I believe the politicians will first take Paul Krugmanâs advice and extend existing stimulus programs and create new ones to spur spending. All the talk about fiscal sanity and deficit warnings will be forgotten as politicians on both sides of the aisle panic. Look for further extensions of the home buyer tax credit program, and other programs that politicians believe will help businesses in their districts. Cash for [Your Industry Here] will be the byword. It will add to an already huge federal debt and will result in more wasteful spending and non-viable short-term results.
On top of all this, the politicians will hammer Bernanke to create jobs, which is one of the Fedâs mandates. Â But how can he do that? He will try to inflate.
The Fed has limited options in such a case. They canât reduce the Fed Funds rate any further and they canât force banks to lend. It is likely that banks will further restrict credit as the economy declines.
I think their only viable option is to use Open Market Operations (OMO) to inject new money into the economy. The next question is: what will they buy?
From January, 2009 to April, 2010, the Fed acquired $1.25 trillion dollars of mortgage backed securities (MBS) through OMO purchases. The only problem is that it didnât do much for the economy. Most of the OMO money pumping has been going into the hands of the big financial institutions which has been driving the financial markets. It is no coincidence that Goldman Sachs had 63 perfect trading days in Q1. New York restaurants are recovering nicely.
There is a theory called the Cantillon Effect which says an increase in money supply doesnât affect all prices equally: money flows initially into some assets, tends to stick there, and the inflationary effect is borne by later by consumers who get no benefit from the new money, only the burden of higher prices. Such an effect may have occurred when the Fed bought MBS from dealers which resulted in cleaner balance sheets and high profits for the big banks and left consumers with slightly higher prices. But I recognize that this idea is conjecture on my part. But, as I pointed out above, (i) OMO money pumping doesnât have the same multiplier effect as lending by banks, and (ii) credit is still declining.
There are two other asset purchase choices the Fed may consider in its Open Market Operations. Neither alternative is good:
Alternative No. 1. Buy bad CRE loans (non-MBS) directly from regional and local banks.
If it buys CRE debt from smaller banks, it would compound the problem it already has with MBS purchases. That is, it is unlikely they could sell these assets for what they paid.
The positive effect, in the Fedâs eyes, is that banks would more quickly repair their balance sheets and regain financial health. This would then allow them to raise needed Tier 1 capital and commence lending to viable businesses (this is a big âifâ). The Fed recognizes, as Monetarists, that they need to get the smaller banks lending again to spur the economy and create inflation.
This of course ignores the âmoral hazardâ caused by bailing out troubled banks. But I donât think there is a lot of political sentiment to allow massive bank failures. And the political pressure on the Fed to âdo somethingâ will be intense.
Setting all this Monetarist-Keynesian folly aside, the question still remains: if these banks are artificially restored to health, would that lead to economic expansion? In my opinion it will lead to a âbomb-bustâ cycle (economic stagnation and inflation).
Alternative No. 2. Buy Treasury paper which would have the effect of monetizing Federal debt (the government prints currency to pay for its own debts).
The monetization of federal debt on a large scale basis would certainly increase the money supply. The downside is that it would cause greater economic distortions than if they bought bank CRE debt because the effect would be to fund wasteful government projects.
Further they still have the problem of getting banks to lend and if they just buy Treasury paper from these small banks, they will sock the cash away at the Fed as excess reserves.
