As the magnitude of the financial meltdown became terrifyingly clear over a trillion dollars was pumped into the banking system, and short-term interest rates at which banks could borrow were reduced, essentially, to zero. The prime rate of interest at which an individual or business could borrow (and, of course, the rate which households could earn on their savings or investments) plunged accordingly. Thus, the money supply rapidly expanded and the economy, in theory, should have briskly expanded thereafter. It didn’t.
That’s because banks, now awash with cash, didn’t loan that cash to consumers or businesses. So we experienced a rapid increase in the money supply but no real acceleration in the velocity of the money supply (the rate at which money changes hands).
Banks had, and have, two reasons for hoarding their taxpayer provided largess. First, why take on any risk at all when the Fed is making money available at, essentially, no cost, which can then be recycled (at no risk) into interest bearing government treasuries with the banks pocketing the difference as profit. Second, the banks know that their balance sheets still carry enormous levels of real estate (residential and commercial) valued far in excess of their realistic current value. The incentive is huge for the banks to hoard all, or the lion’s share, of the free cash as a hedge against a day of reckoning the banks know (or fear) may be coming. So, in effect, trillions of dollars (increases in the money supply) are locked in irons (curtailing the velocity at which money changes hands) and have had little value in stimulating the economy.
We don’t minimize the value of the Troubled Asset Relief Program (TARP), which was initiated under Bush and accelerated under Obama. One can only imagine how devastating the financial meltdown would have been had a bank run reached critical mass. But when, and if, that money begins to flow into the economy its inflationary impact (the resulting increase in the velocity of the money supply) could be disastrous. We do not share the view that we needn’t worry about inflation because it hasn’t reared its head yet. As we opined in a previous essay, that’s like a physician advising a patient not to worry about smoking, because, so far, there is no sign of lung cancer.
The Fed and the government are in a quandary. Interest rates have been kept artificially low, we are told, to stimulate the economy and to keep the country from falling back into recession from which, presumably, it emerged three years ago. That may be true, but the fact is that any significant increase in the rates the government has to pay to its creditors (domestic and foreign) would be a real body blow to any effort to reduce our soaring deficits. We are caught in a proverbial Catch 22. While interest rates may be unrealistically low, and, therefore, in need of some upward adjustment in the near future; the last thing the country can afford is a dramatic spike in the cost of servicing its ever-mounting debt.He continues with a reminder that the deficit exceeds GDP, and we need to deal with it soon. As stands to reason!
This article explains to me also why Romney supported TARP was it was formulated, which I had wondered about. It also explained why now Romney feels so strongly that we tackle the deficit before it conquers us.