Lend, Lend, Bubble, Burst, Bailout, Lend, Lend

Banks should never be pressured to lend. Their first
obligation should be to protect their depositors’ money.

For several years in Iraq I worked with the central bank of
Iraq to fight off pressure from the government of Iraq (and some loose canon’s
in the U.S. Government) to force banks to lend more. Their lending record was
indeed pathetic. From the beginning of 2005 through the end of 2008 bank
lending as a share of total bank assets rose from a pitiful 5% to a mere 8%. For
comparison, U.S. banks’ lending was about 60% of their total assets at the end
of 2008.

Iraq desperately needed (and still needs) to create jobs and
to many it looked like the banks were failing to do their part to help finance
the enterprises that are the basis of real jobs. There was also a dispute over
whether the Central Bank of Iraq was keeping interest rates too high when
setting the rates it paid banks to deposit funds with the Central Bank (they
were actually lower than the inflation rate, i.e., negative in real terms). I
mention all this because it sounds to me like the same loose canons are still
roaming the halls of the U.S. Treasury. In a note to the U.S. Treasury at the
time, I noted that we should be thankful that the banks were not making loans
they did not consider safe. The “security situation” in Iraq was by no means
the only risk of lending. Contract enforcement was highly uncertain. Many of
the laws on which lending is based and secured did not exist or were seriously
deficient. Reliability of court enforcement of existing laws was far from
established. Policy, I argued, should focus on making it safe to lend rather
than forcing banks to lend.

Fast forward to Monday’s meeting between President Obama and
the big bankers. The Washington Post’s front page article proclaimed: “Obama
calls on banks to ramp up lending.” Sam Stein in the December 13 Huffington
Post headlined his column: “[Larry] Summers: Obama will Persuade Bankers
Because ‘We Were There From Them.’” But “Bank executives say they itch to make
profitable loans, as many as possible, but are struggling to find qualified
borrowers. They also say that the administration is asking for increased
lending even as it pursues financial reforms that will limit the ability of
banks to make loans.”[1] The Post’s
editorial Monday it stated that; “in a recent survey by the
National Federation of Independent Business, tight credit ranked well down the
list of small firms’ concerns, after poor sales, taxes and regulation.”

This is all pretty depressing stuff. The economic and
financial crisis of the last two years started with a housing price bubble
fanned by the federal government pressuring banks to lend more to marginally
qualified homebuyers. So, assuming the government would stand behind the risks
it was asking banks to take, subprime loans exploded (especially when the
Government Sponsored Enterprises, Fannie Mae and Freddie Mac started buying a
lot of them). When the housing price bubble burst, banks and other investors in
Mortgage Backed Securities suffered much larger losses than they had bargained
for. Covering these losses absorbed funds banks might otherwise lend and
reduced their capital. Everyone woke up to the fact that many were over their
heads in debt. Their attempts to reduce it (deleverage) made normally liquid
financial assets hard to trade. Even after the Federal Reserve relieved this
liquidity squeeze, some banks no longer had sufficient capital to continue
lending given the prudential capital adequacy requirements of the regulators
(and good sense).

Some banks avoided these toxic assets and managed the risks
they took prudently; some did not. The market is supposed to reward the
virtuous and punished the profligate, and thus keep the system healthy. Banks
needing more capital to continue lending can almost always find it in the
market at a price that reflects the market’s assessment of their fundamental
soundness. However, the government stepped in and bailed them all out (if they
were big enough), thus proving the high risk takers right. Ops, then there was Lehman
Brothers, which was allowed to fail, catching the market off guard.

So the government has been rewarding bad behavior (excessive
risk taking) in the market some of the time, but not all of the time. It is
thus encouraging more bad behavior while keeping the market guessing about what
it will or will not do. Do we really want to start this cycle over again?

The economy cannot recover in a sustainable way until
households reduce their excessive indebtedness (which must be done over time)
and their lower rates of consumption are replaced by increased exports and
domestic investment. The so-called “weaker dollar” (a depreciated exchange
rate) is helping to increase exports, as is the gradual recovery of demand from
the rest of the world. An increase in investment will come (financed by the
increased savings from households) when entrepreneurs have sufficient
confidence that they can make money in the future from doing so. The government
seems to be doing every thing under the sun to keep them guessing. How much
will they be taxed? What risks will be underwritten by government bailouts? The
incentives the government has created are seriously distorting economic
decisions in the market and promoting a return to excessive risk taking. We
urgently need certainty from the government about the rules of the game and if
those rules don’t provide incentives for proper behavior our recovery will lay
a weak foundation for the future.