The Entreblog!

US GDP increased at a 3.5% rate (last paragraph) in the third quarter of 2009.  While this is great news, a lot of people are asking, “where are the jobs?”  Unemployment rate is 10.2% nationally, which is about 6% higher than full employment.  What’s the deal, economy?

Of course there are many potential explanations why unemployment would continue to rise while GDP increases.  Those reasons are specific to each recession, in my opinion.  I believe there’s a simple, plausible explanation, right now.

First, why do firms hire?  Firms typically hire because they expect to grow in the future.  Hiring decisions aren’t made based on current conditions but on expected future conditions.  So, the unemployment rate could be a commentary on firms expectations (or uncertainty) about the future.

But most economists predict growth in 2010.  Yet unemployment projections for 2010 hover at about 9%.  To understand the discrepancy, let’s understand how firms grow.  A fundamental truth of corporate finance is that growth must be financed, either by liquidating assets, selling equity or borrowing.  Borrowing is far and away the most commonly used way to finance growth.

But banks aren’t loaning money right now.  Which means firms aren’t sure they can finance future growth.  Which means they can’t hire people.

So why aren’t banks loaning money?  They have plenty of excess reserves to loan, firms want to borrow and loaning is what banks do.  They have no other significant source of income.  Or at least, they didn’t.

Image by talkradionews via Flickr

Until the Fed started paying interest on excess reserves.

That’s right.  Before October 2008, banks’ excess reserves at the Fed didn’t earn interest.  Huge sums of money would just sit earning nothing (and declining in value, thanks to inflation), so banks took on the risk of loaning it out to earn some return.

But if your choice is earning interest risk-free by leaving your money with the Fed versus loaning it out and taking on risk, you’d do it.  Especially since your capital requirements would drop if you weren’t loaning money out.  Your balance sheet would look a lot better and you’d probably be able to report positive earnings.

So, Fed policy could be to blame for unemployment?

Well, maybe (probably).  The policy makes sense in October 2008 when banks need all their capital to stay solvent from day to day.  Of course, I think they’d keep the necessary capital on hand without the Fed’s incentive out of self-interest.

But in November 2009, it just doesn’t make sense to pay banks to not loan money when the credit market is so much more stable.  The Fed should at least decrease the rate they pay to be less than the risk-adjusted rate of a commercial loan.  That way banks would have a much greater incentive to loan than hold on to their funds.