Bernanke

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Bernanke Speaks: Modest Growth Ahead?

In comments made today Bernanke has given a cautiously optimistic view of the economic outlook. I emphasize the word cautious.

Allow me to summarize:

  • The economy grew about 3.5% in the third quarter, breaking a four quarter span of decline.
  • Bernanke sides with the optimists in arguing that this growth came from sufficiently diverse sources that it is likely to continue even when the inventory adjustment subsides, and the effects of temporary government actions such as the ‘cash for clunkers’ and first time home owner credit programs dissipate.
  • So he sees the economy growing throughout 2010.
  • Nonetheless there are big risks: obviously unemployment is too high, and the flow of credit too weak.
  • Unemployment has started to end its free fall. The economy is shedding about 220,000 jobs a month now rather than the 560,000 a month common at the beginning of the year. The economy needs to add about 100,000 jobs a month just to keep up with population growth, so we are a long way from reaching a tipping point where jobs become more abundant.
  • Unemployment has hit the young particularly hard with the unemployment rate in that category reaching over 19%. This is very damaging long term since it means that younger workers are being denied a chance to develop skills and gain experience that we will need in the future. This imposes a ‘hidden’ cost on the economy as the delayed development of such workers will slow productivity growth down the line.
  • On the other hand: current productivity is growing at very high rates: by about 5.5% this year. This is largely due to employers making surviving workers do more work; and to the shorter work week: average hours worked per week have now shrunk to about 33, the lowest since World War II.
  • The actions taken to bail out the banks worked in that the crisis in the credit markets has eased – as measured by things such as risk spreads. However, banks are lending less. The level of consumer debt has now fallen for the first time since 1951. Lending terms have been tightened significantly although there is evidence that the tightening is at an end. In general banks remain cautious and are likely to stay that way for some time – especially in view of the oncoming commercial real estate refinancing problem.
  • Because of the probable damage done to bank balance sheets by the commercial real estate refinancing problem, the TARP and TALF programs should remain in place at least through next year.
  • There is no upward pressure on inflation presently. The economy is awash with spare capacity so the are few resource constraints – production bottlenecks are a normal source of price pressure during the early stages of a recovery – and the bond market seems quiescent: the expected inflation rate being built into bond prices is well within the limits the Fed sees as prudent [ the Fed has an upper limit of about 2% per year in mind].
  • The dollar is likely to weaken some more, although the current flux in exchange markets is probably not going to last much longer. The Fed remains committed to a ‘strong’ dollar as part of an approach to international financial stability.
  • Taking the state of the credit markets, the low expected rate of inflation, and the outlook for the dollar into account and then setting those against the need for ongoing support until the economy is securely on a growth track, the Fed sees no reason to raise rates in the near future. Indeed there is every chance rates will remain very low for an ‘extended’ period.

OK.

That’s what he said. Is there anything of note in those statements?

Not really.

Bernanke is solidly in the pragmatic-but-optimistic camp. He clearly acknowledges that there remain significant downside risks next year, but he argues that the central tendency of the economy is modest growth. However he wants us to note that the variability is mostly on the potential negative side: the combination of weak credit and weak labor markets could well threaten growth and push us back into recession. He thinks a second downturn is unlikely, but that the threat remains.

As for inflation and interest rates: Bernanke sees a quiet time ahead. Since inflation is not an immediate threat – notwithstanding the hysteria in some media outlets – there is no need to lift rates. On the contrary: given the weakness in domestic demand the bias is still to maintain the very low, and thus stimulative, level of rates for a long time.

As for the dollar: he ‘soft shoes’ around that one. I suspect he would like to see a little more devaluation to help lift exports and thus support growth. He probably doesn’t mind a steady decline in the dollar’s value. What he wants to avoid is anything precipitous. That would force his hand and could potentially threaten the recovery. So he ends up talking pablum about a ‘strong’ dollar without saying what that would look like.

Overall his view seems to fit with where I think things are going. I am less upbeat about next year because i am less sure than Bernanke is about the sufficiency of the current burst of growth: I see much more of the third and fourth quarters coming from stimulus and inventory adjustments, and thus less from ongoing sustainable growth.

The difference?

He puts growth next year in the low 2% range; whereas I am still in the 1.5% range.

No big deal, as long as credit and jobs don’t cause any ripples. My outlook just has less room for maneuver and thus more chance for a downward shift.

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Break Up The Banks: Part 3 … Phew

I didn’t realize that when I first wrote about this issue I was plunging into so deep a pool. I knew that it was a hot topic, but the amount of time and space being devoted to it are, to say the least, extraordinary.

Today’s edition brings two major players into the game: Martin Wolf, my favorite writer at the Financial Times, and Ben Bernanke opining on the Fed’s view.

I disagree with both, so I owe an explanation as to why.

“There is nothing more dangerous in the economy than a greedy dunce. Unfortunately we are blessed with a number of very large ones. They could do less harm both to themselves, and to us, were they all a lot smaller.”

Let’s tackle Wolf first.

His opinion is presented in an op-ed piece in today’s FT. He starts by stating the obvious: big banks are a problem and that the problem is now much worse than before. It became worse because we didn’t do anything yet to fix it, while the big banks that survived the last crisis have now gobbled up weaker players and grown market shares. They are even bigger than before.

Wolf describes all of this, so I am fine up until the moment he backs off the inevitable and obvious solution. If some banks are too big, then we should make them smaller. Instead he offers up a rather lame defense of letting them stay large: we might find it difficult. Plus he muddles some rather easy facts around to create a better target to shoot at.

Allow me to straighten Martin out.

His straw man is the notion – one I agree with in principle – that we should re-instate the separation between regular, main street, banking, and what he calls ‘casino’ banking – I have used the word ‘gambling’ – which used to be the exclusive domain of the old investment banks. The reason for separation is clear, at least in theory: main street banking is boring stodgy and utility like. It includes dull stuff like managing checking accounts and making small business loans. There is very little sexiness in that business which is why all the real ‘high flyers’ flock towards investment banking. The ‘casino’ banks would include all the various activities we have come to know and hate: derivatives, securitized products trading, and the real bete-noir of the AIG collapse those infamous credit default swaps. In other words all the high stakes gambling stuff that any sensible main street bank would avoid like the plague.

Wolf argues that it would be very hard to separate the two activities. He uses a cheeky sleight of hand to support this contention: he says that “all the lending” would be left to the casino banks – including lending to households and small business. This is plainly false. The old commercial banks we had in the US – before the ill-fated abolition of Glass Steagall – were not just payment system operations the way Wolf suggests the new main street banks would be. They went much further: they were the primary providers of credit to small and medium sized businesses and to households. Why they wouldn’t continue in this role Wolf fails to explain. I think he is arguing that the new main street banks would have absolutely no credit risk at all. I don’t see why this should be. The system worked well for decades after the Depression era laws like the Glass-Steagall Act broke the banks up. Yes there were periodic bank losses, but they were never even remotely as catastrophic as last years implosion. All those periods of loss were associated with the economic cycle – banking lagged the cycle because profits dropped as customers suffered losses and defaulted on loans. Last year the banks were the cause of the problem: banking had become a leading factor instead of a lagging factor.

I give Wolf credit though, because he highlights a big issue that seems lost in the current discussion.

He suggests that the solution I just gave – re-creating the old commercial banks – implies that generating loans is good, but securitizing them is bad. He wonders why it is that we should think securitization is bad. Because it separates the bank from its customers. That’s why. He misses the point that the re-creation of the old commercial banks includes with it the reduction – if not the elimination – of securitization.

Why is this so important?

Securitization allows banks to package up and sell loans that they have made – those awful mortgage backed securities based upon packages of sub-prime mortgages are a classic case in point. This process frees up capital on the bank’s balance sheet, it generates fees, and it, in theory, reduces risk for the banks because the default of those loans is now someone else’s problem. All true so far. But: it also means that the lender has no enduring interest in the customer. This is great in good economic times, but when the seas get a little choppy it also means that customer’s have a much harder time getting forbearance or other types of help to allow them to weather the storm. The old fashioned customer-lender link is severed. The economic consequence of this is that there is no organization with an interest in acting as a brake on the deterioration of the asset: the new holders have no relationship to protect, so they are quick to ask for foreclosure on bad mortgages. The other damage that securitization brought us was also rooted in this customer-lender severance: the lender had no long term interest in the loan, but had a very high interest in the volume of loans – that’s where the fees are generated. It doesn’t take a rocket scientist – although the point eluded all the math wizards on Wall Street – to realize that this is a recipe for loose credit standards. If a bank doesn’t have to face the potential loss of a loan it makes it will be willing to lend to just about anyone. Sub-prime mortgages are a direct result of securitization for exactly this reason.

So Wolf gets it totally wrong: securitization is bad when applied en masse to bank loans. The type of commercial bank I advocate as the future would be forced to hold their loans, or at least the majority.

It is one thing, and a very normal thing, for a bank to lose money when the economy goes into recession. It is quite another for banks to lose money because they willfully overlook basic underwriting techniques. Securitization is not the only cause of bad lending – unrealistic profit targeting is another obvious one – but is a major one.

Once Wolf dismisses breaking the banks up he is left to answer the ‘too-big-to-fail’ question in other ways. He resorts to the same arguments that Bernanke also uses. He suggests we impose huge capital requirements on riskier activities; that we introduce laws to make bankruptcy easier and more painless for financial institutions; that we abolish off balance sheet activities – yes banks have vast amounts of assets not recorded on their balance sheets and thus not protected by capital; that we require fancy and more rigorous loan loss provisioning – a loan loss provision is a ‘rainy day fund’ that banks create to offset loan losses, the idea being to set the fund up when the bank is profitable and then to draw it down in hard times; and that force banks to have better capital – more plain equity and more ‘contingent’ equity which is an exotic form of capital that is only converted into plain equity in emergencies.

At this point Wolf and Bernanke are making the same suggestions so I should conflate them for my response.

First: all of these novel ideas have been floating around for years. Why were they not adopted? because the banks lobby really well and managed to prevent them being put into force. Wold and Bernanke will have to be much more convincing to persuade me that the banks, who are now more powerful, will not be able to stop them again.

Second: imputing higher capital ratios is a great idea. I am all for it. The problem is that we have capital ratio requirements already. Banks have proven to be very adept in avoiding them. Regulators have been very lax in enforcing them too. There is no evidence I know that suggests that either the banks or the regulators will change. Indeed as soon as this crisis abates enough I would wager that laxity will pervade and a new crisis will form.

Third: those plans for easy bankruptcy are not that easy. These mega banks are arcane warrens of subsidiaries and murky tax-dodge off-shore vehicles. Unless the bankruptcy procedures include a regulation that clears away all that mess up front – forcing the banks to eliminate their tax dodges would help finance more adequately staffed regulatory bodies, which is an exquisite use of bank profits – the courts will inevitably foul up anything remotely hasty. The unwinding of Lehman still rumbles on with international squabbles over jurisdiction delaying the process. Somehow I doubt whether we could feasibly wind Citicorp up over a weekend even with the best bankruptcy laws in place. Besides the problem is not simply winding up a bankrupt bank, it extends deeply into allowing the markets to digest and value the bits of the bank being wound up. And a mega bank has, by definition, a huge share of the market, which begs the question: who would buy all that stuff? Would we have to resort, as we just did, to forcing a Merrill sized chunk down the throat of an unwilling Bank of America? If so, what have we gained?

There is nothing easy about a mega bank bankruptcy. No matter what the law; no matter what detail its ‘living will ‘ has; and no matter how well oiled the regulatory framework for the bankruptcy may be: at the end of the day we will have to have buyers for the assets. The most eligible buyers would be … the other mega banks. Who would then become super-mega banks and we would immediately compound our original problem. The other alternative would be for the government to own some of the assets itself, but we shied away from nationalization before and are unlikely to go that way in the future.A third course of action would be to break up the failed bank and sell it off as stand alone entities to private investors. But … ummm … both Bernanke and Wolf don’t think breaking up the banks is a good idea.

Unless, apparently, when the bank in question is bankrupt. In which case: I can think of a couple of large banks that fit that category last year. And what did we do? Nothing.

Which brings me back to breaking up the banks.

I am all for all of Wolf’s suggestions. I think they’re dandy. We need to impose them on the newly broken up smaller banks. That way these new banks will have strong incentives not to get too big. That would be great wouldn’t it? A whole bunch of smaller, highly capitalized, safer, and competitive banks. More choice for consumers and businesses. More safety and soundness. A capitalist dream. Who doesn’t want that?

Well Bernanke.

The key insight into his position is when he argues that one reason we don’t want to break up the banks is so that we can preserve value for the financial sector. Wow. Our regulatory regime has to be cognizant of the shareholder value of the banks? It has to preserve that value? I think Bernanke has his proverbial knickers in a twist here. Tightly too. Silly me. I thought the object of the regulators was to preserve safety and soundness – the public part of the banking system. In technical economic parlance the safety and soundness of banking is a ‘public good’. That means it belongs to all of us since we benefit from it. That public good provides us with a motivation to preserve it. It has value to us. Hence our willingness to bail banks out and to regulate them. The ‘private good’ in banking – the profits that go to the shareholders – is of no consequence to us. That’s the private investor’s problem. That’s why they have Boards of Directors. The Board oversees the protection of the private goods. The regulators oversee the protection of only the public goods.

Duh.

Economics 101.

Obviously not at Princeton.

Actually Bernanke’s startling comment gives us an insight into why the Fed – and the Treasury – has been so soft so far in imposing an new regulatory regime – they think like Wall Street. They act tough: Paulson’s hard ball tactics late last year being an instance. But now that things have calmed down they are back to being obsequious. I find it astonishing, and dismaying, that Bernanke has anything but a tangental interest in bank values: capital yes, market value no.

When all is said and done I just don’t see a viable alternative to break up. Everything else can be worked around. Besides, as I mentioned above, all those other methods for controlling the banks are great additions to the break up process.

Let’s have both.

The banks proved to the world that they were a combustible mix of incompetence and venality. There is nothing more dangerous in the economy than a greedy dunce. Unfortunately we are blessed with a number of very large ones. They could do less harm both to themselves, and to us, were they all a lot smaller.

Break them up.

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Bernanke Maps The Future

In a speech given yesterday Ben Bernanke gave us a few hints about the future of the world economy. Unfortunately most of his commentary is similar to speeches given throughout the years by other American officials.

The main story line deals with ‘imbalances’. This is central banker speak for the really big deficits or surpluses that haunt the global stage and are viewed as primary causes of much of the current trouble.In particular are the various trade balances between the US and its main trading partners, and the seemingly unending Chinese surplus that is a source of destabilizing capital flow.

The problem is this: the US consumes too much and does not save. It therefore has to borrow money from other countries to maintain its standard of living – as long as standard of living is defined as GDP growth. This is an historical anomaly of huge proportions because in bygone eras the then dominant economy was always a creditor – it lent some of its surplus wealth to other countries who could then improve their economies. The US is the first dominant economy to depend on weaker or growing neighbors for its growth.

The early years of American development was largely financed by European – particularly British – capital. So as the US grew is sucked in money and ran deficits in order to build for the future. Those deficits were tolerable because they were contributing to future wealth. They could be paid off comfortably from that wealth once the economy became self-sustaining.

Right now this scenario is being played out backwards.

China, which is roughly analogous to the young America, is not sucking capital, it is exporting it. Instead of consuming its capital through domestic investment, and therefore constructing the platform for future wealth, China is content to grow more modestly and export its cash to the US. The reason is straightforward: the US is China’s largest market and therefore it is in China’s interest to have the US continue to consume and grow. Slower US growth is seen, in this scenario, as a threat to Chinese strategy.

Other Asian countries are doing the same thing: they are relying on the US to keep going deeper into debt in order to prop up its consumption habit.

All these trading partners of the US are implicitly suppressing their own domestic demand and are relying on growth abroad to provide an engine for their own growth. This is one reason why the American implosion last year ricocheted so quickly around the world economy: it wasn’t simply that the US financial system crippled the world, it was that the subsequent US contraction in demand left Asian suppliers with an overhang of unused production.

The flip side of this dependence is, of course, that the US is able to run huge deficits with comparative impunity: foreigners are more than willing to pour capital into the US in the belief it is the safest place to invest. Unfortunately this allows the US to avoid confronting its own issues, notably its rapidly deteriorating competitive position and its long run loss of advantage with respect to innovation, education, and other aspects of economic infrastructure. This is why I call the economy at present an ‘illusion’: it looks as if it is healthy, but underneath it is compiling problems and debts at a prodigious rate.

These imbalances have been around for decades: the US shifted into debtor status and a dependency on foreign capital in the Reagan years, but it took the emergence of China and other Asian economies to bring the issue to a head.

The flood of capital flowing onto the world market from the trade surplus countries was a primary cause of the financial bust in the US. Money from China, Japan, Germany, and Asia generally swamped the US economy, drove down interest rates here, facilitated persistent Federal deficits, and ended up being channeled into things like the sub-prime market because there was a lack of sensible investment opportunities here: our manufacturing sector has migrated abroad.

This is odd because in a high wage economy like the US it is normal to see a constant attempt by capitalists to substitute capital – which is relatively cheap – for expensive labor. This constant substitution should drive productivity higher and thence allow the retention of those high labor costs. It was exactly this effect that drove the emergence of the Industrial revolution in the early 1800’s – British wages were much higher than anywhere else, so capitalists were driven to invent automated ways to perform production tasks, the result being a virtuous cycle of higher productivity followed by yet higher wages and thus a new impulse to innovate.

The problem we have had is that our industry has simply off-shored to lower wage nations rather than innovate or invest. So the virtuous cycle was more muted here than it ought to have been. That has allowed the steady erosion of competitiveness and, more recently, threatened US wages. Instead of inventing its way to a higher wage scenario the US has accepted the need to lower, relatively speaking, wages here.

This means that the inflow of capital caused by our constant deficits and our debtor status has been used to support consumption rather than investment – it has not been turned into expanded future wealth opportunities at all.

This unfortunate trend has been noted for years by a succession of American and foreign experts, but there was never the predicted crisis to bring to a head the needed international reforms. In particular thee was never the will to deal with the American deficits – American consumers grew attached to spending what they didn’t earn. On the contrary during the Bush years concerns about deficits were dismissed as the silly whining of old fashioned analysts, and the American ability to keep growing its debt was seen as a virtue – it spoke to the romantic, but not economic, notion that there was nowhere safer than America to invest. That the rest of the world was apparently to keep on plowing cash into the maw of American consumption was, from the Bush administration’s view confirmation of American superiority rather than a symptom of long term degradation. Foreigners went along with the ruse as long as they could extract good returns, and besides, the Us is the world’s largest economy – where else could they invest?

This charade is now teetering on the edge. Foreign countries like China make periodic references to the massive amounts of dollars they now own, and to the inevitable risks that position entails. There is even talk of ending the dollar’s role as a reserve currency due to its over abundance o world markets.

This is where Bernanke steps in: he is simply stating the obvious. The US will have to start to consume less as a proportion of its total GDP. That means it will import less and will want to export more. The problem then becomes what to do about those foreign export dependent economies? How do we get the Japanese, Chinese and Germans to consume more and rely less on America for sales of their goods? The answer is clear, and Bernanke lays it out in plain terms: they have to shift their domestic economic policies towards encouraging spending and placing less emphasis on saving.

That is all easier said than done.

Shifting Americans from their obsession with acquiring ever more stuff, or getting Germans to save less and spend more, will require heavy lifting.

Here in the US we also have to get to grips with our Federal deficit which will require us to raise taxes and to face difficult spending cuts: in particular we are likely to have to confront our defense bill, which in turn, implies a re-evaluation of our role in the world. It is nice to have a huge military presence with which to bully the world, but the long term cost should not be the hollowing out of the domestic economy and the loss of our standard of living.

Likewise, the American system of entitlements needs to be tightened up and made more cost effective. This is the major impulse underlying my support of health care reform: those dollars need to be allocated towards future wealth generation and not simply consumed on today’s generations health issues.

That Bernanke spoke about all of this is symptomatic of the concerns in Washington that the US is finally wearing out its welcome as a debtor. We will be reliant upon the inward flow of capital for many more years as we re-tool our economy to produce more domestically. So we cannot be precipitous in our actions: quick movements in the dollar could undermine confidence in the US economy and threaten that flow of cash. Likewise a continuation of the Bush era indifference to deficits is also destructive: that too would imply a devaluation of the dollar and thence could cause the same ill effects.

So Bernanke needs to keep reminding the world of our determination to get our house in order, and our understanding that the Reagan/Bush era’s dependence on debt will end. Given the short term explosion in the Federal deficit this is doubly true.

But he also needs to communicate that we will not be shifting to a more conservative, and therefore anti-Reagan/Bush, fiscal policy too soon: we need to get past the crisis first.

Which explains the fact he keeps on turning up saying the same thing and then ignoring his own advice when he gets back to his desk.

This is all about positioning and preparation. So that map he keeps showing us is one for the future – let’s say 2011 and 2012 – rather than right now.

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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.

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Retail Sales

We don’t need to dwell too much on today’sretail sales report: they jumped 2.7% in August. Yes, they are still 5.7% below where they were a year ago, but the growth is both solid and good to see.

Or is it?

Well … over half the growth came from auto sales where the ‘cash for clunkers program’ drove a healthy 10.6% increase. This program is now defunct and already there are reports of sharp declines in sales subsequently. Plus the end of summer driving and price increases pushed gasoline sales up: they account for another part of the overall increase, and they too are likely to fade as we move into fall.

With those negative comments out of the way, the rest of the report suggests that there is some life stirring in sales. Hopefully this will translate into a steady rise in consumption and thence into an increase in employment. Sales excluding cars rose 1.1% with the gain being fairly widespread across a variety of categories: clothing, books, electronics, and food all started to show signs of life. These are the basic categories of consumption that we need to have recover if we have any chance of sustaining what now appears to be a very slight expansion.

Ironically this spurt in sales has had a negative effect on our trade balance: imports jumped up in July, the latest month for which we have data. The trade gap widened by 16.3% to $32 billion, which is the sharpest monthly increase for ten years. A good percentage of this jump came from auto imports which reflects both the ‘cash for clunkers’ program and the fact that American auto makers have lost significant market share. Since a trade deficit acts to reduce GDP – exports add to it, imports deduct from it – this sudden spike in the trade gap could endanger the recovery. Or at least it will make it slower.

One last piece of news: business inventories continue to shrink. This is generally a good sign for growth because it implies that producers will be forced to increase production in order to re-stock. This is the phenomenon we have been talking about for a while now and is the reason that we hear people like Bernanke and Obama call the recession ended.

Unfortunately an inventory re-stocking provides only a one time kick to growth: it normally gives enough of a jolt that the employers re-hire and consequently consumption grows. Given the massive overhang of unemployment and the cost consciousness of business, the odds of this ‘knock-on’ effect being very strong are low. It will be there, but it could be insufficient to offset the ebbing of the stimulus effect next year.

So today’s insight into retail sales was a welcome sign that we may still be able to keep growth going in 2010. The risk of a double dip still is out there, but after today’s report we can downgrade its odds of occurring.

Good news at last.

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