The Best Stimulus Right Now?

Writing in the Wall Street Journal on December 23, Robert Lucas expresses approval of the Fed’s latest reduction of its target range for the Federal Funds Rate to approximately zero, calling it “welcome.” Lucas notes that this policy does not leave the Fed without the ability to inject additional reserves into the banking system, because it can purchase not only Treasury bills, as it normally does in its open-market operations, but also longer-term Treasury securities and private bonds, which continue to trade at prices that imply substantially positive yields. Of course, Ben Bernanke has already hinted that the Fed is prepared to inject funds into the financial system in any way necessary in order to pump up spending.

Lucas finds the Fed’s actions in adding more than $600 billion to bank reserves in the past few months to be “the boldest exercise of the Fed’s lender-of-last-resort function” in its history. He believes, as I do, that in recent months financial decision-makers have engaged in a “flight to quality”—I call it a flight from risk—and that by injecting reserves into the banks, the Fed has effectively exchanged risky assets (the banks’ collateral securities) for a riskless asset (deposits at the Fed), thereby satisfying their demand to hold additional high-quality assets when the market itself was not supplying more such assets.

Viewing the Fed’s action as an effective way to stimulate spending, Lucas also applauds it as superior to the alternative policies to achieve this objective. “It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities.”

I agree that these alternative policies are probably worse than direct Fed lending to the banks, but, unlike Lucas, I do not view the Fed’s abrupt, massive lending with equanimity. Indeed, as I indicated three days ago, I view the banks’ current, gigantic holdings of excess reserves as a veritable Sword of Damocles with the potential to cause a near-collapse of the dollar’s purchasing power.

I also differ with Lucas—and with Bernanke and nearly all of the mainstream commentators on the financial scene during the past several months—in that whereas he views the present situation as a liquidity crisis, I view it as fundamentally an insolvency problem for many banks and other financial institutions, inter alia. By treating this situation as if it were a liquidity crisis, like the banking situation from 1929 to 1933, one may moderate the recession for a short while or even reverse it, but only at the expense of preserving a plethora of malinvestments that ought to be liquidated by balance-sheet adjustments and, in many cases, bankruptcies, so that the valuable assets can be reallocated to their most valuable uses, rather than being kept impounded in zombie enterprises, including zombie banks. Because Lucas, in good mainstream-economics style, views the current situation in terms of aggregates, he is not looking inside the capital stock and therefore he is failing to see that the easy credit and reckless lending from 2002 to 2007 gave rise to a great many rotten investments that are not viable except by some species of Fed or Treasury bailout.

If the economy is to experience healthy sustainable growth, this garbage needs to be thrown out—and the incompetent managers and investors who created it need to be removed from positions of control over assets they have demonstrated they cannot manage responsibly and successfully. Free enterprise is a system of profit AND loss. If the government rides to the rescue of every large-scale, politically connected loser, the system will grow ever more rotten from the top down.

Yes, this way of proceeding entails short-run pain, but the alternative only pushes the pain into the future while ensuring that when it strikes, it will be even more severe.