James Wood's  Instablog

A simple explanation of the cause of the current Economic Problem: For 25 years, we have had enormous increases in consumer credit, much of which was neither necessary nor could the consumer pay back.  When these consumer loans started going massively unpaid, the crisis erupted and it has led us to deflation of prices, which has led to recession and probably will end in depression. 

A more professional explanation of the cause for the Economic Problem: Economists, particularly at the FED, focus on the “Private Credit Aggregates”, which includes all household and non-financial company debt used to finance consumption and investment (mortgages, auto loans, home equity loans, credit cards,  etc).  Then economists compare this to the nominal GDP (gross domestic product).

For 30 years, from 1954 to 1984, there was an extremely close relationship between Private Credit Aggregates and GDP.  (Go to the underlying article ((www.pimco.com/LeftNav/Global+Markets/Glo...)) by Richard Clarida to see the chart demonstrating this.)  In 1984, $3.5 trillion of nominal GDP was supported by $3.5 trillion of Private Credit outstanding.  By 2007, $14 trillion of nominal GDP was supported by $25 trillion of private credit outstanding.  By 2007, we had nearly double the amount of private credit as a % of our GDP.   We believe much of this excess to be unproductive debt which simply could not be paid back.  This is the problem.

The Obama stimulus plan is based on providing massive amounts of money to banks and the general economy in an effort to return the economy to growth.   While the private sector is deleveraging and reducing debt generally, the public sector is trying to provide economic stimulus with government funds.  The intellectual origins of stimulus go back to Lord Keynes in the 1930’s who first proposed this type of stimulus.  Today, the leading advocates of the Obama stimulus program are Ben Bernanke, Larry Summers and Paul Krugman.

The US financial stimulus plan is based on two central concepts.  The first objective is to get more money into the banks so that they can lend to their customers and be seen by their customers and bank counterparties as a safe depository of funds.  The second is to get prices up, particularly in housing and financial instruments, so that many do not go broke, particularly including banks and homeowners.  These policies have failed.  The purpose of this article is to explain why they could never succeed.  Furthermore, until there is a consensus that  the current policy of stimulus cannot succeed, we cannot move on to more effective solutions to our problems.

The government is trying to stabilize banks through liquidity programs such as TARP, TALP and PPIP.  These programs will fail for the reason provided below.  These programs should be replaced with a program to shutdown failed financial institutions in an orderly and socially responsible way.  This change will shorten the readjustment period of the recession/depression by years and will reduce the total cost of the government adjustment plan by trillions of dollars