Banks Failing to Lend is Not the Problem
It's a myth that the slump persists due to the banks' squeeze on credit, so 'fixing' them will not mean escaping the downturn
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 favour small businesses in promoting job creation. We should favour 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 hypothesise 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?
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