Source: The New Republic
Borrower's RemorseHow many times have you heard that the key to reviving the economy is fixing the banks? The thinking usually goes: If the banks are fixed--if bad loans are taken are taken off the books, and if regulations are put in place to prevent risky new loans--then they will resume lending to consumers who will buy cars and homes, and to businesses that will invest in plants and hire new workers. That's probably why Washington has spent the last six months proposing bank reforms, but not worrying about whether the first stimulus adopted is going to be sufficient. In my opinion, that's a mistake. There is a banking crisis, but much of the solution to it lies elsewhere--namely, with more government spending.
Last fall, the Treasury and the Federal Reserve had to do something about the banks to prevent the collapse of the economy. At that time, banks were unwilling to lend to one another, let alone to individuals and businesses. Federal guarantees against failure and an infusion of reserves prevented the system's collapse. There are clearly more things to be done to prevent a future panic, such as consolidating and strengthening financial regulation, but these kind of measures don't necessarily bear on what's important to revive today's economy.
The real problem is that borrowing is down. According to the Fed, during the first quarter of 2009, private borrowing by households declined by 1.1 percent and by nonfinancial businesses by 0.3 percent. Net borrowing--the funds borrowed minus those repaid--was down $151.8 billion for households and $28.3 billion for businesses. If individuals are spending part of their earnings paying off credit-card debts or student loans rather than buying a home or car on credit, and if businesses are using their profits to pay off debts rather than to invest, then the economy is going to shrink. The question is what accounts for this decline in borrowing.
The usual answer is that the banks don't have the money to loan, or the capital to absorb losses on existing or new loans. But much of the money they loan is not from deposits (which, incidentally, have been rising), or from interest made on loans, but rather money they themselves have borrowed at lower interest rates than they plan to charge. With federal interest rates near zero, banks are able to borrow money cheaply and lend it to individuals and businesses at very attractive rates. Even with old loans weighing them down, the banks' risk of losing money on new loans has been substantially reduced.
Could the problem, then, be with the borrowers rather than the lenders? That's the answer given by Richard C. Koo, the chief economist of the Tokyo-based consulting firm Nomura Research Institute, in a new book, The Holy Grail of Macro-Economics: Lessons from Japan's Great Recession. Koo argues that the Great Depression of the 1930s, Japan's 15-year recession beginning in the 1990s, and our current downturn are examples of "balance-sheet recessions."
During balance-sheet recessions, individuals are reluctant to spend, and businesses are more worried about paying down their debts than maximizing their profits, wary of expanding their output at a time when there's little demand for their products. So individuals save money and businesses stop borrowing it even when interest rates, which normally spur such activity, approach zero. And this is pretty much what happened in the 1930s and more recently in Japan.
During the Great Depression, Franklin Roosevelt's initial reforms stemmed the financial crisis, but they by no means revived the overall economy. The private debt of non-financial businesses and individuals fell from $129.6 billion in 1929 to $100.6 billion in 1939. The reason that the rate of unemployment fell at all during this period and that economic growth picked up was because the increase in public debt--from $20 billion in 1930 to $108.7 billion in 1939--compensated for the decline in private lending.
Koo shows that during the Great Depression and Japan's recession, banks were willing to lend money, but borrowers couldn't be found. Koo cites the surveys that Bank of Japan conducted. These surveys, published in the Short-term Economic Survey of Principal Enterprises in Japan, showed that, except from 1997 to 1998 and from 2002 to 2003, "banks were willing lenders," Koo writes. He reasons, too, that if Japanese banks had been unwilling to make loans, and if businesses had still wanted to borrow, businesses would have raised money through foreign banks or through bond issues. Nothing like that occurred during Japan's recession.
Koo suggests that the same thing might be happening today. His book was finished early in 2008, so it doesn't taken into account the last six months, but there's evidence from the Fed that businesses are now unwilling to borrow. The Fed's most recent survey of bank loan officers, released in May, reports a decline in the number of banks tightening their loan terms over the last few months. At the same time, it reports "a further weakening of demand for C&I [commercial and industrial] loans from firms of all sizes over the previous three months."
As the Fed report makes clear, some banks have tightened their loan terms, but that is not necessarily because of worries about bad loans on the bank's books. They could be demanding risk premiums because of "a less favorable or more uncertain economic outlook," which affects their view of whether businesses or individuals will be able to repay the loans they make. But that doesn't detract from the central point in Koo's analysis: The basic problem does not lie inside the banks themselves, but with the businesses, consumers, and broader economy.
Equally, there may be differences between Japan's recession and the current recession. In Japan, households were notorious savers; it was businesses that accumulated the most debt. In the United States, households virtually stopped saving in the last decade--in 2008, the savings rate was zero. And the greatest concentration of debt was among households rather than businesses. The problem for American businesses may not be so much clearing their balance sheet as discovering sufficient demand among consumers and other businesses for their products to justify new investments. That, too, doesn't detract from Koo's central point about where the problem lies, but it casts it in a more conventional Keynesian mold.
Koo thinks the solution is to use government borrowing to make up for the slack in private borrowing until individuals and businesses clear their balance sheets. At that time, individuals will be ready to spend, and businesses to invest. (The more conventional Keynesian version, which may be more applicable to the United States now, is that government borrowing, by making up for the slack in private borrowing, will provide the demand necessary to inspire economic growth.)
How does government borrowing help clear balance sheets and create demand? The government borrows from Americans and foreigners, from individuals, businesses, and central banks, when its spending exceeds its revenue. It eventually has to repay those loans, but while it has that money, it can be used to stimulate demand. And as Koo notes, borrowing is much more effective when it is used to increase spending rather than to reduce taxes, since consumers and businesses can simply choose to save rather than spend their tax cuts.
Koo's analysis helps to explain something that's always puzzled me. In the early '90s, Japan suffered a massive decline in its assets very similar to that which the United States has suffered. Commercial real-estate prices declined by 87 percent and overall growth faltered--businesses and banks teetered on the edge of bankruptcy, and unemployment rose. The country was suffering from a recession, yet unemployment never reached 6 percent (ours is currently at over 9 percent), and GDP continued to grow, albeit at a slower pace.
Koo says the reason Japan's unemployment didn't rise further was because of the enormous public deficits it incurred. When it cut back on government spending in 1997 (similar to what the Roosevelt administration did in 1937 and what some Republicans advocate today), the economy suffered. Private borrowing finally resumed in 2005--not because of bank reform but because individuals and firms, having cleared their balance sheets, began borrowing and spending again. (This sounds right, although I would wonder, too, whether a boost from export demand in China and the United States also played a role.)
If Koo is correct, then the most important thing that the White House and Congress can do to solve the banking crisis is the same thing it can do to get the country out of the recession: counter the decline in private borrowing with a huge increase in public borrowing. That is, the government should borrow through bonds so that it can spend more than it takes in. The Obama administration started to do that this year. While household and business borrowing was negative for the first quarter of 2009, federal government borrowing increased 22.6 percent and state local government 4.9 percent. But this may not be enough to get the economy out of its doldrums. In an article in International Economy last fall, Koo called for a "seamless" three-to-five year stimulus program. That would go beyond the two year stimulus program that Congress enacted, and would also be unencumbered by tax cuts rather than spending increases.
Judis graph
If the Obama administration wants to solve the banking crisis, it may have to spend its political capital on a second stimulus program rather than on bank reform. The last thing it should do is listen to the deficit hawks squawking about rising government debt. The only way the government will ever be in a position to repay its debt is by getting the economy growing again.
This article originally appeared in The New Republic.