A crisis of confidence
...This is a very interesting argument that seems to be supported by the facts. What it does not address is the crisis of confidence that is causing the seizure of the financial market place. The fact is that we are only gradually working our way through the bad mortgage loans that have infested the market place. We still have not come to grips with all the "toxic" mortgage backed securities that are still in circulation. One of the real priorities is wringing them out of the system so that confidence can be restored.
From this anti-Depression policy has come a stream of costly policy errors that could ultimately prolong the current recession. The Fed's December 16th decision to drop the target federal-funds rate to a record low of zero to 0.25% is but the most recent of these. With rates already effectively trading near zero despite the Fed's previous target of 1%, the decision does not actually change rates, but only sends a negative message about the state of the economy. That worsens confidence. And now the target rate has nowhere else to go, so the Fed will have to resort to new means to increase liquidity — a painful irony since liquidity is not even the problem. (Read TIME's Top 10 financial collapses of the year.)
It is true that the Great Depression of the 1930s was a crisis of liquidity. Stocks plunged, banks went under, and the value of assets disintegrated. Our current policies would have been appropriate in the Great Depression, but they are not appropriate now. Liquidity problems are not the source of our current financial and economic woes. Incredibly, excess reserves of depository institutions have increased from under $2 billion in August to a record $774 billion in mid-December, according to the Federal Reserve's December 18 release. But the banks have not taken advantage of this liquidity to increase their lending. (See pictures of the stock market crash of 1929.)
Why not? Because what we have is not a crisis of liquidity but rather a crisis of confidence. With tremendous excess reserves, it is obviously not the case that banks are not lending money because they do not have the money to loan. Instead, they are afraid that other institutions, including even other banks, will not pay it back. The banks do not have confidence in each other. Businesses, also, are not inclined to borrow money and take risks. Further, consumers are not spending because they are afraid they could lose their jobs.
By continuing to throw money at the banks, the government is on the road to prolong the recession and effect massive inflation when confidence is restored and the economy then has too much liquidity. By making money available to the banks essentially for free, the Fed does not guarantee that the banks will loan out the money to businesses. There is no motivation to lend money at low rates when capital preservation (i.e., lack of confidence) is still a leading issue. Rates may be low, but the banks are not going to offer these rates to the individuals and industries that can make most productive use of them — at least not until confidence returns. (See pictures of the recession of 1958.)
... Recessions ordinarily lead to deflation or disinflation, which increases the real value of assets and acts to end the recession by fostering spending. This natural and necessary corrective mechanism will be thwarted by inflation as soon as we begin to get out of the recession. That is the danger of treating a crisis of confidence as a crisis of liquidity.