Outsized money creation can salvage the mess, but the bill is rather large. Still, it’s becoming almost unavoidable..

In it’s most elementary form, there are two related economic problems:

• The banking system is in a terrible mess
• Aggregate demand has fallen far short of aggregate supply

In principle, the central bank could take over enough bad assets as to clean up the balance sheets of the banks for them to resort back to more or less normal functioning, although more efficient would be (as we argued before here) to provide them with enough capital.

Either way, the bill is going to be large. The balance sheet of the central bank would balloon out of proportion. It is already happening, and known as ‘quantitative easing’.

However, this by itself is not enough, because credit has fallen at least as much because of a fall in the demand for credit, which has to do with balance sheets of companies and households.

Driven by fear, they are repairing their balance sheets, hence demand is falling of a cliff. Not only does this wreck the economy, it worsens the bank problem considerably, in a self-reinfocing feedback loop.

This problem is also, at least in principle, solvable. The only party which could spend to stabilize the economy (and break these vicious cycles) is the government, if only the spending would be big (and smart) enough.

Financing can be done by selling treasuries to the Fed, that is, money creation in much the same way as to tackle the banking problem (and has the additional benefit that long-term interest rates need not rising).

Taken together, the resulting ballooning of the money supply and the Fed’s balance sheet would be enormous. But we cannot stress enough that to a degree, it’s already happening.

What are the problems to go a couple of steps further, and to do it in a decisive way as to break the vicious cycles that spiral these problems out of control?

Basically, a ballooning money supply could create inflationary problems down the road. However, this is likely to be the lesser of evils:

• Inflation would certainly not be created overnight, spare capacity in the economy is way to large
• It definitely would put the brakes on any pending deflationary cycle, which would destroy balance sheets even more, and has to be prevented almost at any cost, in fact, one could argue that a dose of inflation is just what the economy needs right now
• When the economy stabilizes, a considerable deal of the money overhang can be taken away through selling by the Fed of the treasuries (normal open market operations)
• Even some of the bad assets will turn out to be not that bad, some people continue to pay their mortgage, and (especially when the economy stabilizes), house prices will also stabilize meaning that a considerable amount of the now difficult to market assets will turn out to have underlying value. Selling these further reduces the monetary overhang

Since the Fed is already increasing the money supply by a large extent, it’s not a matter of principle, but a matter of assessing at what scale it needs to proceed in order to stabilize the economy, and whether at that scale the advantages of doing so outweigh the disadvantages.

Pondering over the alternative, we think the advantage of scaling the money supply up by buying treasuries and injecting more capital into banks far outweigh the disadvantages, which would create even bigger problems as the vicious cycles of demand and balance sheet destruction feed off on one another.

There are some other risks attached to this proposed solution though:

• Currency markets: there is a risk that the bold money creation would destroy the external value of the dollar though, however, it could be argued that if the program is seen as a success, and America is the first to take decisive measures to stem the economic rot, it might very well be good for the dollar
• Embarking on aggressive money creation is another instalment of what got us into this ‘bubble cycle’ in the first place (we wrote on that here)
• To prevent this mother of all bailouts letting the moral hazard problem manifest itself again, some new financial regulation will have to be put in place.

Still, pondering over the wreckage of the world economy, it looks like these risks are worth taking. Something has to stop the rot, because if it’s allowed to reign for much longer, asset values, balance sheets and the world economy will be in such a mess that it will be much harder to repair the damage and get out of the hole, especially if deflation starts to rear it’s head in earnest.

If that happens, the monetary expansion we are proposing here will have to take place anyway, but from an even much less favourable vantage point.