The Contribution of Monetary & Fiscal Policies to the Current Financial Crisis

The Contribution of Monetary & Fiscal Policies to the Current Financial Crisis

Government:  If you think the problems we create are bad, just wait until you see our solutions.

Most observers recognize that the current financial crisis began when the collapse in housing prices led to a series of defaults on mortgage-backed securities.  It’s also widely recognized that a combination of excessive monetary expansion and irresponsible behavior from government sponsored agencies contributed to the speculative bubble in housing.  What is not widely recognized is how monetary and fiscal policies contributed to the current crisis.

Understanding the role of monetary and fiscal policy in the current crisis is particularly important for containing the damage from this point forward.

How Monetary Policy Contributed to the Financial Crisis

Beginning in 2005, the Federal Reserve recognized that its overly expansive monetary policy had created the potential for higher inflation.  It appropriately began to tighten policy through its standard procedure of raising its targeted interest rate.  However, as often happens, the Fed went too far in the opposite direction. 

A key first step in the monetary process is involves the creation of bank reserves.  Bank reserves are deposits that banks keep at the Federal Reserve.  Whenever anyone other than the Fed purchases anything they need to have money to pay for them.  The Fed is different.  It has the unique ability to pay for its purchases by informing banks that it has increased their deposits (bank reserves) by whatever amount is necessary to pay for its purchases.

Creating more bank reserves tends to provide banks with new funds that enable them to make loans and investments.  This process tends to add to the money supply, which eventually increases the pace of spending.  Over time, an increase in spending over and above the ability of an economy to produce goods and services leads to inflation. 
From April, 2001 to April, 2005 the St. Louis Federal Reserve data on bank reserves (adjusted for reserve requirements) show an increase of roughly 20%.  During the same period other measures of money also increased rapidly—currency 30%, M1 22%, and the monetary base 28%.  Given normal lags, this rapid increase in money led to rapid increases in spending.  From the spring of 2002 to the spring of 2006 current dollar GDP rose 26%.

Beginning in the spring of 2005 the Fed reversed its easy money policy.  From April, 2005 to April, 2008 adjusted bank reserves fell by 3%.  Other measures of money also slowed dramatically during this time.  From the former period of rapid growth to this later period, monetary indicators slowed dramatically.  Using annual rates to make the periods comparable, currency slowed from a 6.7% to 2.6%, M1 from 5.1% to 0.3% and the monetary base from 6.4% to 2.2%. 

In response to this slower growth in money, current dollar GDP also slowed.  From the second quarter of 2006 to the third quarter of this year, current dollar spending slowed to a 4.0% rate from a 5.9% rate in the earlier period.  Indications that spending has weakened further since the third quarter suggest that it will eventually come even closer to matching the slowdown in the growth of money.  

Up until June of this year, the Fed continued to drain bank reserves from the system.  While Fed statements suggested it was increasing liquidity, its actions were very different.  The Fed responded to the financial crisis of the past year by tightening monetary policy and thereby adding to the financial crisis. 

How Fiscal Policy Contributed to the Financial Crisis

The famous economist John Maynard Keynes once wrote “Practical men who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”  If he were somehow able to communicate with us today, Keynes would likely admit that he is now that defunct economist.

Keynes introduced the notion of “fiscal stimulus.”  The theory posits that by borrowing money from some people and giving it to others government can boost spending.  While there has never been any convincing evidence to support this notion, it has become so popular that few people question it. 

Even after the failure of “fiscal stimulus” this past spring, the basic premise survives.  Instead of questioning the theory, proponents suggest that the “stimulus” program simply wasn’t large enough.

Not only is the concept of “fiscal stimulus” flawed, but pursuing such policies can have a toxic effect on the economy.  A basic understanding of the economic process shows why this is so.

Each year workers in the US produce a certain amount of goods and services.  This year they will produce roughly $14 trillion.  In the process they earn roughly $14 trillion in spendable income.  Most of that income is spent on current living expenses such as household rent, health, food, etc.  A certain amount of the income (roughly $2-$3 trillion) is set aside for purchasing capital goods (buildings, machines, roads, etc.).  These capital goods enable workers to produce even more goods and services in the future.

When government engages in “fiscal stimulus” it taps into the $2-$3 trillion of income that workers set aside for capital goods.  If government uses the funds it borrows to send people checks (as it did this past spring), those funds tend to be spent on consuming current goods and services.  They are no longer available for purchasing capital goods. 

As government has continued to borrow to help bolster different areas, it has taken progressively more income from this $2-$3 trillion available for capital goods.  This has created a progressively more serious shortage of funds for capital goods. 
To the extent that government borrowing reallocates these funds toward current consumption, it reallocates spending away from the things that boost future output. 

Farmers have a term for such behavior.  It’s called “eating the seed corn” and it has a depressing effect on future growth.  The negative impact is in addition to its immediate impact.  The impact is to shift spending away from where market forces would have directed it and toward areas where government policymakers want it to go.  This often means reallocating spending away from healthy, growing businesses to unhealthy, failing businesses.  Such a process weakens an economy.

A Tragedy of Errors

Mistakes associated with both monetary and fiscal policy moves have been compounded by serious miscalculations on the part of the Treasury Department.  By arbitrarily acting to shore up certain companies and certain assets at the expense of others, Treasury’s moves have added to the uncertainty regarding the value of various assets.  This uncertainty has had a destabilizing effect on financial markets.
Unfortunately, many of the solutions being proposed to deal with the current financial crisis would make the situation even worse.  President-elect Obama’s advisors propose a $25-$50 billion bailout of weak auto companies.  They are also discussing as much as a $500 billion “fiscal stimulus” proposal.  As each of these proposed solutions are offered, stock prices have registered their disapproval by moving lower.

Real Solutions

The first line of attack for mitigating the impact of the current financial crisis is to have the Fed reverse its restrictive monetary policy.  Since mid-year, there are tentative signs that this is occurring.  In the four months since June, adjusted bank reserves have increased by hundreds of billions of dollars. 

Under normal circumstances a massive increase in bank reserves would signal a shift to an expansive policy.  However, nothing about the current period is normal.

The Federal Reserve recently decided to begin paying banks interest on reserves they keep at the Fed.  Banks have decided that with the Fed paying interest on its reserves, in the current climate it’s safer to keep extra reserves with the Fed than to loan the money or buy securities.  Since the middle of the year banks have increased their excess reserves with the Fed by hundreds of billions dollars.  This action by banks can sharply reduce the impact of additional bank reserves on the creation of money.

Given the unprecedented changes in monetary actions on the part of the Fed, it has become increasingly difficult to determine just what the Fed is doing with respect to monetary policy.   The only thing that appears certain is that monetary actions through the middle of this year were generally restrictive.

On several occasions since August 2007, when the problems in credit markets first became widely apparent, the Fed began to shift to an expansive monetary policy.  On each occasion it inexplicably reversed course.  Even if the recent tentative signs of monetary stimulus continue, normal lags suggest that spending would not begin to recover until next spring.  And, if the Fed were to again reverse its monetary expansion, the current collapse in spending could extend well into the future.

Even after the Fed finally adopts an expansive monetary policy, the damage from “fiscal stimulus” will remain.  While the creation of more money can help to boost spending, the tendency to “eat the seed corn” will make it difficult for the economy to boost productivity.  Over the past eight years productivity has increased by an impressive 40%.  The current destructive fiscal policy mix will make it impossible to repeat that performance in the future.

Conclusion

Recent policy mistakes have taken a problem in the housing market and spread it to the rest of the economy.  The end result is the worst financial crisis since the 1930s. 

As the crisis has spread, policymakers compounded their mistakes making the situation progressively worse.  Instead of recognizing how fiscal policy measures can contribute to the problems in credit markets, policymakers now plan to expand those policies.  While an expansive monetary policy can offer some temporary relief, the destructive impact of further “fiscal stimulus” will last for an extended period.

Strategies

Until there are signs that policymakers recognize the damage they are doing, it is best to remain defensive and avoid investing in stocks.  Even at current fire-sale prices, further destructive moves are not out of the question.

Credit availability is likely to continue to be a serious problem.  Government moves to prop up the economy by massive borrowing of the limited funds available for capital projects will place further strains on liquidity.  As a result, it is prudent for individuals and businesses to be as liquid as possible in the period ahead.