Why Fiscal Stimulus Is Not Enough

Ben Bernanke gave a speech today that will be discussed for, well, at least a few days, outlining the Federal Reserve’s response to the financial crisis. We will probably devote a couple of posts to it (Simon already mentioned it below.)

Although the Obama team and Congress have been focusing on the politically popular fiscal stimulus plan, replete with hundreds of billions of dollars in tax cuts, Bernanke emphasized that stimulus will not be enough (something that Larry Summers seems to agree with, as Simon noted). Here’s the relevant passage:

with the worsening of the economy’s growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions.  Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets.  A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets.  The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. . . . In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.

In a nutshell: as the economy gets worse, more and more loans default, eating into banks’ capital cushions; investors are still nervous about all those toxic assets; and the continuing collapse of the housing market hurts all of those mortgages and mortgage-backed securities banks are holding. And as banks teeter toward insolvency, people stop lending them money, and they stop lending people money.

On the plus side, the famous TED spread dipped below 1 today, a sign that credit markets are doing much better than back in September. (The Calculated Risk article behind that link shows improvements in other parts of the credit markets, not just interbank lending.)

On the minus side, CDS spreads have shot up on Citigroup and Bank of America in the last week – here’s Bank of America:

Bank of America

The main peaks you see are the Lehman bankruptcy, the buildup to the bank recapitalization announcement, and the Citigroup crisis. So while there seems to be general improvement in the credit markets, the underlying problems have not been solved.

5 thoughts on “Why Fiscal Stimulus Is Not Enough

  1. It sounds like you are saying that the original TARP plan was the right one (after you argued vociferously in favor of the recapitalization that was ultimately pursued).
    In fact, as we see now, both were probably needed. The recap was needed to avoid the imminent crisis, while the asset purchase gets to the underlying structural problem. The only issue is whether $750 bln was enough for both — Simon seems to say “no.”

    On a related topic, since the government appears ready to place itself in the position of restructuring the mortgage debt of the US homeowner, it makes sense that the same government should hold the risk/benefit of that restructuring. Looked at that way, the Troubled Asset Purchase auction ought to be the perfect remedy. It would forestall lots of the lawsuits by bondholders that object to the loan workouts. Treasury would essentially hold all the cards, and could maximize the value of its newly acquired “assets.”

  2. When Bernanke says “more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets”, and Paulson asks for the next $350 B in bail-out funds, the obvious questions are which banks are in trouble, how much capital is needed to restore them to solvency, and what policy/regulatory action is necessary so that this never happens again. The returning smell of smoke is real. Its hard to believe these are casual, co-incident comments.

  3. Although the news on the TED spread is encouraging the news on CDS spreads cancels it out. My intuition tells me that the decline in stock market volatility (one of many proxies) is short lived and that uncertainty will raise its ugly head again. In short this may not be the end but only the end of the beginning.

  4. Hi. I’m in search of academic economists who support the stimulus bill, in any form close to what is going on in Congress. I find it hard to find any in the blogosphere. I’ve searched a few weeks of your posts, and I can’t tell if any of you support it or not. I know you support massive banking intervention, but that’s quite a different matter.

    Can I pin you down?

    ERic Rasmusen, Dept. of Bus. Econ. and Pub.Pol. , Indiana

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