Low Interest Rates Making It Easy For Banks To Starve The Small Business Sector

With the Federal Reserve keeping interest rates low, and the US Treasury Department artificially propping up mortgage bonds, there is little incentive for banks to loosen guidelines and …

With the Federal Reserve keeping interest rates low, and the US Treasury Department artificially propping up mortgage bonds, there is little incentive for banks to loosen guidelines and expand lending to small businesses. Ultimately, the government’s current stimulus policy could create long-term consequences, such as fewer jobs and a less dynamic economy. See the following article from Money Morning for more on this.

When U.S. President Barack Obama unveiled the $787 billion “stimulus” bill of extra spending and modest tax cuts last year, it became clear that the U.S. budget deficit was going to eclipse the 10% of gross domestic product (GDP) level for at least one year (and, as we now know, probably three years).

On those grounds, I opposed the “stimulus” – a position that was a lot less popular then than it has since become. However, as I’ll show you below, it now looks as if I was right – and the implications for the U.S. economy are highly worrisome.

You see, the theory postulated by economist John Maynard Keynes holds that the extra spending stimulates additional output fails to address the question of where the money comes from.

Government cannot create wealth – it has to borrow it. If, before the stimulus, government finances were in good shape, as was the case in China, then stimulus does indeed stimulate: The modest budget deficit that it causes is easily financed, and the extra spending creates some jobs and maybe some useful infrastructure, depending on how well targeted it is.

In the United States, however, government finances were in a mess before the stimulus began.

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The Bush administration had cut taxes, then indulged itself in new entitlement programs and an expensive Middle Eastern foreign policy, with military operations in Iraq and Afghanistan. On top of the $413 billion deficit that this caused in the fiscal 2008 budget year, there were then the various bailouts, which were only free if you don’t count the ones like American International Group Inc. (NYSE: AIG), Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), that actually cost serious money.

That meant the U.S. capital market was already stressed at the beginning of 2009. Yes, foreign money had flooded into U.S. Treasury bonds as a “safe haven,” but it was obvious that that “hot money” would flood out again as soon as it found something better to invest in – which it did, in the 2009-10 gold-and-commodities bubble.

So the deficits that stimulus produced prolonged the period of stress far beyond the trough in the economy. That trough occurred about May 2009, before any stimulus expenditures had time to kick in. Instead of lessening the recession, the deficits that the stimulus caused were to hinder the recovery, through a process known as “crowding out.”

There is after all only so much investment capital to go around. Currently, the U.S. Treasury Department is taking far more of it than it should, and mortgage bonds are being propped up artificially with another $1 trillion of government guaranteed paper being issued in 2009. Meanwhile, U.S. Federal Reserve Chairman Ben S. Bernanke’s monetary stimulus – while ensuring plenty of liquidity – is keeping short-term interest rates artificially low.

If the banks can borrow at less than 1% in the short-term inter-bank market, and get nearly 4% on Treasuries, or 5% on government-guaranteed mortgage bonds, why should they ever bother doing anything else? Leverage that 3%-4% risk-free return 15 times, and you’re talking about a 40%-50% return on capital, enough to pay everybody’s bonuses and keep the shareholders happy.

Of course, it’s not really risk-free; when Treasury bond yields rise, the banks will have a capital loss, but hey – Bernanke says rates will be ultra-low for an “extended period,” so banks should be able to extract at least one more year’s bonus out of it, probably.

Small-business lending is difficult. You have to analyze the company’s balance sheet and income statement properly, then make a judgment on whether or not the small businessman is both competent and honest. There are many easier ways to make money, particularly in a recession, when small businesses tend to go bust. And in this recession, Messrs Obama and Bernanke have given bankers a much easier way to “earn” their bonuses.

You can see the result of this in two places. First, in the Senior Loan Officer Survey published by the Fed last week, it was reported that small business defaults had continued rising, while demand for loans was low.

Before you jump to the conclusion that low loan demand means there isn’t a problem, consider that banks have tightened lending standards to an unprecedented degree over the past year, and have not begun to loosen them. If you’re an intelligent small business owner, you therefore don’t bother applying for a loan, because you know you won’t get it. The senior loan officers sit in their plush offices, playing with their paper clips and reporting to the Fed that there is no demand for loans, while small businesses are left out in the cold (and snow), deprived of the funding they need, and collapsing in droves.

You can also see the result of this – demonstrated quantitatively – in the Fed’s weekly report H8 “Assets and Liabilities of Commercial Banks.” Overall, bank credit (including bonds) declined by about 5% between December 2008 and Jan. 27, 2010, as banks downsized their balance sheets. However, bank holdings of Treasury and agency securities (mostly housing-related) rose by 18% over the same period – very easy money, as I said. Overall loan volume dropped by 9%, but real estate loans (including lots of government-guaranteed home mortgages) dropped by only 2%. Consumer loans dropped by 8%, but the big drop was in commercial and industrial loans, which fell fully 20% during the period. These loans, which are the main purpose of banking, were a mere 17.3% of bank credit in December 2008, but fell to 14.6% of bank credit in late January.

The banks aren’t evil; they’re just following the normal, free-market imperative to make a juicy living with the least effort possible. But government borrowing and prolonged ultra-low interest rates are making it too easy for them to starve the small business sector, the main creator of jobs and the main source of innovation in the economy.

This recovery is thus not going to be a healthy one. And Americans will pay the costs of the misguided “stimulus” for a decade or more, in fewer jobs and a less dynamic economy.

This article has been republished from Money Morning. You can also view this article at
Money Morning, an investment news and analysis site.

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