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What Happened?

The US government and Federal Reserve has pumped about $4.7 trillion into the economy to get it moving again.  That’s about one third of the total annual gross domestic product, or what the entire nation produces in a year.  If you don’t think it seems to have done as much as it should have, you’re far from alone. Why this traditional stimulus has failed to kick-start the economy has been at the heart of many policy debates over this summer as we contemplate what comes next.  The central problem, however, is that we have been treating the situation as just another recession and not something very different– despite obvious signs.

Economic stimulus as a way of dealing with recessions is a tried and true practice for our policy leaders.  Simply put, every time we’ve done this kind of thing in the past there has been a “multiplier effect” that has created $1.50 of economic activity for every $1.00 the government spends.  If you want to jack up the economy by $1.2 trillion, you just have to spend $800 billion and let it go.  Easy-peasy.  But this time it didn’t work.

Banks that were given large sums of money to loan saw far too much risk that they were not able to quantify, and have instead decided to sit on what they have.  It’s a situation that is precisely reversed from the financial bubble, when no one saw any risk at all.  I’ll leave it to Federal Reserve Vice-Chairman Donald Kohn to explain, from a speech last 24 March:

The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. … To date, that channel does not seem to have been effective; interest rates on bank loans relative to the usual benchmarks have continued to rise, the quantity of bank loans is still falling rapidly, and money supply growth has been subdued. …[We] will need to watch and study this channel carefully.

Translating that into common English – banks are sitting on their money, which is what we didn’t expect.  It doesn’t take a big leap to conclude that they have no idea what to do about it, either, in a system that is too big to understand.

The amount of money that has gone into bank reserves is staggering.  On 10 Sept 2008 bank reserves were $47.3 billion, and now stand at about $1,100 billion.  That’s money that was intended to kick-start the economy but is, instead, sitting around waiting for an opportunity.  Meanwhile, the Federal Reserve is carrying mortgages and stocks on its balance sheet and is looking to pick up another $1 trillion in us bonds.  They’re sending money out as fast as they can but it all just comes back into the system where we can all stare at it.  Meanwhile, gold has hit a record $1,300 per ounce as anyone with money looks to find the safest place to put it.

The Obama administration was relying on the traditional mechanisms to work when the stimulus program was devised. It hasn’t.  The reason that this hasn’t worked is a very simple one, a reason that regular readers of Barataria will recognize immediately – they completely failed to understand that this is not an ordinary “Great Recession” but something much different.  This is a situation much more like 1929 or, even more accurately 1893, than it is like 1980.

What’s next for our government and the long awaited recovery?  The short version is that all the money that has been put out there has to find something that its masters feel is a good investment before it will make any difference.  That’s what a restructuring is all about.  The sooner we can create new opportunities that define a new economy the better.  The money is there and waiting for the energy and talent of our nation to do something.

Getting that started takes bolder policy initiatives than just spending money.  It takes strategy, skill, cheerleading – but starts with an admission that this isn’t just another recession. It’s starting to become obvious to our policy makers, so let’s see what they do with it.

27 thoughts on “What Happened?

  1. I’ve been away from this blog for a while so I was pleased to see that you are adding to the story as it developes. This is very interesting if very hard to understand. I guess if I was a bank I would want to keep my money safe right now and not do anything that would land me on the evening news! So it makes sense. But that means it is hard to do anything about it, right? If the policy wonks do not know what to do it can only get worse.

  2. I think we are seeing a different kind of multiplier effect related to low consumer confidence. The banks don’t want to loan money to people without jobs, companies don’t want to hire people if they don’t think consumers will buy their products, and people aren’t trying to buy houses because they are either unemployed or unsure about their future. All of these are pretty rational choices, but they don’t help move things along.

    I can’t see how the Obama administration could have escaped bailing out the banks, but because money wasn’t flowing to consumers where 60-70% of the economy is, we can barely grow. If we are going to see growth, something like the payroll tax cut described earlier will have to be implemented to get money in people’s hands.

  3. Bruce: I agree, it’s rational, but what should we be doing about it? My contention is what it always has – like FDR, we have to take this situation seriously and try a lot of different things to get the system going from the bottom up. It makes sense to focus on relief to people who are having real difficulty, such as the mortgage program, but it’s also time to seriously consider how we move the next generation into employment.

    I really do believe that this whole, “Don’t worry, we know what to do” attitude that has come with heaps of denial as to how bad this is has been our worst enemy. We can figure out what to do to get this moving, just like FDR did – but we have to take it as serious as it really is first. We’re only starting to now, from what I can see, because the old ways aren’t working.

    Jan: I hope Bruce and I answered part of your concern. We should start trying a lot of stuff and see what works, and there are some targeted areas we can go after. It’s clear that the people at the top don’t know what to do next because it hasn’t been like this in 80 years – so they have to get a bit creative. Hey, guys like me can suggest stuff and maybe it’ll get up to them. Like everything else good in life you just have to keep your eyes open. 🙂

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  8. The stimulus was put in place before Obama took office. Remember 2008?
    Not that long ago.

    Is this column another hoax?

  9. Tina: What the Bush Admin did was technically TARP, or “Troubled Asset Relief Program”. It wasn’t as much about attempting to stimulate the economy as it was to prevent a massive failure. But if that’s too much of a quibble you do have a point – it makes more sense to refer to “The Federal Government” than “The Obama Administration” above. I do think that would make the piece stronger.

    As for the hoax quip – I think you can answer that yourself, which makes me wonder why you raised it. If you’re sore at me, I’m sorry, but I did feel compelled to do whatever I can for good friends who I think are getting screwed.

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