Thursday, February 12, 2009
How to fix deflation
| How to fix the economy during recession and deflation We can use the housing price collapse of 2008 as a perfect example of how to fix a currency problem. The initial bank rescue package (TARP) was intended to buy "toxic" assets to relieve banks of the pressure caused by devaluation of these assets. Secretary of the treasury Henry Paulson switched gears and instead decided to give the money directly to the banks so the banks had more money to lend. He did this through the purchase of bank stock. In concert the Federal Reserve Bank lowered interest rates and bought more bank bonds. This was supposed to inject money in to the economy, restore confidence in the people and thus right the ship. It did not work, and the reasons are obvious. The Fed and Treasury cannot incease the amount of currency, and thus offset deflation, if the currency doesn't circulate. The government can print trillions of dollars and not cause inflation. How? By burying the money in a deep cave. This is essentially what transpired after the first effort at TARP. President Obama and the Democrats in congress created a stimulus package designed to inject even more money in to the economy to further prime the pump. The stimulus package however became heavily weighted on bailouts of state governments and specially designed spending on infrastructure that creates short term jobs. The bailout of the states will largely go to state bond holders, who will in turn sit on the money until a clearer picture of the economy emerges. The tax cut portion of the package is very small and temporary and isn't enough money to drive lending. To summarize, the three pieces of stimulus were designed to inject money in to the economy, but failed to craft a plan for the circulation of the money once injected. This is why the initial stimulus failed. What was the missing link? All businesses run on cashflow, not the balance sheet. A balance sheet is simply a reflection of past and future cash flow. To incent the banks to lend money, the government needed to remove not only the negative cash flow, but the uncertainty surrounding the potential positive cash flow in the bad assets. This could have been accomplished, and may yet under new Treasury Secretary Tim Geitner's plan, by purchasing the toxic assets. At this point the banks have one certainty, cash flow is going down because no payments are coming on the suspect assets. The banks have also increased their deposits with the money delivered to them from the government on the sale of the assets. Instead of just giving the banks money by purchasing their securities or stocks, the money the taxpayers spent would be backed by a tangible asset. The banks are also incented to lend money to increase, or at least replace, the lost cashflow. The debate on how these assets are purchases is not really important other than in the speed in which they are reckoned. Because of the cirulation required to boost lending, a speedy liquidation isn't all that important. Now we have solved half of the problem. But what if there are no borrowers? For some strange reason politicians have come to the conclusion that a bank flush with cash will circulate the money and stimulate the economy. This isn't true at all. Lending requires two parties, a lender and a borrower. To cause the money to circulate, spending must have already rebounded. This is the reason the Great Depression stretched on for such a long time. Roosevelt and Hoover both injected money in to the economy, but didn't bother to insure that it circulated. In 1932 Hoover raised taxes, which slowed spending, and throughout his administration Roosevelt's hostility to business created a climate of fear in the capital markets, which also prevented the money from circulating. (This is admittedly only one example, there are dozens more during the depression.)If we imagine the circulation of cash in an economy as a whirlpool, credit is at the outside of the vortex and cannot be pulled in to the system until the strength of spending necessitates a need for further capital. This is the point where congress and the president must step in to prime the pump. In an economy as large as that of The United States, large infusions of cash are needed, and it must start with the people and small businesses. There are two ways to do this. The first is through massive tax cuts, the second is with massive cuts in regulation. Both may be temporary in nature, and if history is a guide, probably need not last any more than six to nine months. By this time the spending will have strengthened to the point that cash was moving so fast, credit was needed to further investment and productivity. The banks having been both relieved of the uncertainty of bad assets, and deprived of cash flow have no other option but to cede to the borrowers demands, and start lending money again. |
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