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.
