Helicopter Ben Air-Dropped Money on the Wrong Target

by: Bo Peng

Of all the weapons inventoried by Bernanke back in 2002, most (and all that have been deployed so far) are conventional, indirect stimulation by way of bank lending. Set overnight rate to 0, push down yields on treasuries on increasingly longer terms, buy agency debt, etc -- all are indirect stimulation on the supply side of credit. While giving banks free money (banks get free funding and lend to Treasury for risk-free return) may be outrageously unfair to individuals struggling with mortgage payments and unemployment, it is very much a goal by design from the Fed's perspective. They specifically wanted to replenish banks' balance sheets, help them deleverage, make them more comfortable so that, hopefully, they'll start lending again.

Unfortunately, banks haven't started lending. If you carefully read Bernanke's arguments in his speech on why each of the weapons should be effective you'll understand, with the help of hindsight, why none has worked. But to summarize, the reason is two-fold.

  • Lack of motivation to lend. Banks are buried to the balls in excess liquidity, but, having the free lunch of Fed-Treasury arbitrage, there's no urgency for banks to make risky loans. Secondly, fresh from the nightmares of 2008, banks are rightfully nervous about making risky loans and levering up with fancy securitization schemes.
  • Lack of credit demand. Judging from the huge amount of stock buybacks and cash on corporate balance sheets this year, it's very clear that corporations see no need to borrow and expand. This is rational considering the ongoing risk of double-dipping in the US, austerity in Europe, and China's urgent need to cool down. On the consumer side, housing weakness with no end in sight, unemployment, and babyboomers entering the savings stage together mean the long-term demand for individual credit is down and will remain so for years.

In short, it's a perfect storm of domestic/international, institutional/individual, finance/real-economy factors that conspire to weaken both credit supply and demand.

In other times, the Fed's approach of stimulating credit supply worked quite consistently, but not this time, because there's no credit demand. The hope was that the moral hazard created by bailouts would be temporary and it would trickle down into the real economy and Main Street. Well, the moral hazard part has been a fantastic, permanent success; the second part, not so much. Free money has been given to banks and stayed in banks.

In retrospect, the Fed and the government should've bypassed banks and stimulated credit demand directly or, specifically, housing and private sector employment (instead of government jobs). All the following should be done by Congress and the White House, but the Fed can help by buying up treasuries.

  • Impose penalty for layoffs and give incentives for hiring.
  • Drastically expand small business loans. Small businesses provide the bulk of jobs and can react more quickly.
  • Incentivize corporate R&D and penalize false accounting growth via M&A. R&D is the foundation for sustainable, long-term growth.
  • Penalize builders (both commercial and housing) to limit supply. The fact that builders have continued building in fast pace since 2008 is a strong testimony to how wrong the stimulus has been.
  • Stimulate individual credit demand by direct subsidy to home owners.

I'm philosophically against all bailouts. None of the above is without significant pitfalls and unintended consequences. But if you have to do it, the same amount of money directed towards credit demand would have made a much bigger positive impact on the real economy and consumers, and fundamentally strengthened the economy for long-term growth.

Furthermore, on a more fundamental level, if you agree to the demographic thesis of long-term increase in savings, decline in spending and productivity, and systemic deliveraging across all of the developed world over the next 10-20 years, then it's a clear conclusion that the role of financial intermediary should be reduced much further.

Disclosure: Long puts on FAS