What will it take to get the economy moving again? If you don’t know, relax – no one does, even at the highest levels of power and policy making. Wait … that’s more of a reason to panic than to relax, isn’t it?
That’s not to say that the Federal Reserve isn’t trying, and their heroic efforts deserve praise. But if you want to know how strange everything has gotten look no further than the simple fact that the Fed is far more interested in deficit spending and “stimulus” than the government itself. That’s completely backwards from what we have seen historically. Here’s a quick guide to the problem and what the Fed is trying to do to fix it.
Even before the collapse of Lehman and related institutions in 2008 the Fed was very much on the case, providing emergency overnight loans outside of their usual scope of action. They also pegged their benchmark lending rate at 0%, where it has been since. After that, they have done two rounds of “Quantitative Easing” to create, literally from nothing, $1.4 trillion in additional US Dollars. There is little appetite to do more because the success rate so far has been pretty limited.
Why has it not worked? Bank reserves have increased dramatically, up to $2 trillion today – but the money is not getting out into the economy to fuel investment. It’s called a “liquidity trap”, when rates become too low to justify taking on additional risk. If the going rate of return for a loan is essentially zero, or damned close to it, it’s hard to offset the potential for some of those loans to fail and never be repaid.
The problem is that those with money do not see anything worth investing in given the rate of return that they will get from their loans.
We are up against the limits of what is called Friedmanite or “supply side” economics – the theory that if people who are poised to invest have access to cheap money they will invest more and stimulate the economy with long-term investment. The political version of this theory is that lower taxes on investment stimulate the economy more than deficits or progressive tax rates. It’s held sway in our Congress and been written into the tax code for a solid decade – with little to show for itself.
The latest effort by the Fed is called a “Twist”. Government bonds, or Treasury Bills (T-Bills) have expiration terms ranging from 3 months to 30 years. Many consumer rates are tied to the 30 year rate, which has stayed stubbornly higher than many would like at 3.5%. Rates for T-Bills up to 3 years are essentially zero. By buying the short-term T-Bills and selling off the 30 year the Fed hopes to flatten out that curve and lower the 30-year rate, bringing down interest rates for consumers.
That doesn’t change the liquidity trap, however, which is the real problem. No one honestly expects Twist to change lending anywhere but at the margins.
But the Fed is trying to make something happen. The Government, for its part, seems to be heading into another showdown over very small marginal issues that will only scare the Hell out of everyone again. Before the Debt Ceiling debacle there was job growth on the order of 120k jobs per month – not a big number, but a good start. Since then, unemployment Initial Claims has shot back up to 430k per week, a level that suggests zero job growth. That will be announced at the start of October and there will likely be another round of panic.
Can we blame the end of a decent run of job growth on government antics? The short answer is yes, it seems to have happened at the same time. The long answer is that when you are in a liquidity trap the appearance of risk is very important. If our government does not have a firm hand on the tiller the Fed can reduce rates as much as they want, but growing appearance of risk will dominate the calculations for those who make the loans. So it is reasonable to blame the end of what looked like decent positive momentum on showdowns in Congress. More of the same certainly can’t help.
But blame is not helpful. Moving forward what is needed is a strong policy that builds confidence in our economy so that risk does not dominate. The old saying is that the market is driven by greed and fear in different amounts, and right now fear is winning. There’s a good reason for that, too. Fear comes from uncertainty, and there’s a lot of that to go around. A solid plan, nearly any plan, will do a lot to turn it around.
Not that anyone knows what will really work, of course. But they have to at least try.
Barataria - The work of Erik Hare 
Good explanation as always. What I am trying to figure out is what effect inflation would have on this situation. It seems to me that it would make banks more likely to lend because they lose more with time, but the interest they collect has to be higher than inflation to give them a real return. The real problem is that interest rates can’t go below zero but have you or anyone else thought of a way they could appear to be below zero without inflation?
I am not so sure that ‘nearly any plan’ will help but I agree it can’t hurt. I do think that the more government flails around like chickens with their heads cut off the more its really obvious they do not know what they are doing. So just trying a lot of unconnected things may do even more harm but a solid plan probably would bring a dose of confidence. Worth a try at least.
Anna: Inflation is a headache, but it is the way to a net below zero “real” rate. That’s why the Fed ah an internal inflation target now, probably about the 3.5% that the 30yr is getting. But they don’t tell us just what it is. But no, this does not help the “liquidity trap” one bit because it makes risk even less palatable. You wind up with a LOT of fear, I think. Bottom line to me is that there’s only so much the Fed can do and they have done it (as I have been saying for , what 3 years now!)
Jim: You’re right, we can’t flail around. But there are many things that we know need to be done and we should simply go at them. Implementing the Simpson-Bowles framework would go a long way to restoring confidence, for example. A program of infrastructure catch-up is so long overdue. Education grants would help a lot (see last Friday’s piece). So I think a soup made up of a lot of items that come together as a single “plan” could easily be fashioned and would give everyone a lot more confidence that we’re going to get out of this. If they were really good I think they’d look at the items I listed for transformation and Obama could have a lot ot run on in 2012.
Thanks for the explanations. It helps me feel better that someone knows what is happening.
Jan: Thanks! It would be nice to get the message out a bit further, especially if I was paid for it.
You confirm what I’ve believed since BEFORE the end of the Bush II administration…
…but are SO much more articulate.
Jack: Thanks! >blush!< But yes, I agree, this should have seemed like at least a good question to ask circa 2007-2008. People who are touting it now just can't be paying attention.
That's not to say that the supply-side argument is never valid. There may well be a time and place when investment is the limiting factor in an economy. But not now. There is $2T in capital not being used because the perceived risk is way out of line – more capital will not make a difference today.
I think blame, properly directed, is the best thing we can do at this pt. Matt Miller recently spelled out an ambitious plan for a decade of renewal Steve Benen (and others) pt out that this and other “bold centrist plans” closely match the Obama and democratic party agenda Little is going to happen in the next year in terms of helpful govt policies, so let the campaigning begin in earnest, so voters will know which party has solutions and which is the party of obstruction.
Laurie: If you believe that the game is all about electoral politics at this stage, some level of blame will be useful – I’ll give you that. But the election is still a long way off (no matter how much CNN et al hype it!). In the meantime I think it’s best to focus on forward movement and get done what we can. If nothing else, it’ll prove the point.
Two good links here, as always, but I especially like how you gave us a whole debate. I agree with Benin that it’s fixing the Democratic Party that is important, and I’m trying to do that. The more we are the party of getting things done the better off America will be – and the votes will come through, I think. it’s not sexy, it’s not showy, and it does need to come down to a bumpersticker slogan or two to work, yes. But I think that’s what we have to do.
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