How the Deficit is Blocking Lending to Consumers and Businesses

HOW THE DEFICIT IS BLOCKING LENDING TO CONSUMERS AND BUSINESSES

Over the past few months, an increasing number of commentators have been mentioning that our banks, while more financially sound, are still not lending at a healthy volume. Articles have been written, opining made on television, and even the Obama administration has called the nation’s top bankers to DC to try and ‘persuade’ them to lend more. Well, if you can bear a moment of ‘econo-speak,’ the reason that the banks aren’t lending is mainly thanks to the government's fiscal actions.

Deficits restrict lending? Yes, and there is an economic theory (might be a law) called the ‘crowding out’ which can explain the current lending environment.

YouTube video that explains crowding out:http://www.youtube.com/watch?v=zeNU5ohAvFQ

Crowding out occurs when the government runs high deficits, or borrows more money than what is considered typical. Banks, which finance about 50% of the government debt and a majority of the consumer/business debt, switch over to lending more to the government. This is because government treasuries are AAA rated with a 'guarenteed' return and are about as sure of an investment as cash. However, by lending more to the government (up to $1.5 trillion more per year), the banks are leaving less credit available for consumers and businesses which strains their investment/contribution to the economy. In the long-run, it can make an economy more dependent on a large government presence, and cause noticeable declines in consumer and business spending.

Our deficit went from $300 billion before the financial fallout in 2008, to now at $1.8 trillion per year. Before the fallout, banks financed about $100-$150 Billion per year of the deficit. Now, the banks will be required to finance at least $900 Billion or more per year if foreign investment doesn’t pick up the slack. This article shows that China (our largest foreign lender) is actually buying fewer treasuries than before.

It gets even better.

Part of this massive deficit is $700 billion plus in TARP money. Believe it or not, the government issued that debt, gave it to the banks, and then the banks used those funds to buy the very treasury debt that the government just issued (see this article)! CSC believes that TARP to the banks could be the single greatest fraud ever perpetrated against the American taxpayer since Social Security. If the government actually ends up making money on the deal (which is possible considering the 11% interest rate), then the banks are the victiims of fraud (considering many of them were forced to borrow it), which still comes back to the consumer, because we will end up paying whatever penalties the banks pay (in the form of consumer fees).

Now, some economists have suggested my theory is absurd because banks would be taking TARP funds at 10 to 11% and then lending to the government at 3 or 4%, thus losing money. My response is that the banks are using the same logic to make this investment as they are when they bought treasuries at negative yields. They need to invest the money somewhere, so why not put where they are at least going to get a return without taking the risks. The alternative is to lend it out in mortgages (which at the time nobody was buying a house), business loans (which at the time, businesses were shedding jobs and cutting back), or high risk loans (which is what got us into this mess).

What would you have done with the TARP money?

Ultimately, a crowding out situation can lead to higher interest rates in the consumer markets (because less credit is available for what is being demanded) and thus hurt an economic recovery.

If the government wants the banks to start lending, it needs to cut the deficit quickly. By cutting the deficit, the banks will have fewer government bonds to buy, thus they will have no choice but to lend to the private market. This would restore credit flow to our economy and bring interest rates to a market parity (which are currently being government controlled).

The White House says it’s aware that the deficit cannot remain at these levels, but instead of providing a plan for how we are going to handle higher rates while deleveraging bailout deficits, they provide finger pointing. How many times have we heard President Obama state “we inherited a trillion dollar deficit.” Sorry Mr. President, but that excuse is only going to get you so far. A coach of a NFL team complaining about inheriting a 1-15 roster three years later still gets fired if there is no improvement. Let’s hope the American people are just as fair in grading the President’s performance.

The Bottom Line:

1) Deficits create more strain on banks to lend.

2) More deficits mean more bank funds go to government financing than consumer/business financing.

3) Less consumer and business financing hurts consumer spending and business investment.

4) If the White House wants banks to lend, they should focus on cutting the deficit.