MONETARY POLICY AND RE-LEVERAGING AN OVERLEVERAGED ECONOMY

I wanted to pass along this great quote from Scott Fullwiler, Ph.D, in the comments section:

“The core issue is that any solution via monetary policy requires releveraging, whereas fiscal policy deleverages the non-govt sector. So, even if monetary policy “works” as you hypothesize, the fundamentals are actually worsened if you haven’t dealt sufficiently with the balance sheet recession.”

This succinctly and brilliantly gets to the crux of the issue in the USA and explains why I am often so hard on the Fed for their policies that often promote imprudence.  During a balance sheet recession where the private sector is overleveraged there is ultimately only one solution that can truly resolve the fundamental economic problem – de-leveraging.  The private sector must rebalance their balance sheet before sustained economic growth can ensue.  If they do not, it is likely that the private sector will merely re-leverage (causing a short-term boom in economic growth) and will ultimately collapse when the debt disequilibrium becomes so extreme that it results in mass default.  The resulting recession only exacerbates the situation as asset prices decline, deflation ensues and the spiral continues.  In essence, the answer to the private sector debt problem is not more private debt….

Currently, we are heading in the wrong direction.  If the latest consumer credit report is a new trend then it’s likely that consumers are re-leveraging.  While low interest rates can ease pressures on the debt problem it can also encourage further indebtedness.    If the government insists on intervening in this environment then fiscal policy (such as tax cuts), is the response that will allow the private sector to de-leverage cleanly and establish a sound foundation for sustained economic prosperity.