TJP

The Danger of Excessive Stimulus

By Byron A. Ellis-November 26, 2008

Finally, it appears that the Federal Reserve is beginning to understand how it can restore the economy. On Tuesday, the Federal Reserve Board announced the creation of the Term Asset-Backed Securities Loan Facility (TALF), a facility that will help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).

Such action should have been initiated months ago. However, the Federal Reserve, as well as the Treasury Department, failed to understand the drivers of the economy and focused instead on aiding Wall Street.

Gross domestic product, however, is driven by personal consumption. Therefore, to restart the economy Treasury and the Fed must facilitate consumption spending.

According to the Fed press release, under “the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans.  The FRBNY will lend an amount equal to the market value of the ABS less a haircut and will be secured at all times by the ABS.  The U.S. Treasury Department--under the Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of 2008--will provide $20 billion of credit protection to the FRBNY in connection with the TALF.  The attached terms and conditions document describes the basic terms and operational details of the facility.  The terms and conditions are subject to change based on discussions with market participants in the coming weeks.”

Ellis from The Jethro Project has consistently called for the use of monetary policy to expand aggregate demand. Moreover, he has recently indicated that government policy makers should be cognizant of the ongoing stimulus resulting from lower energy prices.

The current stimulus due to lower gasoline prices could be as high as $900 billion dollars, if we assume that motorists save an average of $35 or more per fill up. The average small vehicle saves approximately $20 per fill up and the average SUV about $50 {($50+$20)/2=$35}. The $35 savings does not account for savings from trucks and larger vehicles.

Therefore, an average fill up of 2 tanks per week for 251,000,000 (BTS) American motorists would lead to a yearly aggregate stimulus (due to lower gasoline price) of about (=$35 x 2 fill ups x 52 weeks x 251,000,000 vehicles on the road) $914 billion. And, if the multiplier effect {1/[1 – 0.80(1 – 0.20) = 2.78} is accounted for, the stimulus could add more than {$914 billion x 2.78 =} $2.5 trillion dollars to the U.S. national income.

Additionally, lower energy prices will cause the prices of other commodities to decrease, such as food, gas surcharges, and so on. Hence, it is important to understand the potential danger of using fiscal policy to over stimulate the economy.

The danger of over stimulation is inflation, which would cause the Fed to increase interest rates in order to reduce inflation. Higher interest rates would slow the economy and lead higher levels of unemployment.

The new administration must be mindful of this potential danger, and the economic cycle of boom and bust.

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