he would have got far more bang for his buck by giving the stimulus to the debtors rather than the creditors.

Guest Post: Steve Keen Out-Thinks Larry Summers � naked capitalism

Inside the beltway and among mainstream economists, Larry Summers has the reputation of being a genius.

But Australian PhD economist Steve Keen points out a huge gap in the thinking of Summers – and all neoclassical economists.

Specifically, in an essay written today, Keen explains the weakness in the Obama administration’s approach to the economic crisis:

Following the advice of neoclassical economists, Obama has got not a bang but a whimper out of the many bucks he has thrown at the financial system.In explaining his recovery program in April, President Obama noted that:

“there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – ‘where’s our bailout?,’ they ask”.

He justified giving the money to the lenders, rather than to the debtors, on the basis of “the multiplier effect” from bank lending:

the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth. (page 3 of the speech)

This argument comes straight out of the neoclassical economics textbook. Fortunately, due to the clear manner in which Obama enunciates it, the flaw in this textbook argument is vividly apparent in his speech.

This “multiplier effect” will only work if American families and businesses are willing to take on yet more debt: “a dollar of capital in a bank can actually result in eight or ten dollars of loans”.

So the only way the roughly US$1 trillion of money that the Federal Reserve has injected into the banks will result in additional spending is if American families and businesses take out another US$8-10 trillion in loans.

What are the odds that this will happen, when they already owe more than they have ever owed in the history of America? …

If the money multiplier was going to “ride to the rescue”, private debt would need to rise from its current level of US$41.5 trillion to about US$50 trillion, and this ratio would rise to about 375%—more than twice the level that ushered in the Great Depression…

But the amount of consumer credit outstanding has plummeted:

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So consumers will borrow less, and the Summers’ plan of multiplying the trillions thrown at the banks by the government won’t result in any meaningful multiplier effect.
Keen continues:

I’ve recently developed a genuinely monetary, credit-driven model of the economy, and one of its first insights is that Obama has been sold a pup on the right way to stimulate the economy: he would have got far more bang for his buck by giving the stimulus to the debtors rather than the creditors.

The following figure shows three simulations of this model in which a change in the willingness of lenders to lend and borrowers to borrow causes a “credit crunch” in year 25. In year 26, the government injects $100 billion into the economy—which at that stage has output of about $1,000 billion, so it’s a pretty huge injection, in two different ways: it injects $100 million into bank reserves, or it puts $100 billion into the bank accounts of firms, who are the debtors in this model.

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The model shows that you get far more “bang for your buck” by giving the money to firms, rather than banks. Unemployment falls in both case below the level that would have applied in the absence of the stimulus, but the reduction in unemployment is far greater when the firms get the stimulus, not the banks: unemployment peaks at over 18 percent without the stimulus, just over 13 percent with the stimulus going to the banks, but under 11 percent with the stimulus being given to the firms.

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Keen concludes simply:

So giving the stimulus to the debtors is a more potent way of reducing the impact of a credit crunch—the opposite of the advice given to Obama by his neoclassical advisers…
Obama has been sold a pup [i.e. tricked into buying something that is not worth anything] by neoclassical economics: not only did neoclassical theory help cause the crisis, by championing the growth of private debt and the asset bubbles it financed; it also is undermining efforts to reduce the severity of the crisis.

This is unfortunately the good news: the bad news is that this model only considers an economy undergoing a “credit crunch”, and not also one suffering from a serious debt overhang that only a direct reduction in debt can tackle. That is our actual problem, and while a stimulus will work for a while, the drag from debt-deleveraging is still present. The economy will therefore lapse back into recession soon after the stimulus is removed.