Summary: The financial crisis began in December 2006. The recession probably started in early 2008. The economy went into cardiac arrest last week. This is the fourth in a series of posts discussing what needs to be done. For those of you who do not watch TV, “stat” is a medical term from the Latin statim, meaning immediately.
Introduction
The policy response of our leaders has been too slow and too small. While each step has been larger than its predecessor, all have been reactions to the past dimension of the crisis — not the future. That is, our leaders have been “behind the curve.” Paulson and Bernanke have taken actions that would have been effective if applied 6 months or so earlier. Up to and including the Paulson Plan, which is now almost irrelevant to the current situation.
Arresting the economy’s downward spiral at this late date will require immediate and drastic actions. The severe effects of the recession — now affecting the entire world — will soon be felt, further destabilizing the economy and the financial system.
Recommendations
For a summary see A solution to our financial crisis.
- Stabilize the financial system (first aid)
- Stabilize the economy (emergency medicine)
- Arrange long-term financing for steps #1 and #2 with our foreign creditors (finance the treatment)
This post discusses step #2: stabilize the economy. Now. Taking action only after the new Administration has redecorated their offices will allow the economy to deteriorate for at least another year before these programs take effect.
Why we need to do so, stat!
An inevitable consequence of a financial crisis is panic — and a rush to build cash. With so many businesses — even state and municipal entities — doing so, a crash of business spending and investment is almost certain. No matter what the government does now to help the financial sector or restore business liquidity. For more on this see “The Coming US Consumption Bust”, by Nouriel Roubini (although the situation has grown much worse since wrote this on 6 September.
A massive disintermediated (direct government lending to businesses) liquidity program (which they have not yet begun) is necessary to allow routine economic operations, but is insufficient to maintain aggregate demand in the US economy. Combined with today’s cascading defaults (both household and business loans), and we have a deflationary contraction.
Chairman Bernanke explains the result in one of his best-known speeches, “Deflation: Making Sure ‘It’ Doesn’t Happen Here” (21 November 2002):
The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending — namely, recession, rising unemployment, and financial stress. … The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending…
So it’s fiscal policy time. The Fed will of course lower rates and print money (aka monetary stimulus). But while effective, monetary policy affects the economy slowly. Fiscal policy — the government spending money on goods and services — works much faster. And fast action is needed to avoid what could be a deep spiral down of economic activity.
Ways to Spend Money
I recommend “B” and “C” from the following list. If we wait too long to act, we might follow Japan’s desperate efforts to restart their economy in the 1990’s through construction of totally useless public works (the equivalent of “D” and “E”).
(A) Tax rebates are fast but have relatively little effect during a panic, as people (like businesses) seek to build cash — so they get saved, which reduces the impact.
(B) Make block grants to communities to fund loosely defined infrastructure construction, so long as it goes to non-employees (to prevent it funding existing operations). This could be fast. In local hands by January, with contracts out by April. Tens of thousands of small programs averaging a few million dollars each. The result will be sometimes wasteful, often corrupt, but economically efficient.
(C) Large scale Federal Programs will be an important part of the solution, but have long lead times. For example, we could commit to providing all communities with over 100 thousand people with secondary and tertiary sewage treatment facilities. Municipalities would have to consider how to do this, issue requests for proposals, process the bids, then wait for construction to begin. That will provide valuable stimulus in late 2009 and 2010. We will need it, so let’s get the process started now. But faster action is needed (using #2 above).
(D) Burying money for people to dig up, from Lord Keynes great work The General Theory of Employment, Interest and Money (1936):
Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.
It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly “wasteful” forms of loan expenditure {debt-financed State programs} rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict “business” principles. For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions.
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again … there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.
(E) Dropping money from helicopters, as described by Nobel-laureate Milton Friedman in The Optimum Quantity of Money (1969).
(F) Start a war, which are the functional equivalent of “D” and “E” plus bloodshed.
Side effects
What will be the side effects of these measures?
- on the value of the US Dollar (assuming no prior negotiation with our creditors)?
- Interest rates?
- Inflation?
Probably ugly. The cost will be fantastic, probably beyond anything we imagine today (that’s how these things usually work out). Hence the importance implementing recommendation #3 to stay ahead of the consequences, opening negotiations with our creditors while we still have a reasonably strong negotiating position.
Mechanics
How can Congress do this after the election? Not my field, but almost anything can be done with sufficient need, leadership, and willpower.
Updates: Progress of the fiscal stimulus legislation
Update: A large fiscal stimulus is coming!
“Lawmakers Weigh Plan for Stimulus“, New York Times, 10 October 2008
“Time to grasp the fiscal nettle“, Barry Eichengreen, op-ed in the Guardian, 9 October 2009 — Excerpt
In these desperate economic times, the only option left for governments is aggressive fiscal policy. … Fiscal initiatives will have to be large to succeed in stabilising an economy in freefall. In the US case, we are talking 5% of GDP, or $700bn (there’s that number again). This means that the US deficit may be closer to $2tn than $1tn next year. But desperate times require desperate measures.
“House Dems plan second stimulus package“, CNN, 10 October 2008 — “Congressional aids say it could cost $100 billion and is aimed at supporting state and local government agencies.”
“Pelosi Convenes Economic Figures for Stimulus Talk“, Fox News, 13 October 2008 — “House Speaker Nancy Pelosi convened a high-level meeting on Capitol Hill Monday with Democratic lawmakers and noted economists to discuss how to bolster the flagging economy.”
Afterword
If you are new to this site, please glance at the archives below. You may find answers to your questions in these, such as the causes of the present crisis. I have been writing about these events for several years; since November 2007 on this site. As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.
Please share your comments by posting below. Please make them brief (250 words max), civil, and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
For more information
To read other articles about these things, see the FM reference page on the right side menu bar. Of esp interest these days:
- about the Financial crisis – what’s happening? how will this end?.
- about The End of the Post-WWII Geopolitical Regime.
Some FM posts about the current crisis
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Treasury Secretary Paulson leads us across the Rubicon, 9 September 2008
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High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
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Say good-bye to the old America. Welcome to our new socialist paradise!, 17 September 2008
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Another voice warning about the nationalization of AIG, 18 September 2008
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A vital but widely misunderstood aspect of our financial crisis, 18 September 2008
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A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
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Another step away from our Constitutional system, with applause, 19 September 2008
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What do we know about the financial crisis? What are the key questions?, 20 September 2008
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Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
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America appoints a Magister Populi to deal with the financial crisis, 21 September 2008
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Legal experts discuss if the Paulson Plan is legal, 21 September 2008
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Essential steps to surviving the current crisis, 23 September 2008
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How should we respond to the crisis?, 24 September 2008
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A solution to our financial crisis, 25 September 2008
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Is the US economy in good shape, or in terrible shape?, 27 September 2008
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A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
A few of the most important posts warning about this crisis
This crisis has long been forecast by many, including in articles on this site. Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results. To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime. Here are some of those posts.
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A brief note on the US Dollar. Is this like August 1914?, 8 November 2007 — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
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The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
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We have been warned. Death of the post-WWII geopolitical regime, 28 November 2007 — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
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Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
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Geopolitical implications of the current economic downturn, 24 January 2008, – How will this recession end? With re-balancing of the global economy, so that the US goods and services are again competitive. No more trade deficit, and we can pay out debts.
- A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
- What will America look like after this recession?, 18 March 208 — The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
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The most important story in this week’s newspapers , 22 May 2008 — How solvent is the US government? They report the facts to us every year.
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The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.
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“The changing balance of global financial power”, by Brad Setser, 22 August 2008