Just quickly since this topic is pretty complex and I am rather focused on other topics this weekend:

“If the Fed had rushed to lend money to banks in trouble, the wave of bank failures might have been prevented, which in turn might have avoided both the public’s decision to hold cash rather than bank deposits, and the preference of the surviving banks for stashing deposits in their vaults rather than lending the funds out.”

Basically phase one of Bernanke’s attack was based on this premise, and what we can see, to date, is that it hasn’t really worked as expected (or as the theory it was based on would have expected). Apart from Lehman Bros there have been no spectacular bank collapses, yet here we are back again in the Great Depression, or something which feels incredibly like it. Look at contraction rates in places like Ukraine, Russia, Japan, Germany etc.

So now we move over to stage two, which is attempting to avoid outright deflation as everyone deleverages. The main strategy here is to boost government debt as the other major agents deleverage, and facilitate large quantities of liquidity to the banking system. (See my recent “US Fiscal Deficit Projected At 12.3% of GDP In 2009″).

Will it work? Well we are about to see, but I have my doubts. At least I have my doubts that a substantial contraction in output can be avoided. And if it isn’t, then this will turn out to have been wrong I think:

“Friedman and Schwartz claimed that the fall in the money supply turned what might have been an ordinary recession into a catastrophic depression, itself an arguable point.”

Because we will have seen an ordinary recession evolve into a catastrophic depression with the monetary and fiscal authorities effectively unable to stop it (which doesn’t mean that their activities are worthless, but this is not the same point). Which means we may then like to abandon the idea that real economic activity “always and everywhere” follows money, and begin to accept that – as per the arguments in this post – the relationship is a more complex one.

The key question now is whether, in the US and a number of other key economies, price expectations turns strongly negative, or whether we simply have a short sharp “flirt” with deflation.

Lastly, and this needs to be a second post, we need to think again about trade linkages and Eichengreen’s arguments in “Golden Fetters”, since what we can now see is that this contraction has spread very rapidly due to these connections (the inter-connected world). Eichengreen famously argued that these connections were not so important last time round. It is my hunch that this is also not entirely adequate as an analysis, but this will require more argumentation on my part.

“In interpreting the origins of the Depression, the distinction between the monetary base (currency plus bank reserves), which the Fed controls directly, and the money supply (currency plus bank deposits) is crucial. The monetary base went up during the early years of the Great Depression, rising from an average of $6.05 billion in 1929 to an average of $7.02 billion in 1933. But the money supply fell sharply, from $26.6 billion to $19.9 billion. This divergence mainly reflected the fallout from the wave of bank failures in 1930–1931: as the public lost faith in banks, people began holding their wealth in cash rather than bank deposits, and those banks that survived began keeping large quantities of cash on hand rather than lending it out, to avert the danger of a bank run. The result was much less lending, and hence much less spending, than there would have been if the public had continued to deposit cash into banks, and banks had continued to lend deposits out to businesses. And since a collapse of spending was the proximate cause of the Depression, the sudden desire of both individuals and banks to hold more cash undoubtedly made the slump worse.

Friedman and Schwartz claimed that the fall in the money supply turned what might have been an ordinary recession into a catastrophic depression, itself an arguable point. But even if we grant that point for the sake of argument, one has to ask whether the Federal Reserve, which after all did increase the monetary base, can be said to have caused the fall in the overall money supply. At least initially, Friedman and Schwartz didn’t say that. What they said instead was that the Fed could have prevented the fall in the money supply, in particular by riding to the rescue of the failing banks during the crisis of 1930–1931. If the Fed had rushed to lend money to banks in trouble, the wave of bank failures might have been prevented, which in turn might have avoided both the public’s decision to hold cash rather than bank deposits, and the preference of the surviving banks for stashing deposits in their vaults rather than lending the funds out. And this, in turn, might have staved off the worst of the Depression.”

http://www.nybooks.com/articles/19857

This makes me less concerned about the current state of affairs, inasmuch as pronounced deflation is less likely so long as we keep our cash in the bank….(even if there is only one left)

Also, to the extent that individuals kept thier cash out of the banking system for fear of bank failures, wouldn’t that have a negative effect on the Fed’s ability to effect monetary policy?
In other words, if some increasing chunk of the monetary base is taken out of the banking system as individuals shun banks, can’t you argue that the monetary base isn’t really growing (as the chart you show suggests?) I don’t know how big this was as a percentage of the total though….

Thanks again.

US 63%
Japan 173%
France 70%
Germany 65%
Canada 64%
UK 47%
…
Belgium 88%
Italy 113%, Greece, Portugal worse, etc. [all data OECD]

Secondly, total household debt as a % of disposable income is 141% in the US, compared to 186% in the UK, 139% in Canada, 131% in ‘high-saving’ Japan, 106% in Germany, etc. [OECD, Fed]

Interestingly, the IMF had a chart showing that credit to non-financial corporations in the Euro area was 58% of GDP compared to just 13% of GDP in the US.
http://www.imf.org/external/pubind.htm

Fin’l corp leverage is higher in the US, but this is due to double- [and triple-] counting due to disintermediation. A sure way to get that number lower would be to eliminate the mortgage-backed market, the asset-backed market, the leveraged-loan market, etc, with disastrous consequences.
68% of growth in total lending in the US came from fin’l-sector firms, but this is still less than the UK, for example. Obviously highly-levered banks have already suffered and are likely to continue to do so, but the remaining 32% growth in debt of consumers and homeowners is not some overwhelming nightmare that cannot be de-levered at a measured pace [which is already happening!] As I always say, it makes loads more sense to have borrowed more today while paying lower rates and lower DSR than it did in 1980-84. Borrow $40k at 15% then or $52k at 5% now? Simple.

Let’s face it, the US is in the best position to weather the downturn, more able to spend it’s way out, while paying very, very competitive interest rates along the way.

FX markets noted all this several months ago, sending the USD on a massive rally up 30%+ vs Euro, Sterling, Loonie, Ruble, et al.

“That’s an important moral issue in this economic crisis; Who are to blame for this crises and did they take their responsibility?”

Of course there is, and of course they didn’t. I’m just against punishing all the rest of us for what they have done. That seems like shooting myself in the foot to me.

And I remind you, people in Auschwitz put God on trial for what was happening to them, but unfortunately it didn’t do any good. Bribing a guard or digging a tunnel worked better.

“I am not an economist, so due to a lack of knowledge, I am missing the logic of some information that I receive through the media.”

Well look, the points you raise are quite complex really, even though on the surface they seem simple – that’s what economics is all about really. The ECB rates is only a technical benchmark rate around which the rest of the rates are positioned, they are what banks can borrow money from the ECB for to meet their SHORT TERM liquidity needs (overnight, two weeks or whatever). They are to help them temporarily balance the books among all the incomings and outgoings, and banks cannot lend of this basis.

Banks lend either by:

a) attracting deposits
c) attracting lending from other banks or investors (via eg issuing securities)

It is this second mechanism that has been structurally damaged by the financial crisis, and as a result our economies are now all contracting since they have little money to lend and modern economies work on credit. If Nassim Taleb has his way perhaps we will go back to a more medieval economy where credit is regarded as usuary, and there is little of it.

Who knows, maybe more people could become monks and nuns and we would all be better off. Poorer but happier, and with a lot less consumption. After all, a lot of people out there don’t like the consumer society.

Anyway, to get money into deposits (ie to get people to save, not borrow and buy cars and things, close the factories now!) the banks are offering more money for term deposits. Those Dutch banks you are referring to obviously have liquidity problems, and will fail if the government stop supporting them. They borrow money from you at 5% and lend to others at 7% or 8% (depending on whether or not they think their job is secure over the next five years or so). Do you have a vegetable garden?

http://www.spectator.co.uk/coffeehouse/3078296/the-true-extent-of-britains-debt.thtml