Thursday, October 4, 2012

Joseph Stiglitz: "Adding liquidity is not enough" ... something else is needed

In a must read Guardian column, Nobel prize winning economist Joseph Stiglitz makes the case for why monetary policy is not going to end the financial crisis and why something else is needed.

Professor Stiglitz argues that the something else that is needed is fiscal stimulus.

Your humble blogger never likes to argue with a Nobel prize winner, but we have tried both of these in combination and it did not end our current financial crisis.

There is a reason that together monetary policy and fiscal stimulus did not end the crisis.  The reason is that neither monetary policy nor fiscal stimulus address the losses on the excess debt in the financial system.

Until these losses have been addressed, as shown by Japan, the economy remains in a downward spiral interrupted by periods where a new fiscal stimulus program creates an uptick.  As soon as the fiscal stimulus ends, the economy slows down and resumes its downward spiral.

I have spent a considerable amount of time on this blog documenting why this downward spiral occurs.  It is the result of not realizing the losses on the excess debt and putting the debt service burden on the real economy.  This burden deprives the real economy of the capital it needs to maintain itself and to grow.

This burden is further exacerbated by monetary policy.

When central banks pursue zero interest rate and quantitative easing policies, they trigger a number of unintended consequences.  One of these unintended consequences is the Pension Fund Death Spiral.

When pension funds and retirement plans do not generate the anticipated returns on their assets, someone has to cover the shortfall.  For pension plans, the shortfall is covered by the sponsoring companies and deprives them of the capital they need to reinvest and grow their business.  For personal retirement plans, the shortfall is covered by the individual by saving more and consuming less.

The actions by both the companies and the individuals cause demand to fall and the economy to shrink.  The central banks respond to a shrinking economy with more zero interest rates and quantitative easing and a negative feedback loop is established.

History shows that when the banks are required to absorb the losses on the excess debt in the financial system, the economy responds positively to fiscal stimulus.

This was first shown in the US during the Great Depression and most recently by Iceland during the current financial crisis.

But the stimulus that is needed – on both sides of the Atlantic – is a fiscal stimulus. Monetary policy has proven ineffective, and more of it is unlikely to return the economy to sustainable growth. 
In traditional economic models, increased liquidity results in more lending, mostly to investors and sometimes to consumers, thereby increasing demand and employment. 
But consider a case like Spain, where so much money has fled the banking system – and continues to flee as Europe fiddles over the implementation of a common banking system. Just adding liquidity, while continuing current austerity policies, will not reignite the Spanish economy.... 
But lending would be inhibited even if the banks were healthier. After all, small enterprises rely on collateral-based lending, and the value of real estate – the main form of collateral – is still down one third from its pre-crisis level. Moreover, given the magnitude of excess capacity in real estate, lower interest rates will do little to revive real-estate prices, much less inflate another consumption bubble....
And here is the great irony of the financial crisis.  What it takes to end the financial crisis is to not preserve the "health" of the banks, but rather to force them to absorb all the losses on the debt in the financial system that is in excess of the borrower's capacity to repay.

By preserving the "health" of the borrowers, the borrowers can service their debt and the value of real estate stabilizes so that banks can be comfortable lending against it.

When borrowers can service their debt, fiscal stimulus can trigger a long lasting upswing in the economy.
For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending.

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