Recalling Basic Economics

I had an interesting conversation at my fitness club the other day with an acquaintance who is in the accounting/consulting field. We were discussing the current economic situation, and he asked me, to paraphrase,

'What do you think of the notion being circulated that Bernanke is pursuing QE2 and low rates in order to drive equity market prices up, to make businesses and investors feel better, so to better spark a real economic recovery?'

I replied that, if true, it's a misguided approach. I noted that, for those who recall their basic economics, we're now in a classic Keynesian liquidity trap. Rates aren't driving investment and, if anything, as I've written in some prior posts, are likely to fund marginal, unwise projects, because of the ultra-low rates and their inability to include adequate risk pricing.

We discussed the wasted so-called stimulus spending and added deficits, neither of which have really affected the unemployment rate.

It was then that, in answer to my colleague's question concerning what should have been done, I repeated my belief that banks and other firms, e.g., GM, contrary to auto czar Rattner's contentions, in need of capital should have been allowed to properly enter a formal Chapter 11 process. Profitable operations would have been protected and either spun off or sold. Unprofitable operations would have been liquidated, which is what Citigroup and GM subsequently did. Merging failed banks is no longer a major issue, given FDIC deposit insurance. This myth that large-scale bank failures cripple the economy persist only so long as government and industry officials allow it to perpetuate.

Once you've insured depositors, what's the risk? Loans are transferred or sold. Operations are transferred and merged. Shareholders lose, which is appropriate. Bondholders line up in order of seniority, according to bankruptcy law.

Where's the problem? We're overbanked in the US as it is.

Then I touched on the inequity of government's enforcement of a mortgage foreclosure moratorium. How unfair it has been for existing owners to be given breaks, while equally-deserving buyers at the true, lower market-clearing housing prices are denied the opportunity to do so. Which only delays a true housing recovery.

Anyway, my colleague agreed with my suggestions. But, further, I recalled for both of us some more basic economics, i.e., you can't have recoveries without real recessions. You can't have the release of resources- capital and labor- without the liquidation of failed firms. If firms aren't allowed to fail, resources don't experience the necessary Schumpeterian recycling into new uses.

We can't experience robust economic recoveries without full economic recessions. Despite politically-originated attempts to chop off the downside phases of economic cycles, we can't always be in an expansion. Real capitalistic economies have expansions and contractions.

King Canute couldn't stem the tides, and our government can't rewrite economic laws to eliminate periods of economic contraction.