Cash-for-clunkers, Dollars-for-dishwashers, and Other Government Consumption Stimulus Ideas

The news of the week is rising auto sales in the US, stimulated by the Federal program called ‘cash-for-clunkers’ where you trade in fuel-inefficient car for a more efficient one, and get thousands of dollars from the government. The program has been such a ‘success’ that it has made lawmakers think of other possible ways to stimulate consumer spending, such as the dollars-for-dishwashers program, which gives $300 mil in federal rebates for new appliance purchases. Of course, a larger version of this same theme is the new-home purchase credit. All these efforts are attempts to stimulate consumer spending, and all go in exactly the wrong direction.

Why should we be trying to stimulate consumption? We ought to be attempting to stimulate saving and investment, for these are the keys to long-term prosperity. Perhaps the most pernicious economic fallacy is revealed in the oft-repeated phrase: ‘consumption spending is the driver of the economy’. Before one can consume, one must produce. The best way to stimulate production would be to allow market competition to determine interest rates, and to eschew the pro-cyclical tendencies and distortions of fractional reserve banking. During the Panic of 2008, money destruction took place even as the Fed cut interest rates, because banks restricted their lending faster than the Fed created liquidity.

Banks had good reason to restrict lending; they were over-exposed to bad loans, their balance sheets crammed with assets of dubious value. Bank reserves shot from $44 bil to $800 bil in a year, going from less than 1% of deposits to over 10%. At the same time, lending fell (although there was massive borrowing from the Fed by banks to increase their reserves).

All parties in the economy, from the government, to corporations, to households, must reduce their debt, or ‘de-leverage’. Consumers see the wisdom in this, recognizing the frailty of their situation when they live paycheck-to-paycheck, without any cushion of savings, while debts steadily mount. The government cannot reverse the process of de-leveraging. When it tries, it loses credibility. We still remember the spectacle of Fed chairman Alan Greenspan urging consumers to take on adjustable rate mortgages. The best that can be done is to allow de-leveraging to proceed swiftly. And let’s look on the bright side; while many businesses will fail, most will survive, and they will be stronger for it, because the market, given time, rewards prudence at the same time as it punishes foolish risks.

SNL on the Banking Crisis

This clip speaks volumes about how the Treasury Dept deals with banks.

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.

Solving the US Banking Crisis

[Written for the Borsen-Kurier]

Most efforts proposed these days go exactly the wrong direction: back toward unsustainable economic activity like debt-funded consumer spending, home buying, and government spending, or away from the transparency that markets need to reach equilibrium (for example, the recent proposal at the G-20 meeting that accounting standards be ‘temporarily’ loosened—as if we could escape our problems through denial).

Here is an economic plan that would work immediately; it would stabilize the banking sector instantly, preventing the crisis in the stock market from reducing business investment in the real economy, thus preventing a major contraction of GDP.

The catch? It will involve some short-term economic pain.

The reason that banks are fragile is that they have only a fraction of their deposits on hand at any given time. Because banks are currently scrambling to increase their reserves, they have restricted lending by $100 bil from October 29th to November 19th. Granted, this is a small decrease when the total volume of loans is over $7,000 bil, but any decrease in lending tends to be pro-cyclical, resulting in the contraction of the money supply at precisely the wrong time. In theory, a money multiplier of 10 would imply that a $100 bil restriction in lending would lead to money destruction of $1,000 bil. Additionally, because of decreased consumption and investment spending, there is a falling velocity of money, meaning fewer transactions per week. This exacerbates the effect of a contraction in the money supply. As of November 28th, 2008, the total money supply (M2) was $7,854 bil. Bank reserves have skyrocketed from $44 bil in August to $652 bil in October, while bank deposits have stayed constant at about $7,000 bil.

Here’s the plan, in two parts.

Part 1: the total cash and coin in the US is less than $800 bil. Print an additional $7,000 bil, and give it to banks in exact proportion to their deposits. Then make sure that bank reserves always equal bank deposits, creating a 100% reserve system. This would cause no net change in the money supply, for we’d simply have printed money to back up bank deposits, money that was already in use. We’d merely replace checkbook-money with paper money. No problem so far. There would be no inflationary pressure, and the cost would be minimal - the cost of printing and distributing the money.

Part 2: Define the dollar as a portion of gold. This is where the sacrifice begins, for it involves a substantial devaluation of the dollar. The US holds 8.133 bil grams of gold, and the IMF has another 3.217 bil grams; if we divide the total money supply M2 by the total US and IMF gold reserves, we get about $700 per gram, meaning a dollar is worth 1/700th of a gram. Now the tough part: we keep this ratio in good times and bad, at all times allowing anyone to trade $700 for a gram of gold. Since the current market price of gold is about $26 per gram, this plan would entail that the dollar must fall to 3.7% of its current value. (The drop would probably be less severe, as this plan would pull gold out of private gold stocks and into service as money).

The sacrifice would begin when all imported goods immediately rise in price dramatically (an imported good that costs $1 may rise to $25). International trade flows would change as markets reach equilibrium. This would certainly cause some dislocation. But we’d skip the lasting pain of a sequel to the Great Depression because the main damage to the economy would be avoided. The money supply would not contract due to banks rational fear of collapsing during the financial crisis. Banks would be on a solid basis, and they could immediately begin lending (from savings accounts only; these would have to be set aside specifically for investment purposes, and would no longer be available on demand).

Sacrifices would continue as the US could no longer maintain a current account deficit without draining US gold reserves. The federal government would not be able to borrow billions or trillions to finance deficit spending. The depreciation of the dollar would mean foreign bond holders would immediately lose money, and large-scale selling of bonds would ensue. While it is unfortunate to break the trust of those who bought US bonds, it is simply unavoidable. The US has too much debt to pay it back. The US government will repudiate its debt, either simply and honestly, as in this plan, or covertly, through inflation.

Without access to deficit spending, cuts in government spending will add to the economic contraction, but the plan will prevent future pain, for the current strategy of massive money creation and fiscal deficits will surely devalue the dollar, without the benefit of ever leading to a sound medium of exchange.

The financial crisis is first and foremost a debt-deflation crisis, which was produced by banks’ wanton money creation during the expansion of the 1990s and early 2000s (an expansion supervised by the Federal Reserve). If we give the market a medium of exchange that can be trusted to hold its value, the extraordinary ingenuity and entrepreneurship that is America’s greatest asset will be unleashed, and we will soon be enjoying prosperous times again.