Policy Responses to the Depression--February 2-May 1, 2009--Part I

By February 2, when I finished my book, the government had already adopted, or signaled the imminent adoption of, a number of policy responses to the depression, and I discussed these in the book. In the two months since, there have been a variety of new developments on the policy front, many quite dramatic and some important. But none has changed the fundamental character of the anti-depression program that could be discerned in the earliest days of the Obama presidency and was discussed in the book.

The anti-depression program as it has emerged--which incidentally exhibits considerable continuity with the Bush Administration's program--is divisble as follows: (1) reducing interest rates and expanding the money supply (these are not quite the same thing), which can in turn be divided into (a) conventional Federal Reserve money-supply expansion and (b) "quantitative easing"; (2) bailing out (that is, recapitalizing with Treasury money) the banks; (3) mortgage relief; (4) keeping the Detroit automakers from liquidating; and (5) a "stimulus" package (that is, Keynesian deficit spending), which can in turn be divided into (a) tax relief, (b) expanded benefits (unemployment benefits, health benefits, food stamps, etc.), and (c) public works, such as construction of transportation infrastructure.

All these are discussed in my book, so as in my previous blog entry I will just be updating. But there is plenty of updating to do, and so I have decided to split my discussion into three separate entries. This first entry examines the first three measures above, all related to banking. The second entry will focus on the other three measures, and the third will be an assessment of the six measures. 

(1)(a) One way to stimulate demand in a depressed economy is to reduce interest rates, as that encourages borrowing, and most borrowing is for purposes of spending, whether for consumption or for investment; either form of spending stimulates output and therefore employment. Traditionally, a central bank, such as the Federal Reserve, that wants to reduce interest rates purchases short-term government bonds. (The procedure the Fed currently uses, involving repurchase agreements, is slightly different, but the older procedure is more intuitive so I will pretend it is still the one used.) The cash that the sellers receive in these sales is deposited in bank accounts and thus increases the amount of the money that banks can lend. Moreover, the central bank's purchases, by increasing the demand for bonds, drives up their prices, which in turn reduces the interest rate that buyers receive, because the dollar amount of interest is fixed when the bond is sold and so becomes a diminishing percentage as the price of the bond rises. Thus the central bank's purchases exert an additional downward pressure on interest rates.

The Fed uses as the target for its traditional money-creating activity the rate at which banks lend money to each other for repayment the following day (the overnight or federal-funds rate). The lower that rate, the more fully the banks' reserves (i.e., their cash) are employed in making loans. Although the overnight rate is obviously a short-term rate, it influences long-term rates, such as interest rates on mortgages. It does this both because of substitutability of short-run for long-run loans and because the lower the costs of borrowing to banks, the lower the rates which they are forced by competition to lend their borrowed capital.

Beginning last fall, the Federal Reserve pushed the overnight rate down virtually to zero, and it has kept it there. But as I say in my book, you can lead a bank to money but you can't make it lend. The banks prefer to hoard any additional cash they receive (or invest it in very safe securities or use it to buy other banks) than to lend it, because lending is risky in a depression. The demand for loans is reduced, and many banks are undercapitalized as a result of the collapse of the home-mortgage market, in which the banks were and are deeply invested. (Oddly the Federal Reserve is paying interest on bank reserves. On the one hand, this increases the banks' income, but on the other hand it reduces their incentive to lend their "excess" reserves, that is, the cash they are not required by the regulatory authorities to retain but are free to lend or otherwise invest.) The more hoarding there is, the less money is available for investment, so interest rates rise.

This is not to say that the injection of added cash into bank accounts has been pointless. It has doubtless reduced the decline in lending that set in last September when the banking industry teetered on the brink of outright insolvency. But bank lending remains far below normal levels.

 (1)(b) The Federal Reserve has supplemented its downward pressure on the overnight bank rate with what is called "quantitative easing." This means that it is buying other forms of debt besides the short-term Treasury bills that it buys when it wants to reduce the overnight rate. The other debt it is buying includes credit-card debt and mortgage-backed securities. With the overnight rate effectively zero, manipulating that rate cannot have any further effect on the cash that banks have available for lending. Moreover, the only direct effect of the overnight rate is on bank balances. Banks are not the only lenders, and buying the debt of other lenders is a way of getting cash to firms that may be less wary about lending than most banks at present are. The quantitative-easing program was under way on February 2, but is being expanded.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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