America’s Reaction To Economic Crises

  
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Why You Should Read This: Banks have too much capital, and they don’t want to lend it. Even though the Fed is buying bank assets, the money banks receive isn’t going anywhere.

America’s Reaction To Economic Crises

The US dollar has been the world’s reserve currency for over 50 years now, affording America the opportunity to stimulate their economy at will, without the fear of defaulting on debt payments.

But since the 2008 Financial Crisis, America has stretched their economic stimulus powers to their limits. The Federal Reserve balance sheet is at an all-time high, banks are holding trillions of dollars in excess reserves for the first time in decades, and interest rates are flat-lining at zero percent.

With the shock of Coronavirus pushing the Fed and the US government to act and stabilize the economy, it’s important that we understand what tools the Fed has at their disposal, and how much further they can push those tools to keep the economy on track.

Monetary Stimulus

The two primary monetary stimulus measures the Fed uses to stimulate weak economies are:

  1. Interest rate cuts

  2. Quantitative easing

Interest rate cuts enable people to take out loans for a lower cost, incentivizing them to spend, and therefore stimulate the economy. This is a fast-acting relief strategy, but one that the Fed has already used. Interest rates are almost exactly 0% already, meaning the Fed no longer has the capacity to meaningfully lower interest rates.

Slightly negative rates are possible, but anything lower incentivizes banks and people to just hold physical cash instead (at 0% rates).

Quantitative easing gives lenders the freedom to lend, by purchasing loans on their balance sheets. As the Fed swaps the loan for cash, banks end up with excess reserves they can lend out to businesses. But that only happens when banks feel confident they will earn money on their loans. 

And since 2008, banks haven’t been able to lend out all their excess reserves. So that money that is supposed to stimulate the economy, just sits there. For quantitative easing to work, banks need to lend out their excess reserves.

Fiscal Stimulus

The two primary fiscal stimulus measures the US government uses to stimulate weak economies are:

  1. Tax cuts

  2. Infrastructure spending

Tax cuts are straightforward, allowing people to keep more of the money they earn. By temporarily cutting taxes, consumers have more money to spend. But there’s a downside.

The US government earns money through taxation, and that’s what funds their operations. And US debt is already at historic highs. Tax cuts right now could push the US even deeper into debt.

Infrastructure spending is the opposite side of the same coin. Instead of lowering taxes (resulting in a deficit), the US could take the approach of increasing spending (resulting in a deficit). The idea of a multi-trillion dollar infrastructure bill has been floated around on Twitter, but the main issue is the same. How will America dig itself out of the deficit that comes from the extra infrastructure spending?

Simply put, America is close to exhausting their typical methods of stimulating an economy. Pushing these tools any further may result in excessive money-printing, and therefore inflation.