and everybody, right hand side of the curve, responded – creating a large amount of wealth for all Canadians.

As both sides move “up” the Solvency curve, as I stated earlier in my previous blog, the new bull market will begin.  I’m really happy to see the proper questions being asked, as Mr. Wolf does, now we just need the policies in place to make it happen.

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