« Goldman's Winning Streak | Main | Congress and the Fed: Why the Bark is Worse Than the Bite »

Tuesday, May 11, 2010

"Banks Failing to Lend is Not the Problem"

Dean Baker takes on the "banks not lending" explanation for the persistence of the downturn and sluggish movement toward recovery:

Banks failing to lend is not the problem, by Dean Baker: One of the big myths of the current downturn is that the reason the slump persists is that banks are refusing to lend. The story goes that because the banks have taken such big hits to their capital as a result of the collapse of the housing bubble and record default rates, they no longer have the money to lend to small- and mid-sized businesses.
We then get the story about how small businesses are the engine of job creation, responsible for most new jobs. Therefore, if they can't get capital, we can't expect to see robust job growth.
This story of banks not lending is used to justify all sorts of special policies to help out small businesses and banks. In fact, the Obama administration has plans to make a special $30bn slush fund available to banks if they promise to lend it out to small businesses.
In reality, every part of this argument is completely wrong. First, small businesses are not special engines of job growth. Small businesses do create most new jobs, but they also lose most new jobs. Half of new businesses go under within four years after being started. Jobs do get created when the businesses start, but jobs are lost when the businesses fail.
The reality is that businesses of all sizes create jobs. There is no special reason to favor small businesses in promoting job creation. We should favor businesses that create good paying jobs with good benefits and conditions, regardless of their size.
The other parts of this story make even less sense. Let's hypothesize that many banks are crippled in their ability to lend because of the large hits to their balance sheets from bad mortgage debt. Well, not all banks got themselves over their heads with bad mortgages. There are banks with relatively clean balance sheets.
If it were the case that a substantial portion of banks are now unable to issue many new loans because of their inadequate capital, we would expect to see the healthy banks rushing in to fill the lending gap. There should be accounts of dynamic banks that are taking advantage of this once-in-a-lifetime opportunity and rapidly gaining market share.
While this may be happening, there certainly have not been many accounts in the media of banks that fit this description. In other words, it does not appear to be the view among banks, including those with plenty of capital, that there are many good potential customers who are unable to borrow money.
The other missing part of the story has to do with the nature of competition between small firms and their larger competitors. We know that large firms have no difficulty attracting capital at present. They can issue bonds at near record-low interest rates. They can also borrow short-term money at extraordinarily low interest rates in the commercial paper market.
If small and mid-sized companies were being prevented from expanding due to their inability to raise capital then we should be seeing larger companies rushing in to take market share. Retail stores should be opening up new outlets everywhere. Factories should be rapidly increasing output and transportation companies should be rushing into new markets.
Of course, we don't see any of this happening. If anything, most large businesses are expanding at a slower rate than they did before the crisis. If their competitors have been hamstrung due to a lack of credit, no one seems to have told Wal-Mart, Starbucks and the rest. They have both slowed the rate at which they are adding new stores, not sped it up as the credit-shortage story would imply.
There is truth to the credit-squeeze story, but it goes in the other direction. Stores that have seen their business plummet as a result of the downturn are, in fact, worse credit risks from the standpoint of banks. Many businesses that were profitable in 2006 and 2007 are now highly unprofitable and may not be able to stay in business. As a result, the banks that were happy to lend money just a few years ago are no longer willing to lend money to the same business. This drying up of credit happens in every downturn. It is just more serious this time because of the severity of the downturn.
The moral of this story is that we should not think that "fixing" the banks will get us out of the downturn. The problem is that we have to generate demand, which means having the government spend more money to stimulate the economy. Unfortunately, the politicians in Washington are scared to talk about larger deficits, so more spending seems off the table at the moment – therefore we get this nonsense about insufficient bank lending.
But hey, at the rate we created jobs in April, we should be back at full employment in seven years anyhow. Who could ask for anything more?

This is not a supply problem, banks are sitting on mountains of excess reserves (some of which are serving as insurance against unexpected contingencies, but even so the excess reserves in the system are voluminous). But the ample supply of loans available to be loaned out at the right terms does not automatically create a demand for them.

I think the problem is on both sides. Supply has tightened up due to poor economic conditions -- as noted above banks are unwilling to loan to firms who look shaky during the downturn, firms that might have looked very solid and worthy not all that long ago. But the demand for loans has fallen as well since firms have little reason to invest in such bad economic conditions. So if the goal is to generate more investment, the solution is twofold. First, the demand for loans must be present. Additional government spending as called for above can help, but so can measures such as an investment tax credit or other financial incentives for firms that undertake to new investment. Second, banks must have the money to lend and be willing to do so at reasonable terms. Available reserves are not the problem, it's the fear of losses due to poor economic conditions that is making banks hesitate. One way over this hurdle is for the government to share in losses that banks realize on these loans. With lower expected losses through the loss sharing arrangement, the banks would be more willing to part with funds.

But the big question for me is the desirability of promoting investments that the private sector does not think are a good idea. If the result of this intervention is a bunch of failed investments and wasted resources, then this is not the best way to stimulate the economy. If there's some sort of market failure that is preventing firms and banks from entering into productive deals, then there is clearly a role for government to step in and fix the problem. One could make an argument that, say, risk is artificially elevated (disconnected from its "fundamental" value) and hence some sort of intervention is needed to restore the market, and I think there's some merit to the market failure arguments. Still, rather than helping firms in this way, I'd prefer to have more help for those households suffering the most from the downturn, i.e. additional government spending, transfers, and job creation -- that means a far bigger stimulus program than we got -- and then let firms respond to the additional demand as they see fit.

Finally, this is a bit different -- it involves investment in basic research rather than investment by firms -- but some types of government intervention appear to be productive:

Federal investment in basic research yields outsized dividends -- innovation, companies, jobs, EurekAlert: How can the United States foster long-term economic growth? A new report suggests that one of the best ways is through investment in the basic research that leads to innovation and job creation. ...
"There is no question that the public benefit gained from funding basic research is exponentially greater than the initial investment," said Susan Desmond-Hellmann, Chancellor of University of California San Francisco. "The success stories highlighted in this report demonstrate that fact and are a reminder that the continued scientific and technological leadership of the United States – and our economic well-being – depends on consistent, strong funding for research." ...
These success stories include global industry leaders like Google, Genentech, Cisco Systems, SAS and iRobot, as well as relative newcomers such as advanced battery manufacturer A123 Systems; network security company Arbor Networks; AIDS vaccine developer GeoVax Labs; and Sharklet Technologies, which has developed a novel surface technology based on the qualities of shark skin to combat hospital-acquired infections.
The report illustrates the substantial economic benefits the U.S. reaps when companies are created as a result of discoveries in federally funded university laboratories. One example of this return on investment is TomoTherapy Incorporated, based in Madison, Wisconsin. A $250,000 grant from the National Institutes of Health's National Cancer Institute to two researchers at the University of Wisconsin-Madison enabled the development of ... a highly advanced radiation therapy system that targets cancerous tumors while minimizing exposure and damage to surrounding tissue. Each year the technology is used to help improve the outcomes of tens of thousands of difficult to treat cancer patients around the world.
"That original investment generates many times its value in salaries and taxes returned to both the U.S. and Wisconsin governments," says University of Wisconsin-Madison professor and TomoTherapy Co-founder and Chairman Rock Mackie. TomoTherapy employs 600 people. ...
"University-launched startups can be powerhouses for value creation, becoming public companies at a far greater rate than the average for new businesses," according to Krisztina "Z" Holly, vice provost for innovation at the University of Southern California (USC). "Higher education can play a crucial role not just in spurring pioneering ideas, but in creating entrepreneurs who turn breakthroughs into innovations." The results benefit everyone, she says. Holly points to 24 USC startup companies that currently employ 500 full-time workers, more than half of whom are in Los Angeles. Sixteen of these companies have raised at least $148 million in financing over the past two years, during the height of the recession. ...

    Posted by on Tuesday, May 11, 2010 at 10:08 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  Comments (57)


    Feed You can follow this conversation by subscribing to the comment feed for this post.