Kevin Drum writes

Karl Smith keeps telling me that [the aging auto fleet] is what’s going to spark a strong recovery in 2012. At some point, all those cars just have to be replaced, and that spending will drive improvement in the economy. Ditto for pent-up demand for houses and apartments.

I really want to believe this. I do, I do, I do. But with wages stagnant, credit tight, unemployment high, and the world economy flatlining, where’s the money going to come from?

The core answer comes from the Chairman of the Federal Reserve.

But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8 Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies.

In practice the functional limitation of non-standard methods of injecting money into the economy was the freak-out on the part of hard money advocates both on the FOMC, the policy world and amongst the chattering classes generally.

This dynamic creates the potential for a strong non-linearity in the economy.

When the natural rate of interest is below zero you drift along in a funk boosted only by productivity increases, but if the natural rate of interest creeps even the tiniest bit above zero you will blow it out of the water in roaring boom that returns you to full employment.

The reason  is without non-standard measures Fed Policy can’t be stimulative. But, as soon as they are a little stimulative, that stimulus raises capacity utilization, employment and inflation, which in turn makes the exact same policy even more stimulative.

In the same way that the Fed needs to move the interest rate faster than the rate of inflation to stabilize inflation, if the Fed stays still in the face of a growing economy it will “destabilize” growth, which means growth will feed on itself.

In real life this it works like this:

As the vehicle fleet ages used car prices begin to rise. You can think of this as pushing down money demand for those folks in the market for cars over the next few years.

I prefer to think of it as raising the marginal return to capital which is equal to the interest rate.

In either case borrowing becomes a better idea. Healthy banks will then respond to that increase in consumer demand by increasing loans. Those loans create new money. In practice you will see excess reserves being turned into required reserves.

That money will then become income to car dealers and manufacturers, who will pass it along to employees or spend it themselves. Those folks will then have the income to allow them to take out further loans which becomes income to someone else, which allows further lending and so forth.

In particular, it will allow kids to move out of their parents basement which will push up rents which will encourage apartment developers to take out large loans.

As long as interest rates stay low this process will feed on itself rapidly increasing the lending and undoing this carve out.

FRED Graph