Out on the road today, I saw a deadhead sticker on a Cadillac – a little voice inside my head said: Don’t look back, you can never look back, so intoned Don Henley in his classic Boys of Summer.
Economists and policy makers would be wise to take Mr. Henley’s advice about looking back. Today, the Federal Reserve announced that the country was experiencing “economic headwinds.” It is this sort of deep statement of the obvious that ensures me that the money I pay to keep the Federal Reserve System in operation is well spent.
The Boys of Washington believe that the American economy is going through a period similar to Japan’s lost decade. According to the Economist Magazine, America’s initial response to the recession drew on the lessons from Japan. About $1.2 trillion in fiscal stimulus has been injected since President Obama took office. The Fed cut interest rates to nearly zero and injected $2.3 trillion of new money into the economy. As of this month the Fed has kept its target Federal Funds Rate at zero percent (implying an interest rate for short term bank borrowing of about negative 4 percent) for 30 months! And while all of this loose-money has brought down Treasury yields, encouraged the investment in more risky assets, inflated the stock market and pushed down the dollar, it has done little to stimulate the economy.
By looking back, the Boys of Washington assumed that low interest rates would encourage banks to borrow from reserve funds at the Fed in order to lend to consumers and businesses. This has historically been one way to encourage economic activity and help the economy out of a recession. But since the Fed reduced rates to zero, the economy has grown by only 3.5 percent, and lending has slowed. Consumer borrowing is lower today than before the recession, and has barely budged since the beginning of 2010. Business debt is down by 13 percent since 2009 alone.
The reasons behind this are simple. The financial crisis and recession were not caused by a lack of credit, but rather by too much credit. In this instance, increasing the money supply in order to stimulate the economy is no different than attempting to cure a hangover by drinking another bottle of scotch. It may have some temporary effects, but will only extend the hangover for a longer period. The Economist cites research from the Peterson Institute that shows this to be the case. Excessive debt can only be corrected by a long period of deleveraging and injecting more fiscal and monetary stimulus only postpones the inevitable.
Fortunately for the American economy, even though bureaucrats want to look back to the 1930s for their models of how the economy should work, both consumers and businesses are looking to the future. They understand that the credit cards, mortgages and bonds need to be paid, and that interest on debt is real. They have begun the necessary deleveraging process, and even thought the Federal Government has picked up much of that debt, overall borrowing levels have at least begun to fall.
However, not until the Boys of Washington finally stop looking back and allow the painful process of deleveraging to work, will the economy truly start down the path to recovery.