Monetary policy is not working

The explosion of U.S. banks’ excess reserves since last fall illustrates the dramatic failure of monetary policy.

By Gerald Friedman

DOLLARS&SENSE

This explosion of excess reserves represents a signal change in bank policy that threatens the effectiveness of monetary policy in the current economic crisis. Aware of their own financial vulnerability, even insolvency, frightened bank managers responded to the collapse of major investment houses like Lehman Brothers by grabbing and hoarding all the cash that they could get. At the same time, a general loss of confidence and spreading economic collapse persuaded banks that there are few to whom they could lend with confidence that the loans would be repaid. Clearly, our banks have decided that they need, or at least want, the money more than consumers and productive businesses do.

Banks could have been investing this money by lending to businesses needing liquidity to buy inventory or pay workers. Had they done so, monetarist economists would be shouting from the rooftops, or at least in the university halls, about how monetary policy prevented another Great Depression. Instead, even theWall Street Journal is proclaiming that “We’re All Keynesians Again” because monetary policy has failed. Monetary authorities, the Journal explains, can create money but they cannot force banks to lend or to invest it in productive activities. The Federal Reserve confronts a reality shown in the graph above: it can’t “push on a string,” as Fed Chair Marriner Eccles famously put it in testimony before Congress in 1935, in the depths of the Great Depression.

If the banks won’t lend, then we need more than monetary policy to get out of the current crisis. No bailout, no TARP program, can revive the economy if banks hoard all the cash they receive. The Obama stimulus was an appropriate response to the failure of string-pushing. But much more government stimulus will be needed to solve a crisis this large, and we will need programs to move liquidity from bank vaults to businesses and consumers. It may be time to stop waiting on the banks, and to start telling them what to do with our money.

Gerald Friedman is a professor of economics at the University of Massachusetts at Amherst.

http://www.dollarsandsense.org/archives/2009/0509friedman.html