Economic Stimulus and the Banking Sector

The incoming Obama administration has been steadily increasing the size of the proposed economic stimulus, which now stands at $850 billion. Thus far, much of the debate has centered around the question of how big a stimulus ought to be, and what should be the mix of tax cuts versus government spending. This week, discussion has centered on what kind of spending would be desirable, and while the proposal of ‘green tech’ and repairing infrastructure is appealing, the criticism has been raised that since 97% of construction workers are male, and most are white, infrastructure projects leave out many of the most vulnerable poor, among them women and minorities.
The size of the stimulus will no doubt continue to grow as economic conditions worsen, particularly in the job market, where job losses appear to be accelerating, with 524,000 jobs lost last month. As for the overall effect of the stimulus package, Macroeconomic Advisers estimates that the Obama stimulus will increase GDP growth by 3.2%, and reduce unemployment by 1.7% by creating 3.3 million jobs.
Given the sudden reluctance of consumers to spend, it seems likely that the $275 billion portion of the stimulus package that is tax cuts will effectively disappear into savings or toward paying off household debt. But if lenders receive payment, they can make new loans, right?
I wonder. So far lending has fallen by $133 billion since October 2008, which means the money supply is contracting just as the stimulus is put in place, perhaps by as much as $1.33 trillion, assuming a money multiplier of 10. The big question is if banks continue to reduce their lending. It seems likely that banks will have reduced demand for loans without the mergers and acquisitions boom, and with de-leveraging occurring on all sides. If lending falls by another $100 billion in 2009, it means another $1 trillion decrease in the money supply, which would easily swamp the stimulus. This is one of the great weaknesses of the fractional reserve system: it tends to destroy money at exactly the wrong moment.
Think of the classical quantity theory of money: MV = PQ. The money supply is falling, and it seems likely that the velocity of money is also falling, as consumers spend less and save more. (It’s hard to measure the velocity of money directly, and it is typically inferred by measurements of the other variables.) This leads to falling prices and economic output. The adjustment process shouldn’t take long, if left alone: a year or two at most to purge failed ideas and business models, to de-leverage and move toward saving.
But of course it is hardly being left alone. Instead an ocean of money is being created and borrowed, all to prevent the natural adjustment of the economy back to a sustainable course. This adjustment cannot be prevented, though it may be delayed, it may be drawn out. The casualty of all this will be the US dollar, which is in its last days of being the world’s reserve currency.