Why Fiscal Stimulus Is Not Enough

Ben Bernanke gave a speech today that will be discussed for, well, at least a few days, outlining the Federal Reserve’s response to the financial crisis. We will probably devote a couple of posts to it (Simon already mentioned it below.)Although the Obama team and Congress have been focusing on the politically popular fiscal stimulus plan, replete with hundreds of billions of dollars in tax cuts, Bernanke emphasized that stimulus will not be enough (something that Larry Summers seems to agree with, as Simon noted). Here’s the relevant passage:

with the worsening of the economy’s growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions.  Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets.  A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets.  The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. . . . In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.

In a nutshell: as the economy gets worse, more and more loans default, eating into banks’ capital cushions; investors are still nervous about all those toxic assets; and the continuing collapse of the housing market hurts all of those mortgages and mortgage-backed securities banks are holding. And as banks teeter toward insolvency, people stop lending them money, and they stop lending people money.

On the plus side, the famous TED spread dipped below 1 today, a sign that credit markets are doing much better than back in September. (The Calculated Risk article behind that link shows improvements in other parts of the credit markets, not just interbank lending.)

On the minus side, CDS spreads have shot up on Citigroup and Bank of America in the last week – here’s Bank of America:

sg2009011355627.gif?w=700&h=501

The main peaks you see are the Lehman bankruptcy, the buildup to the bank recapitalization announcement, and the Citigroup crisis. So while there seems to be general improvement in the credit markets, the underlying problems have not been solved.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.

One Response to "Why Fiscal Stimulus Is Not Enough"

  1. LG   January 15, 2009 at 10:37 am

    “Shovel ready” projects need to be bidded out and that takes time. If you build a Starbucks and no one has money to buy the coffee what good is it?How about real “shovel ready” changes:1) Stop the foreclosures and put people in fixed rate loans. If they can’t afford them, let them rent with an option to buy until conditions improve.2) Credit card interest rates should be at 9%3) Instead of $500 to $1000 tax cut, how about a $50,000 check per family and a $12,000 check per single person – tax free. Now that would make a difference. Imagine, they could buy a car, make a mortgage payment, pay that doctor or credit card, pay college expenses or even, buy health insurance.4) Universal healthcare. It seems to work for Congress.Yes, it will add to the deficit but the numbers are already going up and there seems to be little to show for it. Rebuild the foundation first before the penthouse.