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Most economists ignore the behavioral side of finance.  They tend to stick to their models, equations and textbooks.  This is, in large part, what makes economics such a frustrating endeavor for so many people.  They tend to ignore the simple fact that there is an unquantifiable variable in the equation – human emotion.  And no matter how much we evolve and advance technologically this variable will always be the most important piece of the puzzle.

Over the last few years I have argued that much of what the government planned to do would have destructive psychological ramifications.  Unfortunately, this appears to have come true as no one truly trusts the stock market these days.  Small business sentiment shows a total lack of faith in the government.  Consumer confidence remains abysmal.  This is all very disconcerting because a deflationary environment has a way of snowballing and becoming self destructive.   It can eat at a society from within as they become discouraged.  The following story nicely summarizes the damaging impact of deflation:

“Once upon a time it was announced that the devil was going out of business and would sell all his equipment to those who were willing to pay the price.

On the big day of the sale, all his tools were attractively displayed. There were Envy, Jealousy, Hatred, Malice, Deceit, Sensuality, Pride, Idolatry, and other implements of evil display. Each of the tools was marked with its own price tag.

Over in the corner by itself was a harmless looking, wedge-shaped tool very much worn, but still it bore a higher price than any of the others. Someone asked the devil what it was, and he answered, “That is Discouragement.” The next question came quickly, “And why is it priced so high even though it is plain to see that it is worn more than these others?”

Because replied the devil, “It is more useful to me than all these others. I can pry open and get into a man’s heart with that when I cannot get near him with any other tool. Once I get inside, I can use him in whatever way suits me best. It is worn well because I use it on everybody I can, and few people even know it belongs to me.”

This tool was priced so high that no one could buy it, and to this day it has never been sold. It still belongs to the devil, and he still uses it on mankind.”

I believe this is exactly what happened in Japan in the 90’s.  Deflation became accepted.  And as it became accepted discouragement came with it.  And discouragement has a nasty way of eating at people’s everyday activities.  When you are discouraged by the environment you exist in you are more likely to quit, not to participate or to simply sit on your hands while you wait for things to improve.  Prices fall, wages decline, profits suffer, etc.

The government is trying to talk us out of becoming discouraged.  They have rescued the financial system with record bailouts, trillions in stimulus and hope-filled messages.  This continues to this day.  We are told that the Federal Reserve will bolster markets with quantitative easing and supportive monetary policy.  We are told that the government will stimulate Main Street and small business.  We are told that they will give us tax credits for buying new cars or new homes.  We are told that saving the banks will save us all.  But when one looks under the hood at all of these policies you realize that none of them have been beneficial to Main Street.  Almost without exception they have been short-term attempts to bolster a banking system that has failed us.

Quantitative easing is just the latest gimmick to bolster bank balance sheets and generate hope of a real recovery.  Real recovery will come when Main Street is cured of its debt disease.  Until then, discouragement will continue to eat at the core of this system as the government continues down its misguided path.  I used to think that Americans were too hopeful and prideful to be discouraged for any extended period, but this government appears to be doing a pretty good job of scaring us with their rhetoric while also implementing policy that proves them entirely ignorant in regards to all things economics.  Until something actually changes in Congress it’s likely that the threat of deflation and discouragement will remain. And with it will be depressed economic growth.

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