Thursday, September 20, 2012

Money Going Down a Black Hole

For the past four years the Federal Reserve, the President and Congress have operated under the Keynesian notion that we can spend our way through the recession/depression/financial crisis, and that if we did, economic growth would eventually return. Keynes had the idea that during an economic down turn governments should engage in deficit spending as a counter cyclical economic force to speed up a recovery. Keynes even postulated that it didn't matter how the money was spent. A work crew could be hired to dig a hole while another was hired to fill it in and the result would still be economic activity. Of course I'm over simplifying some what. Keynes also thought we should run surpluses when times were good. But it is essentially this theory that both the US government and the Fed have operated under in their attempt to get the economy moving again.

In February 2009 congress passed the American Recovery and Reinvestment Act of 2009. The bill's total cost was  $831 Billion dollars. It was then thought that there would be a "multiplier" effect, that is for example, for every dollar spent on the stimulus, there would be say $1.50 of economic activity generated. This is precisely what Christina Romer (Chair of the Council of Economic Advisers in the Obama Administration) had predicted. So in other words, the $831 Billion spent would generate about $1.2 Trillion in new economic activity. This was the basis of the Obama administration's projections for unemployment shown below:

Obviously the actual results were not what had been expected. Why? According to John Cochrane:

Estimated macro models used for policy evaluation—whether old Keynesian or new Keynesian—have this basic mechanism built into them. However, they differ greatly in their predictions of the policy impact because of different assumptions about expectations, the marginal propensity to consume, the speed of price adjustment, and crowding out of other spending. For example, Christina Romer and Jared Bernstein used old Keynesian models to predict the effect of the stimulus package of 2009 before it was implemented. They predicted large effects of the package with multipliers around 1.5. In contrast, in research with John Cogan, Volker Wieland and Tobias Cwik, I used a new Keynesian model to predict the effects of the 2009 stimulus. We predicted a much smaller effect, with multipliers averaging 0.5, even less when you include transfer payments.

As we will see it was actually much lower...about .2. Yep, for every $100 spent, we generated $20 of economic activity. Not a very good investment. It is explained rather well in the video below from Charles Biderman:

So we are spending far beyond our means (Over $1 Trillion each year for the past four years) and an extra $831 Billion on a stimulus that has not generated enough economic activity or growth to justify its use.

Its just as bad or even worse at the Fed where they have bought $2.5 Trillion of junk assets from banks and newly created treasury debt. The new QE3 will take us to about $5 Trillion over the next few years but is just as doomed to fail as QE1 & QE2. Why? The Fed operates under some assumptions that are dislocated from reality.

First, is the money multiplier which I've explained before using the example of the Fed's fractional reserve where a bank can take $100 of deposit money and make $900 in loans. QE is partially about getting more money to banks by buying Treasuries from banks in the hope they will make loans. In this way the money multiplier would create new economic activity in the economy. The problem however, is that the banks aren't lending or are being extremely tough with their underwriting of new loans. Anyone trying to get a new mortgage knows what I mean. So the money sits on their balance sheets or is lent back to the Federal reserve where they get paid for their excess reserves or they buy new treasuries paying a risk free rate of return of 2-3%. The result is that there is no money multiplier in the real economy.

The graph below from the St. Louis Fed shows the money multiplier has fallen below 1 since 2008:

The combination of both of these types of multipliers (monetary and fiscal) being essentially between zero and one explains why both monetary and fiscal stimulus have not worked so far.

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