Monday, January 10, 2011

An important monetary inflection point

This chart shows Commercial & Industrial Loans by all U.S. banks, a good measure of borrowing by small and medium-sized businesses—those too small to access the credit markets directly. It reflects both the appetite for credit among smaller businesses and the willingness of banks to extend credit. This measure of lending fell by 25% from the end of 2008 until hitting a low last September. It has now moved up a bit, and shows flat growth since last August. Bottom line: the great develeraging and credit contraction that began in the wake of the financial crisis of 2008 has apparently ended.

Many have argued that deleveraging is a major factor limiting the economy's ability to grow, but I disagree. I note that the economy grew strongly starting in mid-2003 even as bank credit continued to contract, and the recent recovery started in mid-2009 even as bank credit was in free-fall. The extension of credit by itself cannot create growth (you can't grow an economy by printing money, you can only "grow" prices), but bank credit can facilitate growth by making the economy more efficient; by channeling funds from savers to borrowers in ways that individuals could not manage by themselves. Rising bank credit can also signal rising confidence, and that is symptomatic of an improving economic climate.

If, as it appears, bank lending is once again starting to expand, I think that reflects a combination of factors: businesses have finished deleveraging; businesses feel confident enough about the future to expand their borrowings; and banks feel confident enough about the economic climate to expand their lending activity. Put another way, this chart shows that the demand for money has passed an important inflection point—instead of rising, it is now beginning to decline. (If money demand is strong, then the demand for loans is weak; if money demand is weak, then the demand for loans is strong. On the margin, businesses now want to be "short" money instead of being "long" money.) So there is a combination of factors at work here that reflects an improving economic climate (more confidence on the part of banks and businesss) and a change in the monetary dynamics of the economy (the beginnings of a decline in money demand). With the Fed still very willing to extend credit to the economy, and the economy now becoming more willing to borrow, monetary policy could start gaining "traction" in a meaningful way: both economic growth and inflation are likely to pick up.

HT: David Gitlitz


Benjamin Cole said...

"The extension of credit by itself cannot create growth (you can't grow an economy by printing money, you can only "grow" prices)"

Well, true, but with context.

Indeed, both John Taylor and Milton Friedman (and Bernanke for that matter) advocated that Japan increase its money supply thru quantitative easing to stimulate growth.

Taylor even wrote a paper pronouncing Japan's QE program a success (that is Taylor as in the Taylor Rule). Unfortunately, Japan halted the QE, and they slumped back into perma-recession.

What MF said was that when there is slack in an economy, spurring the money supply will lead to growth until capacity is reached, and then inflation.

John Taylor, Bush appointee, conservative, Republican, Stanford man, wrote this paper, well worth reading:

The Lantern said...

It is pretty disappointing for small business loans to be 8% below the levels of a year ago, when deposits have grown. The detailed Fed report shows you where the banks are putting their money: trading securities are up 52% in the last year. Holdings of Treasuries are up 17%. That is disconcerting.

Benjamin Cole said...

I see the link to John Taylor's paper did not come thru. To read it, go to Taylor's webpage, and then older papers, and look in year 2006.

Public Library said...

What is 'efficient' about the mal-investment of capital?

Our entire economic structure is directed towards consumption via debt issuance. Some might call that insane rather than efficient.

Benjamin Cole said...

Five years ago, Newport Beach resident Dennis Holland hauled a 1916 ship from Newport Harbor to his side yard and began a thorough restoration. In 2009, the city passed an ordinance restricting "long-term backyard ship restoration in residential neighborhoods." And now, in 2011, Holland and his son continue to work on rebuilding the Shawnee. His permit for the project expires this weekend, he says he has no idea when the boat will be done, and officials are not pleased.

From LA Times.

Yeah, tell us about free enterprise in Newport Beach, CA.
Same city where you cannot build a skyrise condo.

Sheesh, you can't even fix up a boat in your yard.

Scott Grannis said...

Re: John Taylor and quantitative easing. In the link below he makes it clear that while he fully supported the Bank of Japan's quantitative easing program (at the time I did as well), he does not support today's QE and he is "certain" that Milton Friedman would not support it either.

Benjamin Cole said...


Thanks for your reply about John Taylor.

Yes, now he says he does not support QE for the USA--although there are others who say MF would today support QE in the USA.

John Taylor is a well-respected economist, and a gentleman. I am no John Taylor.

However, Taylor may be given to partisan impulses. Some on the right-wing opposed the recent tax cuts as they felt they would boost the economy, resulting in an Obama victory. Along these lines, Rush L. has said he hopes Obama is a failure, although he has tried to clean up that statement.

I find it odd that the same economists who jawboned the Fed to ease when Reagan was president (and inflation at 4 to 6 percent) now say the Fed is too loose.

For me, I didn't care too much about McCain vs. Obama. They both seemed like nice guys (yes, politicians) but with so-so economic plans.

I have to say, I am puzzled by Taylor's triumphant embrace of QE in 2006, and his turnabout in 2010.

Anyway, it is Bernanke who calls the shots. I think Bernanke is right, but time will tell.