Opinion: Why government pumping money into the economy won't work

By Infometrics Economist Geoff Simmons Lots of people are saying that this recession is "different". But why? Our national income is a bit like a river. We can usually measure the amount of water (i.e. money) in it by looking at how high the water comes up the riverbank. When times are good and the rivers are full, we can ease the pressure by letting some water out. The Government does the same thing with the economy - when it is growing too fast, the Government takes money out. They do this indirectly through the Reserve Bank raising interest rates (which means we all pay more for mortgages) or directly by taxing more than they spend "“ i.e. saving money. When the river gets low, we put more water in. Before all the farmers out there get too excited we can't usually do that with a river, but we can with the economy. The Reserve Bank drops interest rates and Government spends more than it taxes (i.e. runs deficits). So surely the answer to our current dilemma is simple. We have a recession, i.e. the water levels have dropped. We need to measure how far the water has fallen, and get Government to pump more water in to equal what we have lost. Right? The only problem is this isn't working, and it probably won't.

There is more going on beneath the surface of the water in this recession. You can't always measure the amount of water in the river by looking at the height of the river. The speed of the flow of the water also matters. A lot. And actually the economy works like this too. How much income we all have is partly determined by how quickly money flows around the economy. In recent years this flow accelerated, and commercial banks played a big part in this. Banks make loans, which people spend or invest, and most of the money ends up deposited in someone else's bank account. Banks can then loan this money again. In the past however, banks made sure that a bit of that money was set aside for every bit deposited or lent out. They made sure you had a deposit to buy a house, and they kept a portion of all deposits on hand in cash. This meant that every time the bank made a loan, it got less of the money back, and in turn could lend out less of the money to the next person. It was a bit like the banks made little reservoirs along the riverbank. This slowed the flow of water down the river, but made sure there was enough water set aside for times of drought. In the last boom however, banks relaxed these restrictions. They reduced the deposit needed for a house. They sold off their loans to investors so they could make more loans. One by one, banks emptied the reservoirs they had made along the river bank. This happened here, but even more so overseas. The river flowed faster and faster, and we all felt richer. We went white water rafting on the international rapids of cash. We didn't need deposits for a house, and interest rates were low, so we paid higher prices for houses. House prices rose, we all felt rich and so we took money out of our house and bought a new car. Now the white water ride is over. Banks have realised they needed those little reservoirs along the riverbank, and they are trying to fill them up again. Households are also realising they need a reservoir too "“ a house is no longer enough because they are losing value. So banks and households are refilling their money reservoirs. This is reducing the water levels in the river, and slowing the river down. Governments around the world are furiously trying to pump water to raise the river levels, but this is getting absorbed by the reservoirs. No matter how much money the Government pumps out, the money river will never flow as fast as it did in the past. It was unsustainable, a man-made flash flood. That is why the current recession hurts so bad, we got addicted to a speed of money flow that cannot be repeated. And as we all know by now, the faster you flow, the bigger the mess. ___________ * This piece first appeared in the Dominion Post on March 14, 2009. Infometrics is an economic information and forecasting company based in Wellington. To find out more, see its website here.