How Tight Money is Hindering Recovery

It is axiomatic among students of financial history that tight money policies by central banks aggravated the economic downturn of the 1930s and pushed the world from a deep recession into the Great Depression. Policy makers, especially the Federal Reserve, have sworn on many stacks of many books to avoid the mistakes of the 1930s by maintaining an easy credit policy. Yet credit is tight, in some respects very tight. While the tightness isn't pushing us into a depression, it makes recovery very difficult. At its meeting today, the Fed Open Market Committee promised to keep short term rates at zero as far into the future as one can imagine, and to continue its program of quantitative easing by buying longer term U.S. Treasuries. Its accommodations, however, will do little to ease credit conditions.

Where is the tight money? Everywhere. Mortgage loans are subject to strict underwriting requirements, which may be getting stricter as the real estate market continues to soften. Credit cards are issued only to customers with sterling credit ratings. Business lending may be easing slightly, but the smaller businesses that can't directly access capital markets (like the S&P 500) find that bank credit is somewhere between almost inaccessible and absolutely unattainable.

The tightness of money is a reaction to the credit binge of the 2000s, when anyone with a pulse and a signature could get a loan. After the financial tsunami of 2008, banks, regulators and mortgage underwriters like Fannie Mae and Freddie Mac found prudence in their hearts. With the fervor of the newly converted, they now hew to the straight and narrow, dribbling pinches of credit only to right-thinking, clean living, pure-hearted borrowers who've never said a cuss word in their lives.

The tightness of credit is good for taxpayers, who are directly or indirectly on the hook for just about every liability of every bank in America (and perhaps some banks in Europe if the Euro crisis isn't resolved soon). And it's good for rebuilding America's balance sheet. The nation's banks, consumers and governments all are deleveraging, and another credit bingeapalooza is the last thing we need. Relaxing credit standards to accelerate economic recovery could easily foster a faux prosperity that would collapse when reality inevitably trumps fantasy.

The Fed's easy money isn't being loaned out much. To a large degree, it sits in banks' accounts at their local Federal Reserve bank, where it likely serves as a buffer against real estate losses the banks are afraid they'll have to book. The Fed surely knows this. So what is it doing, triggering battered savers syndrome from sea to shining sea? One suspects that it's deliberately trying to create inflation, in order to scare catatonic consumers into spending. The Fed's nightmare is deflation, which can inhibit consumer spending and thereby worsen a downturn. Instill the fear of inflation and consumers presumably will buy in order to avoid higher prices later.

The theory may be tidy. But what if consumers are afraid of losing their jobs? A new high-end washer/dryer combo won't make you feel very good if you're laid off the week after it's delivered. Even with the threat of inflation, consumers may choose to save (and invest in the best inflationary hedge they can find). The Fed has to contemplate the limits of monetary policy, and consider whether it's doing more harm than good. Its quantitative easing program has driven long term interest rates up, raising mortgage rates, cutting off refinancings and reducing the pool of qualified buyers of homes. That, in turn, may push real estate prices lower and cause credit standards to tighten even more. In other words, quantitative easing may be making credit tighter--and retarding recovery.

At the same time, if quantitative easing does trigger inflation, we could end up with much dreaded 1970s style stagflation. Then, leisure suits might come back, multiplying the horror of the situation.

In matters economic, the law of unintended consequences is remorseless and inflexible. Its judgments are rendered swiftly, with nary a thought given to mercy. The Fed normally likes to keep all its options open. But this time it seems hellbent on spending $600 billion smackeroos on Treasury securities, come something or shinola. The Fed is steering the toboggan toward slippery slopes. Hang on tight.