US Government Efforts to End the Credit Freeze and Recession: The Analytics and Numbers

US Government Efforts to End the Credit Freeze and Recession: The Analytics and Numbers

 by Elliott R. Morss, Ph.D.

 Introduction

 In an earlier article, I have addressed the time phasing of the transition. Just after the credit freeze, there was total panic. Everyone wanted US dollars – all other investments were liquidated, and bank deposits surged. In this period, all government efforts went into saving the Western banking system. But the asset loss resulting from the dramatic fall in real estate and stock market assets led to a dramatic fall in consumer and business outlays resulting in the global recession. With the credit markets somewhat stabilized, government efforts went into stimulus packages to end the global recession.

 This article will focus on what was done in the US to end the credit freeze and ward off the global recession, and what shape government finances are now in. The NYT reports Bernanke suggests it is time to start thinking about raising interest rates.

 Analytics

 To clarify what has happened, I start with a definitional equation familiar to all economists:

MV = PY = GDP 

In this equation M stands for the money supply (M2 in the numerical work that follows), V stands for the velocity of money (how many times is it used to buy goods and services in a given time period); P is a price index; Y is real gross domestic product; and GDP stands for gross domestic product in current dollars. For this exercise, we will focus on

MV = GDP since we are not worried about inflation.

 Back in the boom years of 2006 and 2007, the velocity of circulation (V) got up to 1.95 per quarter. That meant on average, every dollar was spent to buy goods and services almost twice every quarter (3 months).  By the end of the second quarter of 2007, the real estate collapse had started in the US and V had fallen a bit, but it was still a healthy 1.91. By the end of the second quarter in 2009, V had fallen by more than 11% to 1.68.

 It is important to recognize that V is an overall average and that most of it represents monthly living expenses. Suppose that 11% of goods and services purchases in 2007 are discretionary purchases. That would mean that by the end of the second quarter in 2009, people were not spending money on anything but necessities. Consider what this would mean:

• the government could lower the interest rate but nobody would borrow;
• the government could reduce taxes but nobody would spend the tax savings;
• the government could spend money to hire people, but people would save the money they earned.

 In short, this would mean there was nothing the government could do beyond hiring more and more people to stimulate the economy. So what did the government do beyond various actions to prevent a complete financial collapse? It printed a lot of money – Bernanke kept the printing presses going day and night. Part of this money came directly from the Fed in the form of direct credits to financial institutions and part of it went to the Treasury to finance its deficit. At that point, we were not worrying about finding outside buyers for our debt – the Fed bought (printed money) as much of Treasury debt as was needed. In such circumstances, there was absolutely no reason to worry about inflation.  

 How are the Fed and Treasury actions manifested? Over the same period that V fell by slightly more than 11%, M2 was increased by almost 15%.

 Table 1 highlights alternative scenarios for different V and M2 values. 2009 GDP was $14.5 trillion. It would have been $1.9 trillion or 13% higher if V had not slowed down. It would have been $2.1 trillion or 14% lower if M2 had not been increased.

 Table 1. – Alternative GDP Values

	GDP  – end 2009	Difference
Actual	14,463
With  V @ end 2007 -2	16,345	-1,882
With M2 @ end 2007 – 2	12,386	2,078

 Fed Numbers

 We start with major items in the Federal Reserve balance sheet. Table 2 compares the situation at the end of January 2008 with today.

Table 2 – The Federal Reserve Balance Sheet, Selected Items

Item	30-Jan-08	3-Feb-10	Change
Total Assets	886	2,231	1,345
Selected Assets
Securities held outright	718	1,912	1,194
U.S. Treasury securities	718	777	59
Bills	205	18	-187
Notes and bonds, nominal	471	709	238
Notes and bonds, inflation-indexed	37	44	7
Inflation compensation	5	6	1
Federal agency debt securities	0	165	165
Mortgage-backed securities	0	970	970
Repurchase agreements	50	0	-50
Term auction credit	50	39	-11
Other loans	0	88	88
Credit extended to AIG		26	26
Term Asset-Backed Securities Loan Facility, net		47	47
Other credit extensions	0	16	16
Purchases of Various AIG Assets	0	90	90
Net portfolio holdings of Commercial Paper Funding Facility, LLC		9	9
Currency in circulation	812	924	112
Reverse repurchase agreements	39	54	15
Deposits with F.R.Banks, other than reserve balances	12	135	123

 The differences are truly striking. In this one year period, the Fed’s assets have increased by 150% from $886 billion to $2.231 trillion. They bought a net $58 billion of Treasury securities and another $164 billion of agency securities. On top of that, the Fed purchased $970 billion of mortgage-backed securities.

 And then we have AIG. Paulson wanted AIG bailed out before he got TARP. His only option was the Fed. The Fed can do pretty much what it wants to do without Congressional approval. At Paulson’s urging (quite possibly to get Goldman bailed out), the Fed has lent $26 billion to AIG. On top of this, it has bought outright $90 billion of AIG’s “troubled” assets. This is more than the entire amount it allocated for its Term Asset-Backed Securities Loan Facility ($47 billion). Once TARP was approved, Paulson immediately gave AIG another $40 billion.

 The table also indicates a $112 billion increase in currency in circulation.

 TARP

 $700 billion was allocated to TARP. According to the latest report from TARP’s Inspector General, Treasury had announced programs involving potential spending of $549.4 billion of the $698.8 billion maximum available for the purchase of troubled assets.

As of December 31, 2009, 67 TARP recipients had paid back all or a portion of their principal or repurchased shares for an aggregate total of $165.2 billion of repayments and a $5.0 billion reduction in exposure, leaving $368.8 billion, or 52.8%, of TARP’s allocated $698.8 billion available for distribution.

 In addition to the principal repayments, Treasury has received interest and dividend payments on its investments, as well as revenue from the sale of its warrants.

As of December 31, 2009, $12.9 billion in interest, dividends, and other income had been received by the Government, and $4.0 billion in sales proceeds had been received from the sale of warrants and preferred stock received as a result of exercised warrants.

At the same time, some TARP participants have missed dividend payments. At the end of 2009, there was $140.7 million in outstanding unpaid CPP dividends. There are also some bankruptcies. Three TARP recipients that received a combined $2.6 billion in TARP funds have filed for bankruptcy.

The TARP IG is not enthusiastic about steps taken to avoid a similar disaster in the future:

• To the extent that huge, interconnected, “too big to fail” institutions contributed to the crisis, those institutions are now even larger, in part because of the substantial subsidies provided by TARP and other bailout programs.

• To the extent that institutions were previously incentivized to take reckless risks through a “heads, I win; tails, the Government will bail me out” mentality, the market is more convinced than ever that the Government will step in as necessary to save systemically significant institutions. This perception was reinforced when TARP was extended until October 3, 2010, thus permitting Treasury to maintain a war chest of potential rescue funding at the same time that banks that have shown questionable ability to return to profitability (and in some cases are posting multi-billion-dollar losses) are exiting TARP programs.

• To the extent that large institutions’ risky behavior resulted from the desire to justify ever-greater bonuses — and indeed, the race appears to be on for TARP recipients to exit the program in order to avoid its pay restrictions — the current bonus season demonstrates that although there have been some improvements in the form that bonus compensation takes for some executives, there has been little fundamental change in the excessive compensation culture on Wall Street.

• To the extent that the crisis was fueled by a “bubble” in the housing market, the Federal Government’s concerted efforts to support home prices — as discussed more fully in Section 3 of this report — risk re-inflating that bubble in light of the Government’s effective takeover of the housing market through purchases and guarantees, either direct or implicit, of nearly all of the residential mortgage market.

 Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car. 

The Government Budget

 In addition to TARP, there is the $787 billion stimulus package that is now in the process of being spent. What does TARP, the stimulus package, and the other budgetary items mean overall? According to the Congressional Budget Office’s latest projections, the overall Federal deficits will be $1.6 trillion, $1.4 trillion, and $900 billion in 2009, 2010, and 2011, respectively.