Those who know me know that since the beginning of this crisis, I’ve been in the Stiglitz/Johnson/Galbraith/Krugman/Calculated Risk/et al. camp, advocating for a restructuring of the banking system. I believe that only through a restructuring of the debt loads plaguing the private sector could the system be reset to support sustainable economic activity and growth. However, such a course of action involves short-term pain and negatively impacts the banking sector’s interests, therefore it was not tried for lack of political will.
That leaves reflation. But is the course of action we’ve taken in the U.S. the best way to reflate? If I may summarize the current response in a nutshell: the Fed has lowered interest rates and supported asset prices through massive QE and a variety of lending programs, while the federal government effected a weak, temporary, and fragmented fiscal stimulus program. This has led to the worst of all possible worlds: assets that are discounting a highly unlikely stream of income, and worlwide bubbles. Deflation is still entrenched, inflation is an unpredictable institutional risk, and economic and financial crashes are likely–especially in the emerging world.
What should they have done? I’d argue essentially the opposite: the Fed should have considered vastly limited asset price support and stuck with moderate interest rates, and made sure that long term rates were also moderately high. At the same time, the federal government should have instituted a massive, durable, and targeted stimulus program, perhaps 3-5 times the size of the current one and including a guarantee work program, as suggested by Galbraith. The money for this project would have come from printing money to limit the real cost to the government. Done deftly this would have limited the likelihood of bubbles, while allowing income to justify asset values. Debts would be repaid and slack taken up, but new debt growth and new business investment would have been limited. The overleveraged condition of the private sector would have thus been remedied and asset prices would be supported (albeit at lower multiple levels). Sustainable economic activity and growth would resume.
I believe that there is still time to institute this latter reflationary policy. The Fed need only start raising rates into the expansion of a massive government stimulus policy, while printing money to cover the cost.
[...] his post below, Julius argues that the government should reflate by providing guaranteed employment rather [...]