I frequently get emails suggesting that governments should force banks to lend and that would solve the recession. I tend to agree but it would be difficult – and the government actions to date have exacerbated the lack of lending.
As it is, there is little to no balance sheet growth at any major bank in America and aggregate bank lending is falling. Excess cash at the Federal Reserve is building up fast. The economy is still sour (and getting more so) and bank credit losses are continuing to rise.
Meanwhile banks sit on cash.
Bank of America (for recent and topical example) is carrying $173 billion in cash and cash equivalents – a number which immunises them against many but not all ills and is about $140 billion higher than normal.
This excess cash inhibits BofA profitability by maybe 5-7 billion per annum (pre-tax). They don’t really want that profit drain – but – in a telling comment – they thought it was worth it to have that negative carry because the cost to running short of liquidity was too high.
The excess cash across the entire banking system probably exceeds a trillion dollars. If only it could be spent – then we would have the stimulus we need.
Alas – that is what is meant by being at the zero constraint of monetary policy. We have banks with a seemingly endless liquidity preference. It is not that there is no demand for loans (though demand is much ameliorated). Banks are rapidly tightening lending criteria too and indeed some banks are just not lending to new customers.
Now lending standards needed to tighten. 2006 was insane. But early 2009 is also insane– and if it were a perfect world lending would have moderated much slower so as to displace maybe 200 thousand workers per month. (The economy can usually generate new jobs that fast.) Indeed the whole idea of stimulus is to slow the rate of job loss in the economy down to a level where normal functioning of the labour market can deal with it.
That is not where we are. We have an extraordinarily rapid change in liquidity preference for banks, an extraordinary tightening of standards and an extraordinary recession.
Now some people are into forcing the banks to lend. Willem Buiter (who is often clever and sometimes wrong) suggests confiscating banks that will not lend. Useless as tits on a bull he says.
That would be fine if he did not want to confiscate marginally insolvent banks too. A bank that is stretched for capital or liquidity would usually preserve both by restricting lending. You restrict lending so as not to be confiscated – except in Willem Buiter’s world where you lend to avoid being confiscated.
Now I thought that the confiscation of Washington Mutual was perhaps the single most destructive government action of this cycle. That was a minority view – and remains one. Felix Salmon thinks I am alone – but a paper from the New York Fed makes it clear that the confiscation of WaMu very rapidly increased the liquidity preference of mainstream banks and hence spread the crisis from the Wall Street Banks to Main Street.
The lesson of Washington Mutual – learned hard – was that you could have adequate capital but a minor run and be confiscated. The only way to cope was to have massive excess liquidity.
And so we are in an unusual liquidity trap. In the Japanese liquidity trap the general populace had massive excess cash savings. The liquidity preference was the preference of the legendary Mrs Watanabe who liked sitting – in cash – on three years of Mr Watanabe’s salary.
In America the liquidity preference belongs to banks. Mr and Mrs Middle America are not swimming in cash. Indeed all the evidence suggests that they are over-indebted. It’s the banks that are swimming in cash. And it is the bank’s excess demand for liquidity that makes monetary policy ineffective.
Now Paul Krugman has argued that it doesn’t really matter why we are at the zero bound in monetary policy – but I think it does. If we are at the zero bound because Mrs Watanabe wants to save to excess then we should target Mrs Watanabe. If we are at the zero bound because Bank of America is scared of arbitrary government action (as evidenced in the confiscation of WaMu) then we should address Bank of America’s concern.
The first way to address Bank of America’s concern is for Sheila Bair to fall on her sword. She should resign because – through confiscating Washington Mutual – she spread the crisis to Main Street. But regular readers should know I have a very low opinion of her and will not be surprised by that comment.
But I have a second proposal. It is floated for discussion only as it is obviously risky. The idea is that the bank capital adequacy requirements be dropped a couple of percentage points – but only if their genuine third party loans fully owned on the balance sheet are growing by more than say five percent per annum.