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Friday, January 23, 2009

Momentum: The One Word Problem for the Economy (and the Solution)

In yesterday's City Journal, Nicole Gelinas has a piece that argued about the limitations of current monetary policy however the piece also illustrates the problems of our economy in the process.

Banks are hoarding much of their new government capital against future losses, rather than using it to make new loans. This behavior isn’t irrational, as many government officials seem to think—among them House Financial Services Committee chairman Barney Frank, who has chastised the banks for their reluctance to lend. The banks just aren’t sure how many existing borrowers—from credit-card holders to big corporations—are going to default, and they’re also unsure whether there’s more federal money on tap if borrowers keep defaulting in large numbers. Banks also want to hoard capital because their private investors—those few left—want them to. It’s unlikely that the market will look favorably any time soon on banks that lend as aggressively as they did a few years ago.

Moreover, borrowers aren’t as interested in taking out loans, cutting demand for credit even as the supply dries up. It’s no surprise that they’re balking. Consumer debt, including mortgage debt, more than doubled between 1999 and 2007, largely based on unsustainable increases in home and other asset prices. With home prices plummeting, consumers who had depended on constant refinancings to take cash out of their homes simply can’t do it any more. As for businesses, they didn’t swell their own debt by quite so much during those years, but consumer borrowing often drove their growth. Customers used money, often borrowed from their homes, to purchase goods and services, from home renovations to plastic surgery. As two bankers in Los Angeles noted recently, small businesses can hardly increase their borrowing when the revenues against which they’re borrowing are down 20 to 30 percent.


It’s not just a lack of capital and fear of future losses that are keeping banks from stepping up and replacing the vanished securitization markets as the economy’s credit creators, however. Banks simply don’t remember how to be banks—that is, long-term direct lenders to customers—any more, since the securitization markets have done that job for so long.

So, essentially, banks made all sorts of bad lendind decisions. Now, not only are banks afraid to make these decisions again but furthermore, they don't know how bad things are. Since banks aren't lending, businesses can't borrow. When businesses don't borrow, they don't expand. When businesses don't expand, they don't hire. When people aren't working, they don't spend. In other words, one economic problem leads to another, that leads to a third, and on and on. So, in a word the problem with the economy is momentum.

With all the momentum pointing down, the economy finds its way in a vicious downward cycle. Now, anyone that has watched sports knows how important momentum is. Yet, in sports, momentum can easily swing. In football, all it takes is a massive hit by a linebacker on the other team's star quarterback or running back. In basketball, it takes a monster dunk. In baseball, it takes a strikeout of the other team's star.

The economy, too, needs a momentum changer. Only with the economy, a momentum changer is much more difficult to attain than in sports. The President believes that a massive stimulus spending bill from the government will change the momentum. He hopes that it will create jobs which will get people spending.

I have a better idea. Instead of massive new government spending, I suggest a massive corporate tax cut retroactive to 2008. I say cut corporate taxes from 35% to 10%. By doing so, most of those companies that had weaker earnings, will in fact keep more money after taxes than they did in 2007. By keeping more money, they will invest more money on expansion. That will provide the momentum changer the economy needs. Corporations will expand and invest. This will create more jobs. With more jobs, consumers will spend more. With consumers working, less loans will go bad. With less loans going bad, more banks will lend. Momentum changed and problem solved.

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