Interest Rates and Bank Lending – What Lending?

Well not quite none. The point being that loans to businesses by commercial banks have been declining steadily for three months, at something like an annualized 28%. So while a lot of media attention has been given to all the shenanigans banks are playing with their retail customers – people like you and me – the bigger news is that they have put the squeeze on business like no tomorrow.

This is not good.

For about three decades banks had become steadily less important as sources of credit to business. The old fashioned bank loan was replaced a long time ago by things like commercial paper. The reason was simple: after the real estate debacles of the late 1970’s most banks had worse credit ratings than their premier customers. That meant those customers could borrow more cheaply from the credit markets than the banks could. The only problem was that there was no vehicle available for these customers to access those markets. In stepped the investment banks with products like commercial paper and within years most major corporations had dispensed with the traditional banking relationships of yore. The big banks lost both customers and income streams which drove them into searching for other ways to make a buck. The boom in credit cards and so on was partially fueled by this sequence of events.

Fast forward to last year: the market for products like commercial paper is referred to as the ‘shadow banking system’. It is a shadow because it performs the same kind of function as regular banking – moving money from people who have a temporary excess to people who have a temporary shortage – but is beyond the reach of the regulatory system. It is in the shadows.

This parallel ‘shadow’ system was, we were told for years, a wonderful phenomenon imbued with all the usual magical powers that free markets are supposed to possess: it was cheap, efficient, and unbiased. Its capitalist motivation drove it, its advocates claimed, to allocate capital in the most socially efficient way possible. And certainly better than the stodgy banks.

Call me skeptical but the results are in and the shadow banking system looks a lot less robust than it used to. All that cash flowing into mortgage backed securities etc probably wasn’t the wisest, most efficient or socially beneficial allocation available. But that’s just me. Those Wall Street wizards obviously know much more than I do.

The relevant part of this, to our story today, is that the shadow system was what froze up last year. So much for that Efficient Markets Hypothesis.

This freeze left most major companies, and a ton of not so major ones, exposed to cash flow problems. Their most important source of cash dried up and withered away in a few days. They faced a massive liquidity crisis.

In stepped the Federal Reserve Board who, acting as lender of last resort, pumped trillions of cash into the banks in order to flood the economy with liquidity. This flood is why we have so few, if any, bank panics. There have been no ‘runs on the bank’.

Since the Fed has to run things through the banking system, and not through the shadow system where it has no [or little] regulatory control, all this cash went to the banks, who were suddenly awash with cash. They still are.

Before I go on I should clear up what might be bothering you: if all the banks were awash with cash why did we need to bail them out?

That’s because the banks had two distinct problems.

We bailed them out because their assets stunk and were exposed as worthless. Or worth very little. Accounting rules require banks with useless assets to right the value of those assets down to the level that they could command were they sold in a market. These right-downs cut into bank capital. And if you right off enough you eliminate capital and through the bank into insolvency. An insolvent bank is one whose assets are wroth less than it owes its depositors. It was to prevent insolvency that we handed out vast sums of taxpayer money – that cash was used to bolster capital and thus allow the right down of assets without having to close the banks down.

So problem number one was a solvency issue. TARP fixed that. Or has so far.

The second problem is one of liquidity.

This arises when customers ask for their deposits back and a bank doesn’t have enough cash on hand to meet those demands. Ordinarily a bank would sell assets to raise the cash it needs. But in an economy riven through with fear it might not be possible to sell those assets. This would set in motion a classic bank run. A bank subject to this could have loads of good assets to sell and may have tons of capital. It simply doesn’t have cash. It is illiquid.

What’s this got to do with the decline of bank loans?

The problem is that we have masses of liquidity. As I mentioned above the Fed flooded the economy with cash in order to prevent banks runs. The banks, for a very short while back last fall, used that cash to provide loans to businesses. In effect the banks moved back into their old way of doing business: they issued bank loans to customers who had been getting their cash from the now defunct shadow system.

But recently the banks have stopped doing this. They obviously are concerned about making loans to businesses who may not weather the recession. Since the banks are still knee deep in toxic assets they naturally are afraid to add more. So they stopped lending.

Hence that dramatic decline in lending.

The implications are profound. Without credit the economy will have a very difficult time getting back on its feet. In fact it won’t. As long as credit contracts the economy will most likely sputter at best. So that 28% decline in business loans looms very large across any optimistic forecast for GDP growth. I would argue it undermines any credible chance of getting a sustainable recovery at all.

The double whammy of prolonged high unemployment and a frightened banking system will most assuredly prevent long term recovery. All our policy actions need to be targeted at resolving those two conundrums.

You might ask – at least those of you who are still with me – what happened to all that liquidity?

Well.

The Fed flooded the economy with cash. The banks said ‘thank you’ and deposited in the safest place they could. After all the purpose of the cash was to provide liquidity. Where is that safest place? The Fed. That’s right. The banks have deposit accounts at the Fed that they can access to pay depositors when they need extra cash. And that’s where most of the flood of liquidity ended up. Back in the same vaults it came from.

Phew.

Now this represents a different problem.

One that you will be hearing a lot about, especially as the first signs of growth emerge.

Here’s why it’s a problem:

When the Fed prints a ton of money – which it did this year – that money could find its way into the pockets of people who then try to spend it. As I just told you this is not a problem at the moment because the banks have stuffed all that cash in the Fed’s own vaults.

But.

What happens when things start to look good?

That banks will start to lend. Surely you will shout: that is a good thing! Well, yes and no.

As long as the economy is producing lots of things to buy, the answer is yes. The money will be there to let us buy all those new things. But if the economy is producing fewer things than we have the money to buy – there is too much money chasing too few things – then we will drive up inflation. That’s where inflation comes from. Too much cash and not enough stuff to spend it on.

And that’s a huge concern.

All the efforts the Fed made to prevent a liquidity crisis could now turn and bite back as rampant inflation.

This is why we will be hearing arguments from conservative economists that the Fed should raise interest rates sooner rather than later. Rising interest rates will slow that rate at which the banks can shovel all that cash out as loans – loan demand will be reduced because the loans cost more. That would allow the dispersal of all that liquidity without driving up inflation.

The risk of this?

That the Fed moves too soon and raises rates too early. That would kill any incipient recovery. That’s what the Fed did in 1937 with the result that the Depression lasted a couple years longer.

My own view is that the flood of liquidity is nowhere near being inflationary at the moment for two reasons: first, as I have told you, the banks are simply sitting on it and not lending. The trend in bank loans is exerting exactly the opposite pressure – it is deflationary not inflationary. Second: the economy is operating so far from capacity that we are a very long way from being at the point where there is excess cash and no stuff available to spend it on.

Combine these two arguments and I simply cannot see a reason to raise rates any time soon.

But I am not at the Fed.

There is a very strong and growing camp in the Fed that is arguing for a rate increase fairly soon.

I think they’re nuts. Those loan figures support me.

There are only two ways to explain those loan numbers. Either, as I have been talking about here, the banks are sitting on the cash for fear of future losses. Or there is simply no demand for loans. Given the drastic decline in industrial capacity utilization we have seen through this recession, this latter cause is highly probable. Add them together and we arrive at a water tight defense of low interest rates.

Bernanke will have to opine regularly on the virtues of tighter money, but once he’s back at the Fed he’ll have to keep the money spigot wide open.

Our problems are not done yet.