Thursday, May 28, 2009

The sorry state of officialdom

Ezra Klein asks:
Recently, I asked an administration official which government program we'd remember as making the most difference in averting catastrophe. Where will the history books place the credit?

"It'll be the Federal Reserve," he replied. "It'll be their decision to increase the size of their balance sheet from whatever it was before the crisis to whatever it is now."
The Fed stepped in to do the intermediation that the banking system was failing to do. By buying longer term government bonds (issued by the Treasury) the Fed decremented one number in their spreadsheet, and incremented another number in their spreadsheet by the the same amount. By substituting one financial instrument for another financial instrument, they "averted catastrophe".

I see this as instituting FDIC insurance where there was none before. If you insist on a system that has built in bank runs, then you need to take market discipline away from the liability side of the ledger.

But the "green shoots" we may or may not be seeing right now come from unemployment, high taxes linked to income, and Federal unemployment insurance. The Federal Government has swung massively to deficit, and begun to undo some of the harm done by the surpluses of the Clinton years. It's still too soon for Obama's fiscal "stimulus" plan to kick in, so the deficit has grown through automatic stabilizers: when people lose their job, they stop saving, stop paying taxes, and start getting fiscal transfers from the Government. Unemployment reduces demand for savings. There was no need to do it this way, it converts a nominal problem into a real one. Savings are easy and free to fund.

If Obama gets serious about shrinking the deficit, through a VAT or higher marginal taxes, then we'll see aggregate demand fall again and the economy slump back into recession, requiring higher unemployment rates to once again increase the deficit, and fund the private sector's demand for savings. We may also see the Fed getting even more active as they uselessly and impotently move a number from one cell in their spreadsheet to another.


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