TJP

The inability of the Bush, and now the Obama, administration to identify the root cause of the economic crisis has prevented effective responses. Many pundits and politicians claimed that the crisis was caused by subprime mortgages; their narrative was that failure of marginal mortgagees caused the recession.

At The Jethro Project, however, we have consistently argued that the crisis resulted from the Federal Reserve mismanagement of the money supply. As a result, we opposed the reappointment of Bush’s Republican nominee, Ben Bernanke, for a second term under a Democratic Administration. We were also uncomfortable with the appointment of the former President of the New York Federal Reserve, Timothy Geithner, as Secretary of the Treasury. Geithner was in charge of the Federal Reserve open market operations prior to the economic crisis.

We also noted that the economic crisis that confronts the United States is primarily an income challenge. Today, there is a gradual recognition that scarcity of income (jobs) affects demand.

Scarcity of income is directly related to the Federal Reserve policy of restricting the money supply, particularly M1. From 2002 to the fourth quarter of 2008 the Federal Reserve restricted the growth rate of M1. The unwillingness of banks to provide loans to Main Street customers also adversely affects the money supply expansion, and hence employment and income.

M1 money supply consist of currency and demand deposits, it corresponds most closely to the role of money used to make purchases.

The Federal Reserve, under Bernanke, responded to the economic crisis by supporting financial institutions through the purchase mortgage securities. They created over a trillion dollars in fiat money, which significantly increased banks’ reserve balances at the Fed.

In order to dissuade banks from lending excess reserves to the public, the Fed began paying interest on reserves (IOR). This policy is in line with the Fed’s inflation targeting policy, where the Fed used monetary rules to control inflation. These monetary rules (equations), however, exclude monetary aggregates and prevent full employment as a policy goal.

The purpose of paying IOR is to prevent expansion of the money supply through bank loans. When the Fed pays interest on bank reserves, the banks have no reason to loan to the public.

Monetary theory indicates that changes in the level of output, employment and even inflation emanate from monetary factors. Therefore, influx of fiat money in a weak economy would radically alter the exchange and production processes.

Money is a necessary condition to execute spending decisions. It is also necessary to create effective demand, so manufacturing facilities can be built and for the expansion of employment.

Thus far, the actions of the Federal Reserve and the banking system appear to be counterproductive. Their actions seem to be a deliberate attempt to prevent economic expansion, while inflicting maximum public damage to the Obama Administration.

Otherwise, we would see the Federal Reserve creating disincentives for banks to hold excess reserves. Thus, they would stop paying IOR and move to establish penalty fees for banks holding excess reserves. This would cause banks to loan funds to Main Street and expand the monetary base, thereby increasing Main Street income. Additionally, we would see banks restructuring home mortgages, which would increase homeowners’ disposable income, and effective demand.

Increase demand would cause business inventory decumulation and increase employment. More importantly, it would also stop housing price deflation and reverse the wait-to-purchase mode of potential home purchasers.

There are other steps that the Obama Administration could take. For instance, the administration could bypass the private financial sector and setup federally sponsored credit agencies to restructure homeowners loan interest rate, and in some instances the principal. Restructuring the principal could include a provision which would provide a portion of future home appreciation, if the home is sold within 10 years, to the sponsored credit agency.

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