Economics

Guys: this is not good news. The days of zero yields have arrived. Here’s the news from the New York Times: As Markets Waver, Treasury Yield Turns Negative

This presents a major problem.

First it renders the Federal Reserve Board much less effective. Traditional monetary policy, as executed by the FRB, includes cutting interest rates in order to induce people and companies to borrow and thus to energize a flagging economy. With interest rates at their current low levels and reaching zero as this news suggests, interest rates are no longer a weapon for the FRB. We have seen situations like this before elsewhere, most famously in Japan during the 1990’s. The Japanese economy suffered through a decade of extremely poor performances even though its Central Bank had reduced interest rates to zero. The comparison is an ugly one. Let’s hope we are not on the verge of copying that decade.

Second: the emergence of zero rates on Treasury securities suggests that people are hoarding cash. This is also terrible news. The more cash is withdrawn from productive use and simply stashed away for safe keeping the greater the chance of the economy weakening. There is clearly cash sitting around. The problem is that no one is spending or investing it. This leads inevitably to shrinking demand and thus sets in motion, potentially, the downward and self fulfilling spiral of economic contraction that leads to very deep recession.

So the news that yields are at zero can only be viewed as bad news for the economy. It is the kind of news that should grab everyone’s attention and focus them on getting a huge stimulus package passed as quickly as possible.

The second coming of Lord Keynes is upon us. It was his great work ‘The General Theory of Employment, Interest, and Money’ that described the policies necessary to break the downward spiral we now seem to be getting into. He wrote that book during the Great Depression. Keynesian economics works. Now is the time to dust off his book and put his theory to use.

David Leonhardt regularly contributes economic articles to the New York Times in his column called ‘Economic Scene’. Today’s is very useful because it continues the discussion over the proposed bailout of the ‘Big Three’ auto makers. Here it is: Economic Scene – Figure Skews Debate of a Bailout for Detroit – NYTimes.com

Apart from the fact that he dissects the wage numbers carefully for us, I bring it to your attention for his last paragraph. He ends the article with the insight that had we as a nation wanted to ‘save’ these particular auto makers we would have bought their cars.

And this is the central point to bear in mind. As I have said before: the plight of the ‘Big Three’ is not solely a result of the economic crisis. In fact the crisis is simply drawing attention to a much more intractable problem. An ever shrinking number of people want to buy the cars GM, Ford, and Chrysler make.

Were it simply a matter of cutting costs then a bailout might help. it could by breathing room for the companies to cut wages etc. But the issue is deep rooted and therefore unlikely to be resolved by any amount of taxpayer money. The American car buying public has voted with its feet. They just don’t like the products the ‘Big Three’ produce.

And that is a very long term problem.

Many of you have asked me recently why I think it is wrong to bail out GM, but OK to help Citibank. This is why:

The answer revolves around the difference between the financial system and the auto industry.

The financial system is a vast and sprawling part of the economy. It is also the economy’s epicenter. Banks provide credit. Their function is to take money in from depositors and other people who have cash, and then to lend it out to individuals or companies who need it for investment. Obviously this is an extremely simplified picture of what goes on, but it captures the essence. The central point is that banks act as intermediaries. They take your cash and add it to the cash of millions of other depositors and they lend it. They are constantly betting that they don’t need just to keep the cash in their branches, but that it is safe for them to move the cash around and make use of it in order to make a profit. They get away with this because they have learned that not all depositors want all their money back at the same time. So even though each day there are lines at the branch to withdraw cash, those withdrawals are only ever a small proportion of the amount depositors have given the bank. So the banks always have deposits they can lend.

More than this the banks actually ‘create money’. Because they only need to keep a small proportion of their deposits as cash available for withdrawal banks can take lend many more times the level of deposits. They can do this safe in the knowledge that the loans that mature on any given day plus the small cash they keep on hand is sufficient to pay any withdrawals that day. In addition, they can take deposits that are short term , that is the depositor can ‘demand’ them at any time or at some near term ‘maturity’, and lend them over longer terms. In this way banks translate short term money into longer term assets.

These two functions combined place the banks at the center of all economic activity. Depositors feel safe leaving their money with banks, and other people or companies can borrow to purchase assets, spend or invest. The financial system provides the flow of credit necessary for growth and wealth creation.

Without a modern banking system our economy would be much much smaller, less vibrant, and we would all be poorer.

The huge crisis that has emerged from the mortgage bubble attests to this. Whole sections of our economy have turned down and some have even sputtered to a halt, simply because the banks are in trouble. Banking affects us all.

In contrast the auto industry, while it a huge employer and makes something very tangible to all of us, is much less significant. If all three of the ‘Big Three’ American auto makers went out of business the economy would suffer enormously. But it would not seize up totally. Companies in other industries and even some people who might like to buy the defunct auto makers, would be able to finance their operations. Those companies would carry on. Non-auto industry jobs would still exist. And after the inevitable recession that the failure of the ‘Big Three’ might precipitate the economy would start growing again.

As a concrete example we should recall what happened in the Great Depression. The reason the economy fell from harsh recession into a prolonged and devastating depression was because of a series of bank failures. The financial system failed. Depositors lost their faith in some banks and withdrew their money in panic. This broke even those banks who were healthy and had no bad assets. Once a run on the banks starts like this panic takes over and economic policy loses its ability to restore growth.

So an economy can withstand the loss of some of its most hallowed manufacturers, but it has to protect its banks.

Look at it another way: if GM was healthy and able to sell cars it would be in deep trouble if there were no banks to provide the car loans many customers need to buy them. Similarly GM relies on getting short term loans to help pay its wage bills and finance its operations. So GM needs a healthy financial system. Indeed one of the reasons GM’s management has used for not going into bankruptcy is that there are no banks to lend it the money [some of which is called ‘debtor in possession’ money] it would need to restructure.

This, in a nutshell, is why efforts to restore the financial system must take precedence over saving other companies.

As for the regulation and management of the financial system: I will post about that later this week.