Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the "animal spirits" of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.
Here, I think it instructive to interject the sobering assessment by Numerian on February 20, 2009 that this new behavioir by American consumers works out to a $20 or $30 trillion drop in economic activity over the next five years. From Why the Banks Won't Lend:
What we are seeing, therefore, is an economy that is deflating to a level that will allow the consumer to save at least 8% of their disposable income every year, plus have some cash flow left over to be used to pay principal and interest on consumer loans. Economists can do any number of studies to figure out what the equilibrium level of GNP would be to allow this to happen, but there is an easier way to think about it. We need to return to the days when the consumer did in fact save over 8% a year, have enough to pay down a mortgage (after putting 20% cash down on the purchase of the home), and purchase one car. The last time the consumer was able to do this was about 1992.
So, the economy needs to be much smaller than it is now if consumers are going to live off their income and not their assets. As we work our way to that level of economic activity, bank lending must and will remain stagnant. No amount of government money will be used by the banks to lend to the consumer in a significant way, because there is no economic justification for making loans that cannot be repaid solely from personal income.
The government can force the issue by nationalizing the banks and mandating that they make uneconomic loans, backed by a federal government guaranty against loss. But even here, the government can only provide a drop in the bucket against what must invariably be a $20 or $30 trillion drop in economic activity over the next five years (this is the incremental 5% savings of disposable income necessary to get the country to at least an 8% saving rate) .
Indeed, Galbraith notes that "What did not recover, under Roosevelt, was the private banking system." It was only after the industrial mobilization of World War Two forced an actual halt to the production of consumer goods, creating a massive reservoir of pent-up demand. This, coupled with war-bond induced family savings that rebuilt household spending power during the war, is what was unleashed once the war was over. Thus, Galbraith notes "the relaunching of private finance took twenty years, and the war besides."
A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.
That being so, what must now be done? The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief, through a moratorium followed by restructuring or by conversion-to-rental, except in cases of speculative investment and borrower fraud. The president’s foreclosure-prevention plan is a useful step to relieve mortgage burdens on at-risk households, but it will not stop the downward spiral of home prices and correct the chronic oversupply of housing that is the cause of that.
Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing—why not?
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Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.
Today the largest problems we face are energy security and climate change—massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.
Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully—say, with a new program of deferred claims to future purchasing power like war bonds—the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.
Galbraith points to a recent paper by economist Marshall Auerback, who has tackled the wrong-wing meme that Franklin Roosevelt’s New Deal did not end the Depression.
[Roosevelt’s] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.
Only by these extraordinary government measures, Galbraith notes, was the unemployment rate brought down from a pre-revolutionary 25 percent in 1933 to a barely tolerable 10 percent in 1936. As we know, Roosevelt and Harry Hopkins were able to put nearly four million Americans to work on an emergency basis in November-December 1933.
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