How to Fight the Crisis: Fiscal, Monetary, Micro and/or Macro?

2009/10 the finance ministers of the Western industrial countries poured large sums of taxpayer money into bank-saving packages and economic stimulus packages. National banks provided massive liquidity to commercial banks and lowered interest rates. These measures are recognized to have prevented a Great-Depression-style depression, even though a number of countries recorded massive GDP losses. The price was high, partly unsustainable sovereign debt ratios, which worries rating agencies and banks – which in turn charged some countries even higher risk premiums which certainly did not help their capacity to repay. This spiral is continuing today.

Many analysts asked themselves why these massive stimuli have not caused inflation; they are worried that hyperinflation is just around the corner. But they forget that effective money supply which drives inflation is composed of the product of national bank money times velocity of circulation. The former has increased significantly, the latter has come to a standstill, first as a result of the Lehman case, more recently as a result of uncertainty and risk aversion. Thus, effective money supply is lower than before the crisis: many banks deposit the liquidity which they receive from national banks again in the same national banks overnight. Other parts they use to buy up sovereign debt, for which they charge up to 7% (having borrowed the money from their national bank at 1%). Some other parts have gone into food price and raw materials speculation. They just do not funnel it into the real economy which is the only way to make economies grow again.

This goes to show that traditional monetary and fiscal policies have reached the point where they are no longer effective. Keynes talks about “pushing on a string”, describing the non-effectiveness of monetary policy in such a situation. Many macroeconomists are requesting still further easing of fiscal and monetary policy, but they cannot explain why they have become ineffective, why the usual transmission channels are blocked. In my opinion macro theory needs to be complemented by micro theory which explains the functioning of firms, of the relations between banks and firms and banks and private households. This is where the blockages occur. Real sector enterprises which engage in large-scale financial engineering instead of investing in the real economy, which are driven by quarterly stock-market performance results instead of the long-term viability of their firms, do not invest in often risky, but longer-term profitable ventures. Giant international banks which combine both commercial and investment banking do not base project evaluation on personal knowledge of the enterprise, the local/regional economy and the sector, but on financial indicators, quite abstract from real business. Private households who do not trust banks any longer, will not put their savings into such banks, because they cannot be sure that the banks transfer their savings into economically beneficial projects, but rather into speculative investments, or overnight deposits with the central banks.

Effective crisis resolution thus requires a clever combination of micro and macro measures. The banking sector must be restructured, investment banking separated from commercial banking, prudential limits set, etc. Bankers must be able to relate to their clients, their region and the project and must have personal knowledge of these. Firms must be restructured in a way that the long-time “shareholder value” concept, focussed on quarterly success, is supplanted by a “stakeholder value” concept, where the stakeholders are the shareholders, the debtors, the workers, the management and the regional economy.

Economic theory must fill this gap between micro and macro theory. Structural changes (not in the sense of the neo-liberal mantra) in firm structures and in bank-firm and bank-client relations are necessary to once more open up the transmission channels for macroeconomic fiscal and monetary policy. This will require strong political will, since the last 30 years have created a lot of very powerful vested interests in the existing, obsolete system. Its beneficiaries will strongly defend their interests. Maybe, however, the recently uncovered scandalous manipulation of the Libor rate setting plus its concomitant insider trading will generate enough outrage by the population to induce politicians to start and increase their efforts to restructure the financial industry and thus overcome the deepening crisis.

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Filed under Crisis Response, European Union, Financial Market Regulation, Fiscal Policy

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