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/)

Monetary String Theory

Writing in the 1930s, J. M. Keynes explained how the state of the economy depends upon the “animal spirits” of entrepreneurs: much of our positive economic activity derives from our optimism about the future. It was therefore the difficult task of governments to help ensure that this optimism was the rule, rather than the exception. But for Keynes, monetary policy could only play a limited role in establishing this convention. In times of economic uncertainty, actors in the marketplace are liable to hold such large reserves of cash that, no matter how much liquidity a central bank makes available, the economy is not going to get the stimulation it needs. The solution, Keynes suggested, was to be found in fiscal policy: government spending to offset lack of private investment.

We have been witnessing something similar unfold since the so-called “credit crunch” of last year. As Irwin Keller at MarketWatch explains, the US Federal Reserve has been attempting to offset tight credit by lowering the bank rate from 5.25% last September to its current 2%. This has been as effective as “pushing on a string.” Overall, consumers in America now have even less access to credit as bank lending has tightened up and the issue of non-financial commercial paper has dropped through the floor. Now the Economist is reporting that, after some delay, the animal spirits are flagging in the euro-zone as well. As the economic future becomes less certain, companies are beginning to retrench their investments.

Back in February, the US Congress took Keynes’ advice and approved a fiscal stimulus package. According to a member of the White House’s economic team, the impact of the stimulus package is already being seen through in higher consumption; the effect on investment will take longer and remains to be seen. There is even talk of a second stimulus package, probably motivated by Congress’ desire to spend more money on its constituents before the upcoming election, but it faces a number of obstacles.

What are we to make of all of this? It’s hard to say. Central banks are charged primarily with controlling inflation but the prospect of uncoordinated fiscal and monetary policy is not a pleasant one - this happened early on in the Reagan years and was an all around mess. Probably the best we can hope for is that central banks aim to ‘do no harm.’ Recent decisions by the major CBs to hold their interest rates steady is likely an attempt to do just that. This is going to be an interesting ride, so stay tuned. The immediate lesson – the one Keynes would have pointed out – is that we shouldn’t look to the central banks to deal with the slowdown.