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business newsWhy Small Banks Are the Key to Recovery, Part 1
Banks need to start lending, but the process by which they do this -- and create real, organic economic growth -- requires two things to happen.
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The critical factor in our economy right now is a declining money supply which has been the result of the "credit crunch" or what Keynesians call a "liquidity trap." I believe deleveraging is the key to an economic recovery and measures of business. The result of deleveraging is deflation, but instead of seeing deflation as a negative, it's a necessary step for growth.
I look at these issues quite differently from Keynesian and Neo-classical economists. As we've seen the Fed has been unable to stimulate money growth through zero interest rate policy (ZIRP) or through quantitative easing (QE). This is something that their theories haven't been able to adequately explain, and the outcomes of their policies have led to continued high unemployment, declining growth, declining money supply, and deflation. The policy makers at the Fed and Treasury have run into the same problems that mired Japan's economy for almost 20 years: sluggish growth amidst deflation.
The reason we're seeing money supply decline is twofold. Banks have (1) tightened lending standards which makes credit less easy to obtain, and (2) banks are finding it difficult to find credit-worthy borrowers. While the money base has increased dramatically, these funds sit in the Fed as "excess reserves" where banks earn interest on it from the Fed. I will explore this issue in a moment.
But first ...
There are two sides to this credit issue: consumers and businesses. Consumers are cutting back spending, paying down debt, increasing savings, and are cutting back borrowing (even if they could get a loan).
Here is the story of consumer credit:
While the consumer is important to the economy, it's not the consumer that I wish to focus on in this article. Consumers are doing all the right things now to help the economy recover. Their deleveraging and savings will help fuel new growth.
What's more important at this stage of our economy's lack of recovery are business loans. In this article I wish to specifically focus on smaller businesses, which comprise one-half of the economy and one-half of the jobs in America, and their banks.
There are two banking systems in the US now: a few very large money-center banks that have recovered or are more or less on their way to recovery thanks to TARP, and all the other banks. Many of the regional and local banks are still suffering, mainly as a result of commercial real estate (CRE) loans they made during the boom. As you recall, they sold off their residential loans, but kept the CRE loans.
The Fed would like all banks to start lending. Increased lending activity would indicate a growing economy. Through the fractional reserve banking system, banks can lend about 10:1 which multiplies the effect of the Fed's money policy. You can see this effect in the M1 Multiplier charts. This is the Fed's main inflation generator. If banks aren't making loans and are holding all the cash that the Fed has tried to pump into the economy as reserves, then not only does the money supply not grow, it can shrink, which is what's happening now. This is deflation.
The process by which banks would start lending and create real, organic economic growth requires two things to happen:
1. Banks need to get rid of bad debt on their books, which is mainly CRE debt, and raise capital and return to sound banking practices.
2. Businesses need to see "regime certainty" and steady economic recovery before they borrow and expand their businesses.
As to No. 1, the government has been doing everything it can to prevent banks from liquidating bad investments. And as to No.2, the government's barrage of new legislation is creating uncertainty for businesses ("regime uncertainty"). That, plus the stimulus seesaw and new banking policies (No. 1) are inhibiting economic growth which makes businesses reluctant to borrow. It's obviously much more complex than this, but these are the bright-line issues.
There are several things to watch in trying to assess whether or not banks are lending. The first is business loans:
As we can see, the level of business loan activity seems to be picking up, but it's still very depressed. Most lending is coming from the big banks and they're lending mostly to medium- and large-sized firms. A new Fed survey reported that seven out of 57 banks surveyed reported easing credit for these companies. This is the second quarter of easing credit conditions. But six of 28 big banks (14.5%) said they had eased credit standards for small companies; this is the first such easing since 2006.
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