Cheap Money Won't Fix This Economy

The Federal Reserve is responding to the stubborn economic slump by creating more money. The central bank will purchase $600 billion in Treasury bonds, in an attempt to drive interest rates even lower. Is this a good idea?

Alas, it's the only tool readily available. But even supporters of the strategy don't think it will accomplish much, and might cause some harm. The problem is that cheap money doesn't work very well in an economy such as this one.

The Dow rose 219 points yesterday, since falling interest rates invariably cause a temporary spike in stock prices. But that is hardly a test of effective policy.

The economy is in a self-reinforcing trap. Consumer purchasing power is down due to high unemployment and falling earnings. Businesses are reluctant to invest because they don't see customers. Risk-averse banks won't lend except to the most reliable borrowers. Depressed housing prices and a foreclosure epidemic are a drag both on household net worth and on bank balance sheets.

Still, cheaper money does produce a modest stimulus. Homeowners with good credit can refinance and lower their monthly payments. Consumers considering a new car can finance it for almost nothing. And the government gets to float its own deficit at low carrying costs.

But none of this is potent enough to get the economy out of its vicious circle of depressed consumption, high unemployment, damaged banks, reduced business investment, and slow growth. In the 1930s, when the same syndrome afflicted the economy, critics likened the aggressive use of cheap money to "pushing on a string.'' It was - and is - the wrong tool.

What's the right tool? The cure for the Great Depression was World War II - a massive fiscal and technological stimulus. Annual wartime deficits peaked at about 28 percent of Gross Domestic Product. The government went on a hiring binge, both for war production and via the military draft. The economy blasted out of depression.

Today, however, both parties are wringing their hands over much smaller deficits, projected this year at about 9 percent of GDP. Republicans just took back the House with a campaign against big government.

So there is no political appetite for the civilian equivalent of World War II - a public campaign to rebuild rotting bridges, roads, ports, water and sewer systems, and to invest in 21st century infrastructure such as a smart electric grid and clean energy technology that would make the economy more productive as well as creating millions of jobs.

The Republicans do speak of "fiscal stimulus,'' but they mean tax cuts. However, a recent report by the nonpartisan Congressional Budget Office concludes that tax cuts are a far less efficient use of deficits than direct public investment.

President Obama signaled at his press conference Wednesday that he will likely compromise with the Republicans' demand to extend the expiring Bush tax cuts, not just for 98 percent of Americans as Obama has proposed, but for the most affluent 2 percent as well. These tax cuts will increase the deficit, provide a mild boost to the economy, but not change the underlying dynamics of stagnation.

So we are left with the Fed, as an unlikely champion of cheap money.

And there are some risks. Cheap money has invited a new wave of leveraged corporate buyouts, which enrich middlemen but don't help the broader economy. Low interest rates are driving down the value of the dollar and exporting inflation to other nations, which increases the risk of currency instability.

Financial traders are using low interest rates to speculate in commodities, raising the price of food and other raw materials. Cheap money with few rules is the best friend of speculators looking for some exotic action - exactly the dynamic that crashed the system in the first place.

Long ago, in an era of broad prosperity, former Fed Chairman William McChesney Martin famously said that the Fed's job was to take away the punchbowl just when the party was getting going. Today, however, the Fed is imploring people to have some more punch. But much of the public is too traumatized to drink, and the wrong people could get soused.

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