Still too much wishful thinking on banks

Thinking on banks is still severely inconsistent in the public domain. Consider those three demands:

1.Continue lending at low rates in order to keep the economy going.

2.Increase the asset quality on the balance sheet.

3.Improve the risk absorbing equity.

Actually, at best only the last two of those three demands are not mutually exclusive. Lending less at higher rates would mean that both an improvement in net interest income and also – over time – an improved risk quality of borrowers. Continuing to lend at low rates to bad borrowers, in contrast, flies in the face of both improved asset quality and increased bank equity.

The sad truth is that after severe banking sector problems coupled with a downturn in asset prices, and especially housing, growth in bank lending to the private sector is flat to negative for an extended period of time.

Examples for this are: 1991 to 1993 in the UK, 1993 to 2003 in Japan, or 2001 to 2005 in Germany.

Quite naturally, in a stock-flow consistent world there has to be a macroeconomic counterpart to this. Which is simply a reduced financing gap/higher financing surplus of the non-financial private sector.

Before this comes down as being far too pessimistic. There is good and bad news in this. The bad is certainly that, given what John Maynard Keynes labeled the “paradox of thrift”, economic growth is significantly impeded for as long as the move towards a stronger surplus position of the nonfinancial private continues. The good news is: Even without an increase in outstanding loans, growth reverts back to the underlying “potential” (i.e. total factor productivity plus population growth) once the rise in the financial position comes to an end, i.e. the financing surplus is being kept at a certain level.

With regard to the latter, it is welcome news that by Q4 2008 the US nonfinancial private sector should be in a slight financial surplus position (we will know that for sure by end-March 2009). That’s up from a deficit to the tune of -4.7% of GDP in Q4 2006. So we might already be in a position where banking actually gets really boring in the sense that it becomes good old-fashioned fund intermediation between surplus and deficit sectors without any lengthening of bank balance sheets.

In order to have overall credit growth falling to zero or slightly negative, i.e. the thing that usually happens in the aftermath of banking sector problems, something in the order of a surplus in the nonfinancial private sector to the tune of 2% of GDP is required. So the recessionary forces are still prevailing for the time being before things might turn more normal in terms of economic growth.

That is where fiscal policy has its role to play: Even the most badly designed stimulus package in terms of direct impact on GDP is a transfer of funds from the public to the private sector and helps to achieve the needed adjustment in the financing position faster than would otherwise be the case.

And, in order to come full circle to the original question on banks: As long as we regard public debt as higher quality relative to private one, changing from the latter to the former in terms of composition on balance sheets can be considered an improvement of asset quality and thus meet one of the demands posed on banks.

On both counts of nonfinancial private sector adjustment and better asset quality on banks’ balance sheets fiscal expansion coupled with a commitment to keep it in place for a prolonged period of time is the right way to go.