The turmoils affecting the economics and financial markets in the United States and Europe do not seem to go away as fast as anyone would want to. Those who warned that this may be a crisis with a “W” shape may well be right. The recent downgrade in from AAA to AA- in the short term debt of the United States Treasury bonds, may be a more psychological and symbolic effect than real, could show checkmate situation. Let us make a short review of the events of the last years and what seems to be the lockout.
After the dot-com bubble and the attacks of 9/11 the Fed went into a low interest rate policy to give energy to the economy. This easy credit nationwide policy, plus specific regulation favoring the housing market, gave place to the housing bubble. Because many goods can be bought from other countries, there where no signals of inflation but, instead, a trade deficit. Imports grew. Export industries in the rest of the world became dependent of the U.S. and other countries. (Export dependent countries ma,y have a difficult situation ahead as well)
Other major central banks, in order to avoid monetary imbalances in, for example, exchange rates, followed the easy credit policy of the Fed. It was not only the Fed, but many major central banks the ones following the same policy. It is no accident, as John Taylor points out in Getting Off Track, that those countries that went further in lowering their interest rates had experienced the greater housing bubbles.
When following an easy credit policy, sooner or later inflation starts to appear (maybe slower in an open economy that trades goods with the rest of the world) or a bubble ensues. Eventually the monetary policy needs to be discontinued and interest rates increased. The housing bubble and the market value of the mortgages collapsed. Financial institutions started to loose their liquidity and went into financial stress. Mortgages could not be sold anymore to get cash and pay for deposit extractions. The rush to sell other assets made the equities in the stock exchange to fall worsening the situation.
Such was the situation that it wasn’t clear which banks were in worst situation and which ones where in a not so bad shape. Banks did not want to lend neither to other banks nor to firms because it was unknown if the counterpart was just temporary illiquid or insolvent. A set of measures were tried in many countries. In the U.S., for example, they where the TARP, QE2, QE3 and stimulus packages. All of them failed to make the economy recover. And all of them pushed the governments to an even worst situation.
Government, should be noted, had accumulated during all this period to much debt because they chronically ran fiscal deficits. Debt, however, cannot grow endlessly. To know what happens if a government decides to default its debt we need to know who holds that debt. And that is, again, the financial institutions. When the governments decided to buy the ‘toxic assets’ from the financial institutions, they should have bought their own bonds as well so that they could, at worst, default to themselves. This is why, even though there is a financial crisis, it has a fiscal nature.
However, given the extreme measures taken by the Fed in the midst of the subprime crisis, a huge monetary expansion took place. Because banks were illiquid and did not want to lend to each other, plus the Fed offering an interest payment to deposit the funds in the Fed, the monetary expansion did not reach the market and that is why there are no high symptoms of inflation. Banks, however, will eventually start to supply extra credit to the market producing inflationary pressure. The Fed chairman, Ben Bernanke, had an exit strategy to avoid that plan. That, however, requires to increase interest rates. And this leaves us on the ‘checkmate’ analogy in the title.
Given the burden of the debt, the amount of interest the U.S. treasury has to pay the fiscal situation is highly sensitive to interest rates. Interest rates, however, are still very low, the Fed won’t be able to perform an exit strategy that involves an increase in interest rates and do not hit the fiscal situation at the same time. If, as the situation is now, the downgrade of the U.S. debt means that further increases in interest rates will make things sensibly worst.
Maybe there is more fiscal creativity to get gains from, but given the situation, there seems to be no much extra time for the politicians and governments to deal with the problem at hand: fiscal deficit and a too high debt burden. This problem is not solved with interest rate policy or stimulus, but with a stable budget, fiscal deficit has to be reduced.
But, why did the stimulus failed? This is because there is a wrong diagnosis of the problem. This is not a demand driven crisis, but a supply crisis. The housing bubble is an example. Investment is needed in the right industries. Investment, however, does not occur when demand grows, but when the rate of return increases. To increase government spending by means of taxation, inflation, uncertainty, makes economic costs grow as well. Until it is not recognized that so much monetary mismanagement provoked a supply problem, and a strong consensus is not achieved by the nation leaders to deal with the fiscal problem, no real solution, but only make-up effects, will be attainable.
Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.