Posted by: Dirk | March 27, 2009

Solving the crisis by turning back the clock 2 years?

The plan by the Obama administration seems to be the following (see FT graphic exposition):

  1. Push stock market prices back up, then
  2. make some modifications to the financial sector …
  3. and that’s it, the economy will start growing again.

Having the Great Depression in mind, I do not believe that this trick will work. Paul Krugman pointed out today that a large financial sector was not always necessary (in his NYT column). He starts like this:

On Monday, Lawrence Summers, the head of the National Economic Council, responded to criticisms of the Obama administration’s plan to subsidize private purchases of toxic assets. “I don’t know of any economist,” he declared, “who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.”

Leave aside for a moment the question of whether a market in which buyers have to be bribed to participate can really be described as “better functioning.”

This point is worth elaborating on. In a (theoretical) free market society, supply and demand establish a price. The price for financial assets is high when people expect those assets to perform well in the future, and they are low if the opposite is the case. Now, we certainly have a lot of pessimistic people in the economy, which explains why prices of financial assets are low. Explaining the pessimism of the people gives us two main possibilities: 1) People are pessimistic for no good reason and 2) People are pessimistic because they have gambled on higher house prices, are loaded with debt and will save more (and therefore consume less) in the future.

It seems that the Obama administration believes in point 1. However, history tells us (those who care about it at least) that probably it is point 2 which has driven the prices of financial assets down. If people consume less, then aggregate demand will fall. This means that prices and also quantities sold will be lower in the future then people had assumed. Prices and quantities sold of course determine future profits, and profits are the reason of holding financial assets. Why should you hold a financial asset which does not offer a return to you?

Well, Geithner and his team think that if you offer monetary incentives to people (hedge funds), they will hold these assets. This might be true in the short run, but in the long run the question will be again: is there any profit to be expected? Will GM, Ford and Chrysler make a profit, yes or no? Of course you could keep up the monetary incentives for holding worthless assets for a long time, but that system will surely not work. In the end, you give money to people who do nothing.

But let’s say, that the plan works and the toxic assets are bought up by non-banking system entities. Then banks can lend freely again, but the big question is: are there any borrowers? With the consumers suffering from debt overload, demand will be declining. Why should companies invest in new products or processes, when they still have a lot of their products unsold in the warehouse? Better to sell these products off first. This would mean that there is no need for investment, and firms might even downsize to adjust to the lower demand in the future. This was the main problem during the Great Depression, and I think this will be our main problem now.

(In terms of the IS/LM model, we are not only in a liquidity trap, but we are also in an investment trap. These traps are really just one. Last autumn I made this point in a paper that I sent out with an application. However, this kind of stuff is impossible to get published in the current academic system.)

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