The 'Credit Crunch' Is a Red Herring
THE favorite indoor sport in Washington these days is trying to pressure the Federal Reserve into printing more money. A key element in this campaign is the allegation that bankers need fresh cash so they can make loans. This is nonsense. Banks already have plenty of money.Bank reserves, which are raw material for the money supply, have gone up at an annual rate close to 10 percent since last winter. In the same period, bank investments in Treasury and state and local bonds jumped almost $50 billion, a 13 percent rate of gain. Bank loans, by contrast, have hardly changed over the last seven or eight months. John LaWare, a member of the Fed, says this is because banks are "backing away from making loans at all and [are] reluctant to renew loans except for the most creditworthy borrowers." On Friday, President Bush pressed the Fed and other bank regulators to prevent bank examiners from being too tough and discouraging bank loans and having a "chilling effect" on the nation's sluggish recovery. In March, the Shadow Open Market Committee - a group of academic and business economists who regularly discuss policy issues - showed that this so-called credit crunch was a red herring. That continues to be the case today. The drop in business loans neither indicates a shortage of money nor a refusal by bankers to lend. To the contrary, banks are cutting loan rates in an effort to drum up business. Anyone with the inclination to read history knows that bank loans (especially bank loans to business) lag the economic cycle. Banks always load up on Treasury bonds in the early stage of an expansion. As activity rebounds, corporate cash flow improves from higher profits and from the sale of goods from inventory. Business people use this cash to repay debt long after the expansion gets under way. At the same time, sales of corporate bonds soared to a rate of $160 billion in the second quarter, the highest since 1986. Companies used the proceeds to pay off short-term debt. Net demand for credit from the corporate sector dropped to zero last spring. That reflected both the aftermath of the recession and the beginning of the rebound in cash flow. Even though growth of nonfederal, nonfinancial debt dropped to a postwar low this year, the ratio of private debt to gross national product has merely stabilized. The slowdown in debt was caused by three factors: First, the borrowing binge of the 1980s inevitably had to end. Individual and corporate borrowers had to rebuild their balance sheets. Second, as the rate of inflation declined, there was a parallel drop in the growth of debt. Third, demand for credit fell when the economy slipped into recession . Fed officials created the myth of a credit crunch in 1990 to divert attention from the fact that monetary policy was too tight. Now that the Fed has eased, easy money advocates in the White House and on Capitol Hill have perpetuated the myth to pressure the Fed to pump up the money supply even more. In reality, there is little to suggest that structural problems in the financial system will block the recovery. While some real estate developers are having trouble getting credit, that is appropriate. Banke rs are correct in tightening up. The last thing the United States needs at present is more empty office buildings or failed banks. The difficulties in the banking system are real enough. Demand for credit is weak, and lenders are properly cautious about lending to marginal borrowers. Remember, the economy went into recession because the Fed overdid its preemptive strike against inflation, not because lenders went on strike against borrowers. Now that the Fed is once again adding to bank reserves, the economy is coming back. In the end, responsibility for ending the recession lies with the institution that caused it - the Federal Reserve. However, that is not an excuse to inundate the country with cash. As the US Chamber of Commerce warned the other day, "many analysts and policy makers mistakenly believe the Fed can jump-start the economy with a flood of new money. It has not and it should not."