No no-one’s surprise, the debate about how to restart economic growth continues to rage on with remarkable disregard for demonstrated efficacy of the proposed remedies. On one hand, there are calls for the Fed to do more, because, apparently, it can. The reality, of course, is that the Fed can print money until we all have to use wheelbarrows of the stuff to pay for a loaf of bread without causing the economy to grow one iota, as has been repeatedly demonstrated among many others in the past two centuries alone: in Germany (twice), Russia (twice), the American Confederacy, Argentina, and quite recently Zimbabwe. On the other hand — and how economists love that expression — we have Krugmanesque calls for more direct Keynesian stimulus, without any regard to the fact that an entire trillion dollars has been injected into the economy already without restarting growth. Instead, predictably, it produced waste, malinvestment, and a crushing debt load. China, that well-known economic miracle, is now finding out the limits of that policy.
The side that calls for the Fed to ease further remarkably argues simultaneously that low interest rates are an indication of tight money and that high interest rates are also indications of tight money. However real question is not whether the central bank makes more money available to the economy, but rather is two-fold: whether the lenders who make the direct loans are lending enough to meet the demand, and whether there is enough demand from businesses to absorb the available money supply. The sad fact is that both of these metrics are very low. Banks — encouraged by the suspension of the mark-to-market rules — are protecting their, consequently fictitious, balance sheets by over-tightening underwriting rules and making fewer loans and. Businesses — seeing few growth prospects for themselves — are not hiring.
History teaches us that a sharp increase in the money supply — even when it feels like an economic boom — ultimately leads to a very destructive crash. When Germany absorbed the enormous for its time indemnity in the wake of the Franco-German war, for instance, prices rose, driving up speculation, real estate, and luxury spending — until the crash and a depression from which Germany would take thirty years to recover. A more familiar example would have been the 1920s when governments the world over ran the printing presses — in violation of the gold standard, one must add — in order to reduce their crushing debt loads in the wake of war. We all know the result.
To see how we can end the — now increasingly more Japanese-disease-like — stagnation it would be useful to examine how we got here. True to its dual mandate, the Greenspan Fed allowed the economy to keep heating up all through the 1990s and 2000s — and by its lights it was justified in doing so because inflation appeared to be firmly under control. Inflation appeared to be under control primarily because of the flawed measure then — and still — in use. Instead of showing up in consumer prices, kept low by the bottomless supply of dirt-cheap Chinese labor — inflation, like a squeezed balloon — emerged in asset prices, both equity and real estate. Just like in the prior two examples, the rise in asset values fueled huge growth of indebtedness, until the inevitable crash. The economy — in the NGDP measure, for those who care about such things — grew larger than the natural level of demand could have supported, and when it collapsed from its artificially high level it was, and is, unable to recover.
The dual mandate for the Fed — that of maintaining monetary stability and full employment — was itself based on an economic theory that holds that the correlation in the Phillips curve between inflation and growth implies bidirectional causality. Since this theory has no empirical support, the dual mandate for the central bank is much like a law court mandated to dispense justice and also to convict every defendant that comes before it. The latter half of such demands can hardly help the former. The fact is that the central bank cannot do anything about creating full employment — it can only cause destroy it by over-tightening. What the Fed can do is maintain a supply of money that fits the level of demand. We know when it is succeeding when consumer prices show stability and asset values reflect reasonable risk premia. The European project realized this when they have created the ECB with the single mandate of price stability — now, inevitably, compromised by politics. The European recession, just like the American, was not created by tight money and will not be helped by loosening.
The current stagnation is caused by two mutually reinforcing factors. As discussed above, banks are not lending because of the large volume of non-performing debt still on their books. At the same time, consumers are overburdened with the same debt and so are not spending. Remarkably, a solution to this conundrum has been tried before and found to be successful. The real estate crash of 1989 looked very similar to the one that happened twenty years later. Equally remarkably, Congress and the Bush 41 administration moved with purpose and decision to establish a “bad bank“, forcing lenders to unload their bad assets and insolvent borrowers into bankruptcy. The pain was sharp but the recession was a short one, and it laid the foundation for the growth of the 1990s, so ably claimed by Clinton to his credit. Unfortunately. this method had the drawback, unacceptable — at least to Democrats in power — of making a few people a great deal richer than they were before, and so no bad bank was formed the last time. Instead, the TARP, foreclosure rules, and accounting rule changes all conspired to create the situation we see now. Whether a bad bank would help now, all these years later, is uncharted territory. One thing is clear though: printing more money and adding to the debt load are only making the problem worse.