WHAT WOULD THE OPPOSITE OF 9-11 LOOK LIKE?:

Animal Spirits Depend on Trust: The proposed stimulus isn't big enough to restore confidence. (ROBERT J. SHILLER, 1/27/09, WSJ)

The term "animal spirits," popularized by John Maynard Keynes in his 1936 book "The General Theory of Employment, Interest and Money," is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings, and our sense of the extent of corruption and bad faith. When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people. [...]

So what must we do to revive our animal spirits and economic growth? We must be certain that programs to solve the current financial and economic crisis are large enough, and targeted broadly enough, to impact public confidence. Not only do we need a fiscal stimulus significantly greater than the proposal that is currently on the table, government action is also needed to take the place of the credit markets that seemingly worked so well when animal spirits were high. The Treasury and the Federal Reserve not only need a fiscal target, they also need a credit target. This should not be a dollar number, but rather a target for how the credit markets should behave. The goal should be that those who would normally receive credit in times of full employment can once again find it easy to do so, at rates with realistic risk premiums.

There are three ways to restore these credit markets. The Treasury and the Federal Reserve have been inventive in applying all three methods. The first is the extension of rediscounting. The Fed has invented many different special loan facilities. They have even invented ingenious ways to combine Treasury money to make very large-scale loans while still within the legal requirement that the Fed can only lend against safe collateral when using TARP funds for the Term Asset-Backed Securities Loan Facility, which will support consumer, student and small-business loans. But so far the total amount of such rediscounting has been small relative to the size of the credit markets. They need to be much larger.

Second, so far more than $250 billion of government money has been used to recapitalize banks. But just making the banks solvent is not enough. The banks, whose managers are suffering from the same flagging animal spirits as the rest of the economy, will not expand their credit much just because they are more solvent. The banks will only expand if they see profitable opportunities to grant loans and if their fear of failure is diminished. It will take much more than keeping the banks solvent to make them take on the disappeared credit flows.

And, finally, especially in considerably expanding the powers to support the lending of Fannie Mae and Freddie Mac, government-sponsored enterprises have replaced a significant portion of the mortgage markets. But the government should do much more here as well. For example, failed banks might be kept alive longer as bridge banks under government supervision with the purpose of making credit freely available.

The interventions so far have been in the right direction. Federal Reserve Chairman Ben Bernanke has been especially inventive and aggressive. But the theory of animal spirits and the loss of confidence tell us that a great deal more still needs to be done. Now is not a time for the timid. To meet our needed fiscal-policy target, the Obama administration's fiscal stimulus should be much greater. And to meet our credit target, the expansion of special loan facilities, recapitalization of banks, and use of government institutions to grant credit where it has dried up must be on a scale great enough to overwhelm further doubts about the economy.

That this is just a psychological crisis is why it was so disastrous for the House GOP to throw fuel on the fire last Fall. But the hope was that electing the Unicorn Rider would break the country out of the mood it's been in. That obviously didn't happen.

Posted by Orrin Judd at January 27, 2009 11:46 AM