A Suspiciously Simple Supply-Side Solution (to the Credit Crunch)

Alliteration is fun! Alex Tabarrok proposes an alternative approach to dealing with the credit crunch at Marginal Revolution. First a recap for the uninitiated.

Briefly stated, the effect of the "credit crunch" is that banks/financial institutions are not lending money to other banks/financial institutions. Moreover, they aren't lending to firms, government organizations, individuals, etc... This means that all sorts of things - funding new enterprise, getting a new mortgage, getting a student loan - has become more difficult or impossible. In short, the financial gears that keep our economy running smoothly are grinding to a halt.

Why did this happen? Again, briefly stated, banks made mortgage loans to people with poor credit ratings (or people with poor credit history took on loans they couldn't afford, depending on how you look at it). These are the sub-prime mortgages. When the housing boom slowed, mortgage rates went up and many of these people defaulted on their payments. Some mortgage lenders went bankrupt and banks lost large sums of money.

Furthermore, banks used credit derivative "vehicles" that packaged sub-prime mortgages with higher-grade assets to spread the risk. These bundles of asset-backed securities were then sold on to other financial institutions. When the value of these securities came into question following the housing collapse, more losses and uncertainty ensued.

That's a painful oversimplification of things. But basically the double-shot of large write-downs and uncertainty about the value of assets has left credit markets dry. As Alex explains, banks are the bridge between savers and borrowers. Those bridges are now collapsing. The US Treasury plan is to prop up those teetering bridges; Alex's alternative solution is to encourage savings and thus increase the flow of credit across the bridges that are still structurally sound. He proposes a tax holiday on contributions to an Individual Retirement Account for a year, with the governenment matching a certain amount as well.

Cool idea, but I'm not sure that it will do the trick. The problem is, saving today means forgoing consumption today - that's bad news for an economy facing a recession. Also, as Keynes pointed out, it does not necessarily mean consumption later: uncertainty about the future economy means people may save to have liquidity (assets that are easily accessible/convertible to money) as insurance against economic misfortune. Money saved in liquid assets doesn't automatically increase demand for 'producible' goods that lead to more employment and a stronger economy. In other words: a penny saved does not equal a penny earned.

Also, if the real problem is uncertainty - financial institutions hoarding liquidity and refusing to lend to one another - it's really not clear how an increase in savings will help. Then again, Alex is infinitely more knowledgeable than I am, so I've probably missed something here.

(Photo courtesy of http://www.lewrockwell.com/)