On the Possibility of Both Monetary and Fiscal Impotence

dre cummings recently used the term "incredulous" to describe his reaction to optimistic accounts of the economy. As usual dre is right. Above is a chart of bank reserves held at the Fed. The bottom line is the banks are still hoarding massive capital--even more than during the fall of 2008. They obviously do not trust their own balance sheets, the economy or both. This represents a massive pool of idle capital. The flip side is that banks are not lending. Thus, the WSJ headline from Wednesday: Lending Falls at Epic Pace. Under these circumstances monetary policy is ineffective because it depends upon banks lending their liquid assets.

We are also out of fiscal policy ammunition. Credit markets are wary of sovereign debt, and as Martin Wolf (Chief Economics Commentator at the Financial Times) points out it seems that a sovereign debt crisis is inevitable. Frankly, we wasted our fiscal stimulus on ineffective tax cuts instead of massive investment, as I argued in late 2008. Political support for a timely stimulus is wanting to say the least.

So with no monetary policy solution and no fiscal policy solution any kind of crisis will not be met with appropriate government action. We seem destined to face the next major downdraft without hope of government rescue.

Will there be such a downdraft? Well, spring is just around the corner, and in Chicago during the spring even the thought that the Cubs could win the World Series seems plausible.

But, the economy is facing severe headwinds. One excellent summary of the problems (with some level of excessive pessimism) can be reviewed here. Everyone should look at the gory facts--all 15 of them. They fully support dre's point. Any one of these problems could cause a repeat of the nightmare of late 2008; in fact, our government has done virtually nothing to assure that such a repeat does not occur. As Noble prize winning economist Joseph Stiglitz puts it:

"On regulatory issues, almost nothing has been done. The structure of the banking sector is worse. The too-big-to-fail banks are bigger. Of the smaller banks, 181 went bankrupt since 2008. In the bailout, the banks didn't do what they were supposed to do, which was to restart lending."

Stiglitz also maintains that US standards of living now have nowhere to go but down. We have been living from bubble to bubble, consuming more than we produce for too long. Now we are indebted and need to tighten our belts not just to live within our means but to pay off excessive debt. Indeed, as the chart to the left shows, our debt situation has worsened through the present crisis, as our wealth has shrunk, our incomes are declining, and our debt is therefore more unsustainable now than it was at the beginning of this nightmare.

To sum up: we still have way too much debt in our economy; the banks still seem insolvent, terrified of their balance sheets and unable to lend; our regulatory system is a proven catastrophe; and we must under go a painful deleveraging that is just getting started because we missed our opportunity for massive government led investment. And, we have reached the point of both monetary and fiscal (or at least political) impotence--something that has never before happened in the history of modern capitalism.

The question I have is this: if we do experience another downturn and government is unable to respond in force, what does that reality look like?