Secretary of the Treasury Henry Paulson, left, and Federal Reserve Chairman Ben Bernanke, right
The government is fighting the current recession as if it were the Great Depression of the 1930s. This reflects a serious misinterpretation of reality, one that will most likely persist beyond Inauguration Day.
Barack Obama's appointment of Berkeley professor Christina D. Romer as chairwoman of the Council of Economic Advisors is consistent with this orientation, as she is an expert on the Great Depression and may lend support to the unwarranted focus on the Depression. Indeed, Romer has supported the Fed's current monetary policy because she sees parallels with earlier financial panics. (See who's in President-elect Obama's White House.)
From this anti-Depression policy has come a stream of costly policy errors that could ultimately prolong the current recession. The Fed's Dec. 16 decision to drop the target federal-funds rate to a record low of 0% to 0.25% is but the most recent of these. With rates already effectively trading near zero despite the Fed's previous target of 1%, the decision does not actually change rates and only sends a negative message about the state of the economy. That worsens confidence. And now the target rate has nowhere else to go, so the Fed will have to resort to new means to increase liquidity — a painful irony, since liquidity is not even the problem. (Read TIME's top 10 financial collapses of the year.)
It is true that the Great Depression of the 1930s was a crisis of liquidity. Stocks plunged, banks went under, and the value of assets disintegrated. Our current policies would have been appropriate in the Great Depression, but they are not appropriate now. Liquidity problems are not the source of our current financial and economic woes. Incredibly, excess reserves of depository institutions have increased from under $2 billion in August to a record $774 billion in mid-December, according to the Federal Reserve's Dec. 18 release. But the banks have not taken advantage of this liquidity to increase their lending. (See pictures of the stock-market crash of 1929.)
Why not? Because what we have is not a crisis of liquidity but rather a crisis of confidence. With tremendous excess reserves, it is obviously not the case that banks are not lending money because they do not have the money to loan. Instead, they are afraid that other institutions, including other banks, will not pay it back. The banks do not have confidence in each other. Businesses, too, are disinclined to borrow money and take risks. And consumers are not spending because they are afraid they could lose their jobs.
By continuing to throw money at the banks, the government is on the road to prolonging the recession and effecting massive inflation once confidence is restored and the economy then has too much liquidity. By making money available to the banks essentially for free, the Fed does not guarantee that the banks will lend out the money to businesses. There is no motivation to lend money at low rates when capital preservation (i.e., lack of confidence) is still a leading issue. Rates may be low, but the banks are not going to offer these rates to the individuals and industries that can make the most productive use of them — at least not until confidence returns. (See pictures of the recession of 1958.)
Far from being helpful, the Treasury worsened the situation by increasing the liquidity of the financial sector through its bailout. However, the greatly enhanced lending capacity of depository institutions has not yet reached the money supply, as evidenced by the tremendous level of excess reserves. When it does, the Fed will find it difficult indeed to summon the political will, or find the ability, to soak up all this excess liquidity. Recessions ordinarily lead to deflation or disinflation, which increase the real value of assets and act to end the recession by fostering spending. This natural and necessary corrective mechanism will be thwarted by inflation as soon as we begin to get out of the recession. That is the danger of treating a crisis of confidence as a crisis of liquidity.
Lawrence H. Officer is a professor of economics at the University of Illinois at Chicago; Ari J. Officer has completed a Master of Science degree in financial mathematics at Stanford University.