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11.02.08 7:18 AM ET

How Obama Can Fix the Economy

Injecting money into the banking system won’t be enough to turn things around.

Ever since the banking panics of the 19th century, the formula for dealing with bank runs has been well known: inject so much money into banks that depositors, reassured they could get their money whenever they wanted to, will keep their money in the banks. That is in effect what governments around the world did in the first two week of October.

They guaranteed deposits and then the vast pool of money market funds. They unveiled unprecedented measures to infuse public money into the largest banks in the world, becoming share holders and active deal-makers in the process. With somewhat less fanfare, central banks injected vast amounts of liquidity—as of October 23, the Federal Reserve alone was providing almost $2 trillion in loans to the banking system.

For all the enormous sums of money we have thrown into the banking system, an additional fiscal stimulus package of the sort being advocated by Barack Obama will be necessary.

There are many signs that the October combination of massive liquidity injections and equity infusions has succeeded in its goal of preventing a complete meltdown of the financial system. The problem is that while these measures have forestalled a catastrophe, they do not guarantee an economic recovery. They do not even ensure that banks will expand lending

In fact, in spite of the infusions of capital into the banking system, there are many signs, both anecdotal and quantitative—for example the widening of credit spreads—that banks are becoming even more fearful about whom they lend to. Instead of using all the public money they have received to make loans, banks are hoarding the cash. What’s gone wrong?

Over the last year, the world has experienced a massive run on its financial system. In contrast to the old days, the run did not start in the banking system proper. It originated in the “shadow banking system” of investment banks, money market funds, hedge funds, conduits and all those other mysterious “off-balance-sheet special- purpose vehicles” that have sprung up over the last twenty years, and at over $10 trillion, have become as large as the banking system itself. Moreover this time round, the run was not characterized by long lines of panicked depositors lining up outside banks to take their money out physically. It was a digital run, fuelled by a panic among bankers themselves, who were able to siphon their money out of these “shadow banks” with the click of a mouse.

It might be useful to take look back at a similar episode during the Great Depression.

In 1931, as bank runs swept across the U.S., the Fed stuck to the principle that it should only lend to institutions facing a temporary shortage of liquidity and that propping up insolvent banks would be throwing good money after bad. The problem was that, much like today, banks experiencing liquidity problems found themselves having to dump assets in a falling market and were thus being driven into insolvency. Depositors with no way of knowing which banks were solvent and which were not, pulled their money out of all banks, good and bad, indiscriminately. During 1931, a total of $1 billion was withdrawn from deposits and converted into cash and hundreds of banks went under.

In late 1930, Eugene Meyer, father of the late Katharine Graham, was appointed chairman of the Federal Reserve Board. He was a self made multi-millionaire, a friend of President Hoover’s and a complete contrast to the mediocrities who had previously held that position. Through much of 1931, Meyer kept pressing his colleagues at the Fed to be more aggressive in their response to the crisis, but he was stymied by the Fed bureaucracy.

Finally in early 1932, fifteen months into the banking crisis, Meyer persuaded the administration and Congress to create the Reconstruction Finance Corporation to channel a total of $1.5 billion of public money into bank capital—equivalent in today’s economy of over $400 billion. Congress would only agree if Meyer took on the chairmanship. For six months he held two full-time positions: head of the RFC and chairman of the Federal Reserve Board. In addition Meyer pressed Congress to amend the regulations governing the Fed so that during 1932, it was able to inject $1 billion of liquidity into the system.

The steps did succeed in stabilizing the banking system for a while. The public stopped hoarding currency for most of 1932, and runs on bank halted. But bank lending kept shrinking—it fell by almost 25% that year. Shaken by the losses they had sustained over the previous year, banks were understandably reluctant to lend out any more, particularly to less credit worthy borrowers, and used the extra liquidity and capital to build up their own reserves. 1932 turned out to be the worst year of the depression.

The risk in the current crisis is that we now repeat the experience of 1932. The steps to inject money into the banking system were necessary to stabilize the situation and prevent a financial catastrophe. They will not however be enough to jumpstart lending or revive the economy. Households and businesses have borrowed too much over the last twenty years. The corollary of this is that banks, including the shadow banks, have lent too much. They will now have to reduce their lending. That is why, for all the enormous sums of money we have thrown into the banking system, we cannot rely on monetary policy alone to get the economy moving. An additional fiscal stimulus package of the sort being advocated by Barack Obama will be necessary.

Liaquat Ahamed is the author of Lords of Finance: The Bankers Who Broke the World, a book about the causes of the Great Depression to be published by Penguin Press in January 2009. After working as an economist at the World Bank, he spent twenty-five years as a professional investment manager in London and New York.