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In the end, there is a simple solution to all of this..

November 9th, 2008 · 1 Comment

It’s not without risk, but these risks are further away, and they can be dealt with.

There is talk of interest rates going to zero. Free money! That’s cool, at least as a concept, because we’re not at all sure that this is going to work.

The monetary authorities can push as much money into the banking system, but if these are hesitant to lend out, because asset prices are still falling, the economy falls of a cliff, and credit default risks are increasing as a consequence of these, they will only tighten credit conditions further.

It has been compared to pushing on a string. In some countries (the UK for instance), bank have more or less been ordered (or at the minimum exhorted) to increase credit supply and pass on rate cuts, a clear sign that banks would prefer just sitting on the cash, in which case it doesn’t help much.

This is akin to Keynes famous liquidity trap, which describes a situation where interest rates have become so low, everybody expects them to rise, and keeps wealth in cash form as a result. Demand for money becomes near infinite, because people fear negative returns on other investments once interest rates rise.

There are two ways out:

  1. Friedman suggested bypassing financial sector and giving money directly to the population (circumventing tightening credit standards), a solution which has since become known as ‘helicopter money’ as it (half seriously) involved throwing money out of a helicopter. However, nobody can guarantee that this money might not be (at least partially) saved, in which case, it’s not very useful
  2. The central bank can give credit to the state directly, buying government bonds directly from the state and crediting it’s accounts.

The latter option is monetary financing of the budget deficit. It defeats any liquidity trap as the government spends the money with disregard to its return, but to get the economy out of a deep recession.

The long-term dangers are that the ballooning money supply will create inflation when the economy recovers. That danger is real, but:

  • At present, there is no inflationary problem, but there certainly is a distinct possibility of a deep recession.
  • The inflationary risks in the midst of a deep recession, one that now seems inevitable, are basically nil. There is a buyers strike, unemployment is rising rapidly, there is much spare capacity and especially in those industries where fixed cost play an important role, deep discounts are inevitable.
  • The inflationary risks can be dealt with at a later date, when the economy has recovered (the central banks simply sells these government bonds on the open market, soaking up the excess money)

This works, but only as a part of increased government spending. That is now all but inevitable. The state can go on a spending spree with free money repairing and building world quality infrastructure, for instance. Something that benefits later generations.

This also provides a form of justice, as the increased government borrowing (when the central bank finally sells the government bonds) also burdens future generations with more public debt.

Tags: Credit Crisis

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