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How Banks Are "Crowding Out" the U.S. Rebound

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.

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.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps – half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

During the stock-market rebound that started in mid-March, Hutchinson's calls on gold, commodities and high-yielding dividend stocks made winners of investors who took his advice.

Experts are taking notice. And so should you.

Hutchinson is now making those insights available to individual investors. His trading service, The Permanent Wealth Investor, combines high-yielding dividend stocks, gold and specially designated "Alpha-Bulldog" stocks into winning portfolios.

To find out more about The Permanent Wealth Investor, please just click here.]

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  1. David Dixon | February 17, 2010

    Why should a small business owner make a 15-20 year bet with all the unknown's
    -Health care
    -the economy
    -Tax change unkowns

    It makes no sense

  2. bruce seligman | February 17, 2010

    the drop in bank lending was partially caused by the fed's requiring banks to raise their levels of capital. this could most easily be accomplished by shrinking the balance sheets.. your comments? bruce

  3. Mike | February 17, 2010

    Only 4.6% of bank credit, wow.

    What's the average in past decade?

  4. Tn.Dave | February 17, 2010

    "the drop in bank lending was partially caused by the fed’s requiring banks to raise their levels of capital."
    They aren't lending because the govt allowed them to change from "mark to market" to
    "mark to fantasy" to cover many billions of toxic and high stench loans. The fantasy part
    of it is to buy time to rid themselves of some of this debt. The crash is coming and this
    can be seen if you watch the trillion or so sitting on the sidelines waiting in anticipation to
    grab some of this debt at very cheap prices. Meanwhile, banks don't dare lend a hell of a lot
    because they are in deep s@#t. Our gutless media covers none of this to any extent. Banks
    rule the country and we were warned a long time ago what might happen. Here are a few quotes
    from our forefathers, Lincoln, Jackson, & Jefferson. ………………………..and when was the
    last time you saw any of these quotes on CNBC or anywhere else ? ……….or even a discussion
    about the dangers we are now in. Too late, the banks win with deep pockets to corrupt just about
    every politician in Washington. No way to fight it except to vote them ALL out and start anew.

    Andrew Jackson to his corrupt banks:
    "Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. "

    ~ Andrew Jackson, 1767-1845, 7th US President, when forcing the closure of the Second Bank of the US in 1836 by revoking its charter.

    "I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered."
    Thomas Jefferson 1802
    That's right 1802

    "I see in the near future a crisis approaching that unnerves me and causes me to
    tremble for the safety of my country; corporations have been enthroned, an era of
    corruption in High Places will follow, and the Money Power of the Country will
    endeavor to prolong its reign by working upon the prejudices of the People, until
    the wealth is aggregated in a few hands, and the Republic is destroyed."
    Abraham Lincoln

  5. Archie | February 17, 2010

    You assume that there was any intention of the US government to repay any of the debt.
    A major devaluation of the dollar was always the way the 'Big Guys' planned to repay the insurmountable debt to China. Why do you think the Chinese are all buying Gold?
    Creating a war and supplying both sides with weapons is the plan for re-establishing the USA as a dominant world player.
    Obama is just a front man for the same people who pulled the stings for Clinton and Bush.
    It is really funny that the same families, who caused the 1929 crash, caused the 2007 crash and no-one seems to have noticed how they sucked up all their competitors at pennies on the dollar.

  6. Trimonious | February 18, 2010

    If you make assumptions about why demand for loans is slack among small businesses and then treat that as a fact which underpins your whole argument, it makes it difficult to treat this as anything beyond opinion. I think the argument that government debt issues is crowding out available capital for private enterprise is generally solid but the extent and consequences of that are poorly argued here.

    I guess the big question critics never answer is: what would your response have been to the crisis? In the panic, I think those in charge behaved pretty soberly and probably averted disaster. Almost every single economist agrees that stimulus of some kind was necessary. So what would you have done differently.

  7. H. Craig Bradley | February 19, 2010


    The name of the game here is to market the "inside scoop", which often is accompanied by the sales lure "get rich quick". Some investors (sic gamblers) can not resist a 'flier', hence the appeal of expensive newsletters by subscriptions with the latest hot stocks at home or abroad.

    True enough, if you see a real trend developing and allocate your investments to take advantage of it, then you probably will earn greater returns than your competition. Generally, the initial stages of an emerging trend are not conclusive or obvious. However, once the trend is entrenched and validated by events, the prognosticators unveil themselves. Next, you read it in the Wall Street Journal or even see it on MSNBC. What a surprise!

  8. Ed | February 19, 2010

    It will backfire on the banks. We (miserable operators ) will pay off our mortgages, stop leasing equipment, stop using our credit cards as a line of credit and only buy when we have cash. After twelve years, I am there. And the bas*** can close for all I care. My combined bank fees at my least favorite ( and fifty four years of an account) was fourteen dollars last month and near nil balance. And I am now very hard to beat in the marketplace.

  9. Bob | February 21, 2010

    I have one disagreement with the article, and it is a major one, but otherwise I think the article is spot on. The comment was made, "…'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…" We are a LONG ways from gold being a bubble. It did flood back into the more riskier asset of Stocks and into the "treasuries and bond bubble". That's where the real asset bubble is and where that next bursting sound will be that we hear.

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