Information about finance, the economy and business. Entertaining and informative. Seeking Alpha Certified Mark Sunshine Chairman & CEO

Money Supply And Economic Data Weekly Watch – Reprint of A New York Times Economix Blog Post

Octo­ber 4, 2008, 6:02 pm

Will Paulson’s Two Plans Unplug the ‘Liq­uid­ity Trap’?

By Mark Sun­shine

Editor’s note: Mark Sun­shine, pres­i­dent of the com­mer­cial lend­ing insti­tu­tion First Cap­i­tal, writes a guest post about why we may be head­ing into what’s called a liq­uid­ity trap. This means that mon­e­tary pol­icy, includ­ing interest-rate changes, can’t pre­vent a deep depres­sion, but that the Treasury’s fis­cal stim­u­lus plans – includ­ing a little-noticed tax change pushed through last week – just might work.

Any­one who reads news­pa­pers or watches TV knows that the bank­ing sys­tem is in cri­sis. Credit is tight, banks are hoard­ing cash and short-term Trea­sury yields are almost 0 per­cent. The Fed has lost its abil­ity to unfreeze the sys­tem and the nor­mal cir­cu­la­tion of money isn’t hap­pen­ing. Almost all of the mon­e­tary signs point to a poten­tially ter­ri­ble new phase of defla­tion and dra­matic eco­nomic con­trac­tion.

This week’s Fed mon­e­tary report showed that dur­ing the week end­ing Sept. 22, money sup­ply (as mea­sured by sea­son­ally adjusted M2) increased by $165.5 bil­lion to $7,900 bil­lion. On an annu­al­ized basis this is an aston­ish­ing 108.94 per­cent growth rate. The Fed has been aggres­sively pump­ing money into the sys­tem in the hopes that rad­i­cal mon­e­tary stim­u­lus will restart lend­ing. How­ever, the newly cre­ated money is being hoarded by banks as they “stuff the mat­tress” with short-term Trea­sury notes.

Here’s why these events are dis­tress­ing: When the Fed douses the mon­e­tary sys­tem with cash but banks hoard it, mon­e­tary pol­icy no longer works and the econ­omy starts to crash. This is called a “liq­uid­ity trap” and it occurs when inter­est rates are at or close to 0 per­cent and mon­e­tary pol­icy is no longer effec­tive. Newly minted money is injected into the bank­ing sys­tem but trapped by finan­cial insti­tu­tions that are par­a­lyzed by fear. When banks don’t recy­cle their money through nor­mal lend­ing activ­ity, it doesn’t mat­ter how much the Fed increases the money sup­ply. Mon­e­tary pol­icy just won’t work. Fail­ing mon­e­tary pol­icy usu­ally means that we are going to have a reces­sion, or worse.

This is what hap­pened at the begin­ning of the Great Depres­sion and dur­ing the Japan­ese bank­ing cri­sis of the late 1990s. In both cases, eco­nomic activ­ity slowed dra­mat­i­cally and defla­tion occurred. No mat­ter how hard the cen­tral bankers tried to pump money into the econ­omy, it wouldn’t work.

Today we’re fac­ing a sim­i­lar prob­lem. Despite the dra­matic increase in money sup­ply last week, it remains sur­pris­ingly dif­fi­cult to get loans from tight-fisted and scared bankers. Cor­po­rate and con­sumer loan inter­est rates shot up to unheard-of lev­els com­pared to Trea­sury yields but still banks won’t lend. Finan­cial insti­tu­tions con­tinue to express their fear through panic buy­ing of short-term Trea­suries as those yields dropped to almost 0 per­cent. Trea­suries are the new “gold” of this mil­len­nium and have become the invest­ment of choice for insti­tu­tions that are afraid of tak­ing risks.

The liq­uid­ity trap has neutered the Fed and its chair­man, Ben Bernanke, because there isn’t much that the Fed can do with money sup­ply or inter­est rates to make things bet­ter (despite reports that the Fed may cut inter­est rates again soon). Only fis­cal stim­u­lus – tax cuts or gov­ern­ment spend­ing hikes intended to increase demand — will unplug the sys­tem.

Trea­sury Sec­re­tary Henry Paulson’s plan, which is now law, is fis­cal stim­u­lus that will be injected directly into the bank­ing sys­tem to sup­ple­ment almost nonex­is­tent private-sector lend­ing with gov­ern­ment cash and deter­mi­na­tion. Mr. Paul­son may be shoot­ing the right weapon at the right time because it will help res­cue the banks while restart­ing cor­po­rate and con­sumer lend­ing.

But Mr. Paulson’s fiscal-stimulus work didn’t end with the bailout bill.

With hardly any­one notic­ing, on Wednes­day he pushed through very tech­ni­cal and obscure changes to tax reg­u­la­tions that pro­vide a “tax sub­sidy” for acquir­ers of trou­bled banks. Just as automak­ers stim­u­late car sales through rebate checks, the Trea­sury is pro­vid­ing a form of tax rebate to acquir­ers of trou­bled banks. Every­one can thank Hank Paul­son and his stealth tax-driven fis­cal stim­u­lus for the aston­ish­ing news that Wachovia was being acquired by Wells Fargo and not Cit­i­group. It was Mr. Paulson’s tax sub­sidy to Wells Fargo that pro­vided the fis­cal grease to make this deal hap­pen. Pun­dits who point to the deal and pro­claim that the “free mar­kets work with­out gov­ern­ment help” don’t under­stand the moti­vat­ing effect of sev­eral bil­lion dol­lars of tax ben­e­fits to Wells Fargo.

Hope­fully Mr. Paulson’s fis­cal moves will pro­vide enough fis­cal lax­a­tive to unplug the bank­ing sec­tor and get money flow­ing again. Only time will tell if he’s done enough or if more will be required from the next Trea­sury sec­re­tary.

Posted in: BANKS, Deflation, Economic Statistics, economy, Finance, Fiscal Policy, GDP, Great Depression, Liquidity Trap, M2, monetary policy, Money Supply, Paulson, Tax policy, Wachovia, Wells Fargo

Leave a Reply

Your email address will not be published. Required fields are marked *


You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>