The economic developments up to this early stage of the new year have reaffirmed the resilience of the American banking industry. After more than a year of recession, bank earnings are rebounding. Non-bank financial firms have dramatically declined or disappeared. Government bailout programs have come and gone in rapid succession doing little better than stimulating panic and sowing confusion among customers and investors—and wasting taxpayer funds. The vast majority of banks have survived all of that.
The early recovery of the banking industry this Spring was publicly interrupted by a set of phony stress tests, subjecting banks to evaluation under hypothetical future conditions that not even the Treasury officials who imposed the tests believed to be realistic. That is, they could not be expected to believe in the hypothetical conditions of the tests, since the conditions assumed that the Obama economic program not only would not work but would actually make things worse. For example, the hypothetical stress tests asked banks how they would do if loan losses became worse than at the deepest point in the Great Depression. We all must believe that the Treasury has better hopes than that for its own economic programs.
Even against those unrealistic measures the banking industry came off well. Despite the fear mongering of short sellers, the obtuseness of accounting standard setters, and the vivisection experiments of policymakers, the bank panic is over and the industry is poised for economic recovery.
The sky ahead, however, is not blue and cloudless. There are three major dangers on the horizon that could play havoc with the economy, the banking industry not excepted. The good news is, that all three are subject to government action. The bad news is that government leaders are showing little sign of even recognizing the dangers, let alone taking action to avoid them.
The three dangers are ballooning inflation, rising interest rates, and increased taxes. The three are related. Any one on its own could stifle recovery.
The Federal Reserve has pumped more than a trillion dollars into the economy, increasing the money supply dramatically. With fewer goods and services to buy with all that extra money we would be in a major inflation now if most people and businesses were not instead hoarding the money. Once coffers and savings accounts get full and people and businesses start spending again inflation can be avoided only if the Federal Reserve can mop up all that extra money and do so precisely as it comes gushing out into the economy. Success with such a delicate maneuver may not be impossible, but it would be astonishing.
The chief baggage from Federal Reserve efforts to reduce excess money supply is higher interest rates. High interest rates are both a tool for encouraging people to save their money rather than spend it, as well as a reflection that the program is succeeding in pulling money out of the system. But high interest rates also depress the economy, making business investment (think new machines and buildings) and consumer purchases (including houses and cars) more expensive.
Complicating this nearly impossible task for the Federal Reserve is the problem that the trillion dollar overspending by the Federal Government—well on its way to more than two trillion dollars—will be demanding hundreds of billions of dollars in borrowing from the public just when the Federal Reserve may be wanting to reduce the money supply. Foreigners are showing reluctance to lend to the Treasury, so domestic savers will have to choose more and more among spending their money, lending it to business, or lending it to the Federal Government.
Treasury debt auctions have already been soft. Interest rates are creeping up to keep Treasury debt attractive. The Federal Reserve may soon be stepping in to buy Treasury debt to keep the auctions from collapsing. If the Federal Reserve did so, it would be pushing more dollars into the economy just when it needed to pull them back to hold off inflation. The Federal Reserve would be in a no-win situation, and so would the rest of the country.
We could overcome both inflationary and interest rate risks to the economy by dramatically reducing taxes, particularly taxes on capital gains—making investment and new business activity more attractive by letting people keep more of what they earn. Instead, the Obama administration is proposing a host of major new taxes. Some are hidden as part of new environmental and health care programs. Others are more overt, such as plans to raise taxes on businesses and the wealthy, the very sources of job creation and investment.
The Franklin Roosevelt administration well earned the condemnation of history by taking a deep economic recession and making it last for a decade—encouraging enemies of freedom all around the world. President Obama would do well to avoid that example.
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