Falling Credit: Unless Lending Can Increase, Crisis Will Continue

The crisis of 2008 was marked by low access to credit for companies and individuals. The reduction in credit was led by losses on the real estate loans made by banks, which closed their doors on the best of businesses and individuals. Credit/loans are the lifeblood of the economy and facilitate commerce by letting businesses take out loans for the production of goods and services. A reduction in credit disrupts the continuum needed to preserve the flow of economic activity. As a result, businesses reduced production and laid off millions of employees. The stock market fell from September 2007 until March 2009. Since March, the market has risen more than 50% and still rising. However, the increase in stock prices has not reflected upon an increase in credit. The total credit in the country continues to fall, and until the trend reverses, the economy will continue to recede.

The graph below depicts an important indicator of economic activity, the total bank credit issued by all commercial banks in the country. As the graph shows, credit had never fallen so precipitously in the last 40 years of account keeping. Even in the severe recessions of 1981-82 and 2001-02, both marked by grey lines, the credit grew, although at a slower pace. A reduction in credit is the most important indicator of how the economy would perform in the medium term.

The decrease in credit has been caused by a reduction in both supply and demand. The demand has fallen from both the companies and the individuals, as the two begin to hoard money in view of the excessive leverage they already hold. As a result, the savings rate, which states the amount of money not spent by the consumers, has risen from a low of 1% in 2008 to a multi year high of 5% in the 2^nd quarter of 2009.

A further increase in the savings rate would cause the hoarding of money to have serious consequences upon the price levels in the country. As spending falls, the businesses will recover less than the cost of production and hence default on their loans to the banks. The prices will fall to reflect the wastage in the system caused by a decline in spending.

Also, the banks have reduced credit, as is shown in the graph below. The credit is currently waning at an annual rate of 7%.

According to a survey conducted by the Federal Reserve, 15% of the commercial banks restricted credit in the three months up to October, while 16% of the banks lowered credit availability to the smaller companies. In addition, more than a quarter of the total banks reduced residential real estate loans during the same period.

The commercial banks, despite their ubiquitous nature only extend about a third of the total credit available in the economy. The other major lenders are private financial companies, credit unions, savings institutions, and securitized assets. Each of the above has lowered credit in the last 2 years by 5-10%. Below are graphs that depict the total decrease in consumer credit as well as the decline in that held by private financial companies.

Conclusion

Even though credit is not a leading indicator of the future economic prospects, it provides a clear view of the near term opportunities for growth. Many economic watchers mistakenly attribute importance to the total money supply, as a forerunner of consumption and prices. However, most consumption is a function of the total income generated or consumer credit issued. The only way to offset the decline in consumption is through massive deficit spending. A massive deficit of $1.4 trillion has somewhat been able to prevent falling prices, but has been unable to motivate the lenders to increase lending. Unless the lending can increase in the economy, the production and employment will continue to fall, thus lengthening the crisis.

Comments

[Michael Clark:]

Lending really can't increase because banks need even more money to try to cover loan losses they are hiding on their books. Now comes commercial real estate, adding more red ink to the banks. The banks are insolvent. Even all the trading profits they are bringing in are not making them solvent. Only the mark-to-fantasy rule is keeping them above water....hiding losses is the ONLY course possible for the banks. We had and have another course, however. We can let the banks fail, use bailout money to protect depositors in solvent banks (new banks if we have to create new banks).

Nov 13 03:11 AM

[chris coonan:]

It is a devastating situation for Architects and Developers in the US. Lack of funding for new projects is severly affecting employment at these firms, in some cases major firms have imploded (500 people to 100 people). If the situation doesn't change in 2010, there will be a major exodus of talent from the industry.

Nov 13 03:35 AM

[TotallyScrewed:]

Rome [America] is burning [deflating] and Nero [the Fed] is fiddling away merrily....

Welcome to the Restaurant at the End of the Universe.

Nov 13 09:58 AM

[ryanclarke:]

I'm 100% in agreement with you, sir. But Pelosi would have to give up her vineyard in Caliland if the banks decide to fold. I've heard it said that "puttin' on the fur coat is a lot easier than takin' it off." In the current situation, pulling the "money plug" from those currently on top of the pile in the U.S. .... is going to be like pulling teeth from an old man with artificial titanium implants ... the banks will continue to threaten societal catastrophe until the powers outside of the U.S. feel confident they have the ability to produce the societal catastrophe the banks are predicting.


On Nov 13 03:11 AM Michael Clark wrote:

> Lending really can't increase because banks need even more money
> to try to cover loan losses they are hiding on their books. Now comes
> commercial real estate, adding more red ink to the banks. The banks
> are insolvent. Even all the trading profits they are bringing in
> are not making them solvent. Only the mark-to-fantasy rule is keeping
> them above water....hiding losses is the ONLY course possible for
> the banks. We had and have another course, however. We can let the
> banks fail, use bailout money to protect depositors in solvent banks
> (new banks if we have to create new banks).

Nov 13 03:21 PM

[flow5:]

Very relevant. Every time a member CB makes a loan to, or buys securities from, the non-bank public, they create new money & credit (your 1/3 of the credit market).

However (in the rates-of-change), of the FLOW-OF-FUNDS, the hardest hit sectors are the financial intermediaries (non-banks). Why? Because an increase in intermediary lending activates existing money (increases the transactions velocity of money), by matching savings with investment. I.e., Average Prices*Transactions (or nominal-gdp)=M*V (aggregate-demand). I.e., money has no significant impact on prices unless it is actually being exchanged.

The volume of savings is only a leakage ("wastage" as you say), when savings are held within the member banking system, or hidden under mattresses (because it is impossible from the standpoint of the monetary system, for the member banks to loan out savings).

The rate-of-change in the flow-of-funds to the credit markets can be increased in two ways. Lower the FOMC's remuneration rate on excess reserves at the CBs so the bankers would have to search for competing instruments and yields. And if you follow that logic further you will see that the proper public policy with regard to our money creating depository institutions is to get them completely out of the savings business. Why? because the banks would be more much more profitable and the economy would vastly expand without needlessly increasing prices.

Nov 14 02:34 PM

[flow5:]

I.e., it is undisputed that the bankers "compete", to pay for what they already own. The source of all time/savings deposits within the commercial banking system, are demand/transaction deposits -directly or indirectly through currency, or the member bank’s undivided profits accounts.

Money flowing "to" these intermediaries (non-banks) actually never leaves the commercial banking system, as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of these intermediaries/non-banks, cannot be at the expense of the member banks. And why should the commercial banks pay for something they already have? I.e., interest on time deposits.

Savings impounded within the commercial banking system are lost to investment, indeed to any type of expenditure (i.e., both consumption & investment has a velocity of zero). If monetary savings are not invested, then prices, production, employment, & incomes will contract (along with the production of goods & services).

This is the depressing effect perpetrated by pseudo-economists (the Keynesian macro-economic persuasion that maintains commercial banks are financial intermediaries).

Nov 14 06:12 PM