A Monetary Drip of $800 Billion

For a short time it appeared to be all quiet on the economic crisis front, but things are seldom what they seem. It is not just a credit crisis anymore. It is clear that even in the Netherlands a far-reaching recession is happening or developing. Piet Hein Donner, Minister of Social Affairs and Employment, has already received the first applications for a ‘subsidized’ reduction in working hours from businesses. However, for big gestures we’ll have to look at the United States.

The FED, the system of central banks in the US, has announced that it will pump $800 billion into the various credit markets over and above the earlier established $700 billion Troubled Asset Relief Plan (TARP). In addition, president-elect Obama is thinking about a hefty stimulation plan for the American economy. The European Commission is coordinating, or at least it likes to think it is, the implementation of an EU-wide stimulus package worth €200 billion, mainly based on the plans of individual member states. This does not sound like much if you compare it to the US figures, but the recession in America is currently much deeper than in Europe. That could change of course.

To combat the crisis, it is important to get the financial system going again. Many readers might think that we should abandon the financial parties to their fate, but the economy cannot afford to indulge in that kind of revenge. Besides, from a law and economics point of view it doesn’t make sense. The only sensible reason for a punishment is to prevent the same thing from happening again.

We have to sort out the various credit markets to get the credit flow going again. The reason this is not happening has everything to do with the heart of the credit crisis: bad loans. A scary example is the collapse of the Japanese real estate bubble at the end of the 1980s, which kept Japan in a deflationary or zero-growth situation for over a decade. The main reason for this was the portfolios of bad loans by the Japanese banks. These loans made it impossible for the banks to issue new credits because they needed all their capital to mitigate the losses in the existing portfolios.

FED chairman Bernanke wants to prevent the US from going into a similarly long period of economic malaise. Buying up the bad loans frees the banks of a heavy burden and makes credit flow possible again. Bernanke is not only doing this for subprime mortgages, but also for other credit markets such as credit card loans and student loans. These markets have a much more direct effect on consumption than the mortgage markets and that is what is desperately needed for an American economy in recession. In addition to Bernanke’s restoration of the credit supply, Obama wants to turn the tide of the fall in demand in the US by presenting a package of stimuli aimed primarily at the middle class. However, Obama is not in the White House yet and he will have to get his plans through Congress first. Bernanke can already begin buying. The combination of the two approaches would of course be far more effective than a solo effort by only one of them. In this respect, the changeover of presidents couldn’t have come at a worse time for the American economy.

The main risk from these interventions is inflation. Bernanke is printing money to buy up the bad loans, which will have an inflationary effect. In the short term this has the advantage that the deflationary (downward) price spiral could possibly be stopped, thus preventing an extended period of falling prices. After all, in a situation with falling prices it is to the consumer’s advantage to defer spending because the goods will be cheaper tomorrow. This effect would be disastrous for the American economy. By printing money, Bernanke is trying to prevent this situation. If this monetary stimulus works, the FED will have to increase interest rates shortly afterwards, this time to contain the inflationary (upward) spiral.

Oscar Couwenberg

Professor of Law and Economics