The reasons why fiscal stimulus may not work.

Credit financed the malinvestments and when you liquidate them in order to release capital banks must recognize their losses, which means they must take back from the economy the same amount of money they put into the economy with the original loan.

If banks lack sufficient profits to extinguish loan losses then they start extinguishing their capital, which would lead to a collapse in bank share prices as investors run for the exits before the capital they invested in bank stock is extinguished along with the rest of the bank’s capital.

A collapse in bank share prices further erodes bank capital that is available for liquidation to cover the bank’s liabilities.

Then the FDIC needs major additional capital to bail out the failed bank’s depositors up to the limits of deposit insurance, and this additional FDIC capital ultimately comes from the Treasury which is taxpayers. There is no hiding from the capital conflagration. Either directly or indirectly, everybody’s money gets burnt down.

It doesn’t matter whether you are an Austrian or a new Keynsian or a devotee of the more recent Richard Koo. There is no painless escape from the aftermath of a popped credit bubble. There is only the choice of how you want to take the pain.

Given the sheer scale of the excess, Austrians expecting “creative destruction” would see destruction followed by nothing, there will be nothing creative about a new great depression and a new world war to end it. New Keynsians who expect a short period of pump priming followed by a return to free market economic growth will see only the pump priming and not the growth.

This is not a cyclical downturn that can be eased back to growth with fiscal stimulus. It is a balance sheet recession that requires years of balance sheet repair before the economy can begin moving forward again under its own steam. All the “growth” was pulled forward from the future into the credit bubble. Now we are in the “hole” in the future. We already have all the “economic stuff”–malls and McMansions as far as the eye can see. Now it’s time to pay for that stuff, and there will be no economic growth while everyone is paying for what they already have.

- Derryl

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