Saturday, January 23, 2010

How to make the credit contraction worse

I believe that it is fair to say that sustained economic growth cannot resume in the US until the credit contraction ends and banks begin lending again. The continuing decline in the credit aggregates is short-circuiting the Fed's efforts to stimulate growth. (Shades of Japan.) 

Despite quantitative easing resulting in an increase in the monetary base from $800 billion to $2 trillion, the real economy remains stalled and prices are flat. This is because, despite massive increases in free reserves, bank loan portfolios continue to contract, and also because the private sector securitization engine remains broken. 

C&I loans are declining at a rate of almost 20% (by far the steepest rate of decline since the Depression), and household indebtedness is also contracting. 

The hole left by the private sector is currently being made up by the government:
  • The federal government is growing its debt at an average annual rate in excess of 20%;
  • The federal government and the Fed are keeping Fannie and Freddie on life support with capital and unlimited credit;
  • The Fed is supporting the ABS markets via the TALF.

Essentially, the economy is in the ICU on oxygen and glucose. The patient is still alive, but is not showing signs of sustainable recovery. 

However, the outlook for a recovery in credit growth is very bleak. It appears that it is the policy of the government to take measures intended to further contract the credit available to businesses and households. 

  • Capital and loss-reserve standards are being raised, not lowered, forcing banks to shrink their balance sheets.
  • The Obama administration has proposed limiting bank size, forcing a reduction in loan portfolios.
  • The administration has proposed a tax on uninsured bank liabilities.
  • The IASB and the FASB want to consolidate off-balance sheet vehicles and to require additional capital against derivative exposures, both of which would put renewed pressure on bank capital ratios.
  • The TALF is inexplicably scheduled to end at the end of March.
  • Populist attacks on bankers, the banking system and bank compensation are not helping to retore animal spirits in the financial system.

These factors suggest that credit will continue to contract, cancelling out the effects of monetary and fiscal stimulus. Contracting credit will pull nominal and real growth downward, reducing federal and state revenue, and increasing the deficit.

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