The Credit Crunch Continues

The credit crunch continues, with businesses large and small finding that their bankers remain exceedingly stingy in the wake of the 2008 financial debacle.

“We need to see banks making more loans to their business customers,” Federal Deposit Insurance Corporation (FDIC) Chairwoman, Sheila Bair, told reporters recently after the FDIC released figures showing that the amount of loans outstanding in the nation’s banks fell $210.4 billion in the third quarter of 2009. That is the largest quarterly decline since the FDIC began tracking loans in 1984.

If we dig inside these data, we see that business lending has contracted at a much faster pace than consumer lending. This trend is not merely a function of contracting economic activity, it is also a function of the fact that banks have been deemphasizing business lending for many, many years.

Numbers from the FDIC reflect this shift over the past decade. At the end of the third quarter of 1999, the assets of the nation’s banks totaled $5.5 trillion. As of September 30 of this year, bank assets had grown to $13.2 trillion. But commercial and industrial loans outstanding barely budged, only growing from $947 billion a decade ago to $1.27 trillion by September 30 this year. Meanwhile, loans secured by real estate increased from $1.43 trillion in the fall of 1999 to $4.5 trillion this fall. And investment in securities doubled, rising from $1.03 trillion to $2.4 trillion.

This secular shift away from “productive” lending to businesses toward “nonproductive” lending to consumers creates a new kind of structural weakness for the American economy.

Robert Prechter makes the point in the November edition of the Elliott Wave Theorist that banks have lent sparingly to businesses for the past 35 years. Businesses report that since 1974, ease of borrowing was either worse or the same as it was the prior quarter, meaning that – at least according to business owners – loans have been increasingly hard to get the entire time.

Unfortunately, from a macroeconomic perspective, lending to consumers rather businesses is a suboptimal emphasis/counterproductive exercise.

Prechter writes in his book Conquer the Crash that the lending process for businesses “adds value to the economy,” while consumer loans are counterproductive, adding costs but no value. The consumer may call his borrowing “productive,” but it surely does not create capital, i.e., build shops or factories or manufacture tools and dies that enhance the productivity of human labor. The banking system, with its focus on consumer loans, has shifted capital from the productive part of the economy, people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).

Total household debt peaked in 2008 at $13.8 trillion, with $10.5 trillion of that being mortgage debt. And as Sean Corrigan explained, “Houses are nonproductive assets, financed with a great deal of leverage.” And while homeowners reap the services provided by homes slowly over time, houses “deliver a large dollop of uncompensated purchasing power up front to their builders or to those cashing out of the market,” making housing “the ultimate engines of created credit on the upswing, and…among the more dangerous deflators on the way down.”

In the last decade, the US system of fractional-reserve banking has created what Frank Shostak calls “empty money,” which masquerades as genuine money when in fact “nothing has been saved.” This explosion of money was created through the banking system, as consumers gorged themselves on nonproductive assets like houses, autos, and big-screen TVs. These purchases gave the illusion of economic growth and good times, but in reality weakened the process of wealth formation; instead of building capital, this system wasted it.

Meanwhile, businesses that create wealth-producing jobs have stagnated. The workforce was induced into working for enterprises that represent malinvestment: home and commercial construction, as well as other real-estate-related jobs, and businesses dependent on consumer consumption.

Unfortunately, the federal and state governments constantly enact legislation that makes the employment of workers more costly and in turn makes business expansion riskier. So wealth-producing businesses, like metal fabrication and the like, have every incentive not to borrow money from a bank to expand their operations and not to wander into a wider thicket of onerous employment rules by hiring more workers. Instead, the entrepreneur puts energy into obtaining a low-interest mortgage and buying a big house, or dabbling in real-estate development and speculation. Besides, up until this current meltdown the entrepreneur could obtain a real-estate loan much more easily than a business loan.

Those in Washington are doing all they can to promote the continued destruction of capital and wealth. Policies like “cash for clunkers”; tax credits for home buyers; the bailing out of the big banks, Fannie, Freddie, and the auto companies; and keeping interest rates near zero only serve to promote speculation and consumer consumption. Instead, Washington should be lowering taxes and the costs of hiring employees, especially in industries that produce capital and wealth.


Douglas French,
for The Daily Reckoning