Friday, February 13, 2009

Un-cynicize yourself

This post, by Paul Ormerod, makes (briefly) the case that we should thank our lucky stars for the all the bailouts and TARPs we've had over the last year:

Why should be be thankful that the Fed and Treasury have kept these banks going?  Because without their actions, we'd be much more likely to be in a real Depression-like situation with deflating prices and massive unemployment.

How does this work. Take a few simple macroeconomic relationships.  First, we can generally state that changes in the money supply translate into changes in prices (and sometimes in the short run, into changes in real GDP). So if we let the money supply fall, then prices will fall (deflation) and we get into a world of pain.  In the real Great Depression, the money supply fell, prices fell, and the deflation ruined everyone who was in debt and basically put a full stop to all real investment activity (like building a new factory or buying a new machine tool).

The reason the money supply fell in the GD was not that the Fed didn't "print enough money".  They did increase the supply of cash.  The problem was that banks and people were so scared that they squirrelled away the cash under their beds, so the effective money supply fell. 

What has happened today? People are scared, but not so scared that they are hiding cash under the mattress (the currency to deposit ratio has remained flat over the last year according to the Fed).  Banks are *really* scared, and are hoarding as much cash as they can get their hands on.  The reserve/deposit ratio (roughly the amount of money in the vault relative to the outstanding value of checking and savings accounts) has gone from under 1% to nearly 12% in the last year. 

If the Fed and Treasury had not furiously provided liquidity to the market, then this massive increase in reserves would have brought the money supply down severely (like, a 50% drop in the effective money supply) and that would have certainly put us on the path to deflation and a much worse economic outlook.

I'm not saying this for certain, but it is not impossible that people will look back at 2008/2009 and say that the Fed and Treasury did an amazing job of preventing another Depression. 

So now what is up with the remaining TARP funds?  We may have arrested the slide, but banks are still sitting on tons of bad loans and so are still hoarding funds.  To end this and get the financial system back to "normal" (albeit hopefully with a little more aversion to risky loans) requires getting banks to come clean on where they stand, and getting them to write down the value of their bad loans.  This means a) banks will fail, and b) other banks will require additional capital - probably both public and private.  Once we get the banks clean, the reserve ratio (that 12% number) will drop and that will free up the cash to provide the loans that are necessary to make the world of business go around.  (Note that we're not talking about crazy loans to buy mortgages, but loans to businesses to make payroll while they wait for accounts receivable to clear).

No comments: