Monday, July 11, 2011

Law and the so-called Debt Ceiling III

The above chart shows the historic accumulation of excess reserves in the banking system. Today excess reserve accumulation stands at an unprecedented$1.6 trillion. In addition the largest firms in America are hoarding another $2 trillion, a record high. Further, Treasury Securities still yield essentially zero as far out as 3 months on the yield curve and last week 4 week notes auctioned off at exactly zero yield. All of this hoarding is a rational response to a sick financial system that has not been repaired and the chronic lack of effective demand in our economy. Deleveraging is destroying confidence precipitating a classic liquidity trap. In fact, but for the government backing of our largest banks, most of them have weak or very weak financial structures. And the most recent jobs report shows just how weak the economy is--unemployment went up, wages went down and hours worked went down. Indeed, the employment ratio, the broadest gauge of employment and unemployment rested at 58.2 percent, the lowest since 1983, matching the 2009 crisis low:
More and more economists (such as Nouriel Roubini, Laura Tyson, Brad Delong and Paul Krugman) therefore recognize the obvious: the U.S. desperately needs more fiscal stimulus, in the short term. Government stimulus is the only thing keeping the economy afloat. Unfortunately, it was too small and is now running out.

Moreover, if President Obama agrees to further fiscal austerity, the economy will most certainly crater. Even Fed Chair (and Bush appointee) Ben Bernanke warns against rapid withdrawal of fiscal stimulus. Some market pundits even warn of tipping the economy into a severe contraction through excessive austerity--which has now already failed in Greece, Ireland, and the UK. As the Economist puts it: "cutting back spending viciously in the short term at a time of private-sector retrenchment would be a mistake." If President Obama agrees to trillions in spending cuts along with tax increases, he should insist upon real economic stimulus or face the political consequences of a stagnant economy in 2012 that could seal his fate as the Herbert Hoover of his time.

On the other hand, should the GOP force the Administration's hand and refuse to increase the debt ceiling, then the Treasury would be obliged to print money to pay its bills. Any inflationary threat generated by the expanding money supply could be neutralized by the sale of bonds by the Fed as needed in its judgment. But this process will directly stimulate the economy without relying on our dysfunctional banking sector to stop hoarding cash and actually make loans. As shown in the FDIC Quarterly Bank Profile Report, bank lending is still contracting rapidly:

Being forced to print money could well turn out to be the most effective government stimulus yet, in terms of putting real money in the hands of those most likely to spend (about 50% would go to people unlikely to save much), with little real threat of inflation in the short term. I the medium term, the Treasury could simply issue bonds to mop up the new liquidity once the GOP comes to its senses and unemployment plunges. Thus, the course of action I argued for in prior posts on this blog (and as originally articulated by Peter Morici) could stimulate the economy, save the US from default, and inflict political pain upon the GOP for their reckless misadventure.

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