Government Didn’t Solve Financial Crisis—It Caused It

Government Didn’t Solve Financial Crisis—It Caused It
December 1, 2009

Signs of a potential economic recovery have policymakers and pundits jumping to claim credit for the expected turnaround. Fed Chairman Ben Bernanke, President Barack Obama, and New York Times columnist Paul Krugman have all weighed in, saying government has saved us from a second Great Depression.

Before relinquishing more power to a growing and powerful bureaucracy, however, it’s crucial to answer a key question: Did government save us from a Depression, or did it cause the financial crisis in the first place?

Interestingly, one who believes government saved us—Krugman—recommended in 2002 we should “create a housing bubble to replace the NASDAQ bubble.” Another—Bernanke—was a member of the Fed when it helped create the housing bubble.

Bernanke now admits the Fed was too expansive in 2002-2005. If the Fed’s admitted policy mistake helped produce the bubble, it raises suspicions about the extent to which government can claim credit for saving us from financial Armageddon.


Rates or Reserves, Not Both

The Federal Reserve can buy and sell securities to target interest rates or bank reserves. If it chooses to target interest rates, it must let bank reserves adjust to reach its interest rate target. If the Fed decides to target bank reserves, it must let interest rates go where they may.

There is a longstanding debate over which procedure produces a more stable monetary policy. Monetarists tend to believe the Fed should avoid targeting interest rates and instead target bank reserves or some other monetary aggregate. Instead, the Fed has chosen to target a specific interest rate—the Fed funds rate—and allowed bank reserves to adjust to its interest rate target.

Bank reserves are the one monetary aggregate the Fed controls. Changes in bank reserves are the first step in the monetary process. When the Fed buys or sells securities, it increases or reduces bank reserves. Increasing bank reserves tends to increase money supply; reducing reserves tends to tighten it.

When targeting interest rates, the Fed has to guess the Fed funds rate that will produce the amount of bank reserves the economy needs. If the targeted interest rate is too high, it won’t create enough money. If the rate is too low, it will create the type of excess money the Fed admits contributed to the housing bubble.


Low Reserves, Recession

The Federal Reserve Bank of St. Louis calculates data for bank reserves (adjusted for reserve requirements) going back to 1918. The data show that except for the aftermath of World War II, every recession since 1918 has been preceded by a slowdown in the growth of bank reserves or an outright decline.

And except for the beginning of WW II, every significant decline in bank reserves has been followed by a serious recession.

The three most serious recessions since the establishment of the Fed occurred in 1929-33, 1937-38, and 2007-09. The recession of 1929-33 was associated with a 15 percent decline in bank reserves over a three-year period, and the one in 1937-38 was associated with a 13 percent decline in bank reserves over 18 months.


Big Shift in Reserves

The most recent recession was preceded by a 3 percent decline in bank reserves over a three-year period. That marked the only time since the early 1930s that bank reserves declined for three consecutive years. Moreover, the decline in reserves followed four years in which the Fed had increased bank reserves at a 5 percent annual rate. Hence, the shift from expansion to contraction amounted to eight percentage points.

From August 2007 to August 2008, Fed members consistently stated they were adding liquidity to the economy. Instead, the Fed offset its purchases of securities by selling $300 billion in Treasury securities. This left bank reserves unchanged for a year after the Fed said it intended to boost liquidity.

Recent moves by the Fed have finally increased bank reserves. In the wake of this increase, there were signs the worst of the recession was over.

Bernanke’s claims that the Fed’s action has avoided another Great Depression thus resemble those of an arsonist who sounds the alarm after setting a building on fire and then wants credit for saving the inhabitants.


Spending Surge

The president’s claim that he saved us from a second Depression is similarly disingenuous. President Bush, President Obama, and Congress all contributed to an estimated 34 percent increase in government spending this fiscal year. The assumption behind such alleged fiscal stimulus is that government can spend money more effectively than the private sector. Before accepting this assumption, it’s instructive to look at the facts.

From 1929 to 1932 government spending increased 50 percent. This massive increase was associated with a 25 percent drop in consumer spending and the worst economic decline in U.S. history.

There was a cyclical recovery in 1933-37 which many attribute to the New Deal. During these years government spending more than doubled. However, bank reserves also more than doubled. The main difference between the two periods isn’t the government spending—it’s the behavior of bank reserves.

The real effect of the current massive increases in government spending won’t be found in the extent to which the economy experiences a cyclical recovery. Instead it will be the extent to which living standards suffer from wasteful government spending.

Robert Genetski (rgenetski@gmail.com) is president of classical principles.com, an economic and financial advisory firm.