Forced Lending To Undermine the Economy

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The Obama administration promises us a program of forced lending by banks. By this means, they intend to promote economic recovery. Amazing as it seems, our major officials do not understand that forced lending by banks severely undermines an economy. Subsidizing loans will destroy the market for bank credit. Bank credit will no longer be allocated by rational means of comparing real costs to real benefits. The results will be to harm many people and worsen the structure of the U.S. economy.

In his testimony of Jan. 21, 2009, before the U.S. Senate Committee on Finance, Timothy F. Geithner told us that the Obama administration intends to induce banks to make loans. Such an assault on how credit is granted by banks will hobble the U.S. economy. To understand how this will happen, we need first to see how the granting of credit works in a free market.

The usual practice in a free market is that bankers assess the making of loans using their internal methods of evaluations. They collect information about the borrowers and what the borrowers intend to do with the credit that the bankers provide. If a businessman wants to borrow, the banker assesses the business prospects. The banker does not generally grant credit to just anyone. Bankers do not want to make bad loans, as this jeopardizes their jobs and positions, their stock ownership in banks, and the survival of the bank. Bankers ordinarily exercise prudence.

These statements may seem counter-factual given the lately departed boom. But deterioration in credit standards is something induced by a central banking—fostered and government-encouraged boom. It is not the norm. When the banks have ready access to ample bank reserves provided by the central bank at low cost, and when the government evaluates bankers on the basis of the volume of their community loans, banks are induced to make substandard loans and loans at interest rates that do not reflect the true values of assets. Rising prices in a central bank—induced boom induce banks to make loans based on speculation that these prices are permanent and/or will continue to rise. None of this is what normally happens in a free market in which banks issue their own credits (their own bank notes) and must evaluate carefully those to whom they grant such credits. In a real free-banking market, there is no generalized inflation. Bank notes of individual banks may depreciate, but those banks are then driven out of business if they do not stop over-issuing credit.

Banking systems around the world are mixtures of free market elements with central bank and government-controlled elements. An important free market element has historically been that each banker evaluates the granting of credit by his own means, in competition with other bankers doing the same. Organizationally, the banks have been privately financed by stocks and bonds. The bank managers historically have substantial ownership interests in the bank so as to align their interests with those of outside suppliers of equity capital. The entire system is arranged so that the bankers allocate their credits in a rational way; that is, they make a business loan only when they expect to earn a risk-adjusted return based on a careful and realistic assessment of the prospects of the business.

One must not be misled into thinking that the bank lending behavior displayed in the recent boom is the kind of behavior exhibited in a market that operates without a central bank and without government inducements to lend. Excessive central bank credit leads directly to bankers making loans that ultimately turn out to be bad loans when the market prices established in the boom start to decline. Bad loans mean that the economy is beset with bad investments by businesses that are receiving too liberal credits. This amounts to subsidizing production in unproductive areas of the economy, which means capital is being diverted into projects whose costs exceed their benefits. These mal-investments are not noticed until the boom fails.

When a business that should not be receiving credit receives credit, the business attracts labor and resources (goods and services) away from sound businesses. The weak business temporarily employs people in work that ultimately does not produce what people want to buy. The business cannot cover its costs. It loses money. It may fail. It lays off employees. Its buildings and machinery and inventory stand unused. They may need to be altered to suit better purposes. Much human effort and time go to waste when the bad business gets loans that it should not get. Employees learn skills in this business that may not be useful elsewhere. They may spend several years attempting to get ahead only to find that there is no future in that business. Their lives are interrupted. They have to seek work elsewhere. In the meantime, they use up their savings. They may have to go back to school or move in with relatives. The costs of bad lending are very high.

Another cost is that bad loans made to unsound business ventures harm the sound businesses. They face greater costs and competition from businesses that are subsidized. This undermines their viability. There are many, many negative effects of the mis-allocation of credit; and I have not even mentioned the very bad effects that arise when people who are poor credit risks are granted credits to buy homes, autos, furnishings, and other goods. Nor have I mentioned that taxpayers are often called upon to pick up the tab, or that business failures of subsidized businesses cause the government to interfere even more into the economy.

The fact that individual banks evaluate credits carefully in normal markets is one of the few things that stands in the way of the excessive central bank credit entirely disrupting the economy. Imagine that the central bank were itself to create credit and grant loans to businesses and persons, or imagine that the government does this (which it actually does in great volume). Imagine that the banks were not in the middle, as they are today, allocating credit by rational criteria of cost and benefit. When the government hands out money, it does not use rational criteria. It plays favorites and showers money on its favorites, even if what they do with that money ends up causing a loss by incurring greater costs than its benefits. The taxpayers foot the bills. If the central bank grants credits directly to businesses or other parties and cuts out individual bankers or other lenders, we are very unlikely to see the same degree of care and prudence as are exercised by individual bankers. The central bank, after all, can create far more credit unilaterally.

Now, in fact, the Bernanke central bank is already extending credits at a scale that is unprecedented. Some of it is direct to businesses, in the form of commercial paper. This is a most dangerous game. The central bank is subsidizing business enterprises directly and probably without the care that individual banks would use. The central bank is intent on reviving business. Its political objectives and its ability to create credit are not the stuff of a free market. Neither is its independence from stockholders and lenders; Bernanke does not own stock in his bank. These factors do not make for careful evaluation of credits and credit granted at full market rates of interest. The Fed is thus busy building an unsound and subsidized economy that misallocates resources. It is busy laying the groundwork for the kinds of personal heartaches described earlier that occur when subsidized businesses are created and kept alive.

This is not all. The Fed has liberally supplied reserves to member banks in the attempt to induce them to make more loans. They are doing so to some extent. The growth of the money supply has picked up to a very high annual rate. The authorities do not think it is high enough. They want to see the official numbers show a rebound in gross national product (GNP). This rebound, when it arrives, whether weak or strong, will be misleading if it is being induced by bad loans. Some Americans will be temporarily employed at work in business operations that eventually will falter or fail. The GNP figures will hide the fact that the costs exceed the benefits of many operations.

The banks have a great amount of excess reserves at present that have been created by the central bank, the Fed. The government wants the banks to make more loans based upon these excess reserves. The government wants to set in motion yet another credit-induced boom. It wants bankers to abandon prudent lending policies and make questionable loans, just as it encouraged them to do in the past. The consequences are before us in the form of a severe recession or depression. Yet the government wants to repeat this process on an even larger scale. The end result of this folly can only be the devastation of the U.S. economy on an even larger scale.

Enter the U.S. government and Treasury department once again leading the foray into this folly. Enter Obama and Geithner. Geithner was asked "Should the U.S. include more stringent requirements that TARP funds be used to lend?" He responded as follows:

"The actions of the Senate last week to authorize additional resources under the Emergency Economic Stabilization Act will enable us to take additional steps to reinforce recovery.

If confirmed, I will carry out the reforms that President Obama and I believe are needed in this program. This program must promote the stability of the financial system and increase lending."

Geithner thinks that the new TARP (Troubled Asset Relief Program) money will "reinforce recovery." This is totally false. As argued above, loan subsidies in any form undermine the economy. This is well known to all economists, and it has been well known for centuries. However, Geithner and company are disregarding and ignoring those all-too-human costs that I outlined. They have a theory that the benefits of what they are doing exceed certain costs, nonetheless. That theory is stated in part here when Geithner says:

"The funds provided to AIG by the government were provided on the basis of a complicated set of judgments about the risks to broader financial stability posed by the rapid and disorderly failure of a firm of that size in a very fragile market environment."

The benefit that he seeks is to preserve or save the existing constellation of financial firms. He will save (bail out) a failing company (AIG) if, in his judgment and not the judgment of market participants, that failure will lead to costs being borne by other unnamed companies and financial market players as well as by the general public. Those costs are in large respects losses. This is what he means by "risks to broader financial stability." He asserts that he is helping us by saving AIG and other financial players from taking the losses that arise from their bad investments.

I think he believes this, for he adds:

"The actions taken with respect to Citigroup to date have been to stabilize and strengthen the firm in order to allow it to perform its vital role in providing credit to households and businesses…. I can assure you that as Treasury Secretary, I would require that any future actions with respect to AIG, Citigroup or any other institution be subject to careful scrutiny regarding the amount of taxpayer money being put at risk by acting relative to the costs of not acting."

Geithner does not believe that Americans can create a sound financial system without these subsidies. He does not believe that Americans can themselves right the financial system. He does not believe in free markets. He believes in Timothy F. Geithner. He will assess the costs and benefits. He will scrutinize. He will spend our money for us. He will decide how to create a stable arrangement.

How will he do this? He intends to save us by taxing us and transferring the money to some of these financial players that he selects by his complex judgments. He will keep alive institutions that have failed or are on the threshold of failure. He will help us by subsidizing bad loans and undermining the economy. He will also, by the way, protect and help his friends.

In the nineteenth century, the U.S. economy recovered quickly from a number of major financial episodes like the current one. Timothy F. Geithner, Ben Bernanke and Henry Paulson, all of whom represent that cadre of persons who believe only in their own powers, were nowhere to be seen. Major banks, brokers, and investment bankers failed. The rot was cleaned out. In some instances, financial figures started over again. The profit motive quickly led to a restoration of credit and business.

Geithner’s words and rationales are hokum, puffery, claptrap, and nonsense. He appears to be deluding himself even as he deludes all within hearing who do not understand the actual content and meaning of his policies, that have Obama’s blessing and continue unchanged from the Bush administration. He is overstuffed with his own arrogance and drive for power, as all such officials are, and that is why he propounds this nonsense to us. His words are the weapons of choice to commit grave misdeeds against the people he is sworn to serve. Is it not to his advantage if he can get his victims to approve of their own victimization? I do not mean to pick on Geithner; his attitude is a handy example of the general mindset of important government officials.

Geithner added the following:

"As a condition of federal assistance, healthy banks without major capital shortfalls will increase lending above baseline levels.

Banks receiving government capital will be required to provide detailed and timely information on their lending patterns broken down by category. Public companies will report this information quarterly, including a description of the factors that influenced their decisions, in conjunction with the release of their 10Q reports.

The Treasury will report quarterly on overall lending activity and on the terms and availability of credit in the economy."

The U.S. government wants to force banks to make loans. The method is to dangle federal assistance or, in some cases, to impose such assistance on banks under the threat of other unnamed political harms to be done them. The assistance, which is the subsidy, carries a stipulation. The banks must make loans above levels laid down by the government. Welcome to fascism, U.S. style. The government is nationalizing the banks. It is dictating loan policies. That is why banks will be forced to report their loans in detail and justify them. The banks are to report to their pseudo—Board of Directors, which has Timothy F. Geithner at its apex, if not Barack Obama.

All of this continues to move the U.S. economy away from free markets and toward fascism, which involves government economic control while leaving the organizational forms of the free market in place. At one time, the government role in providing credits and subsidies was nil or relatively small. The New Deal brought in government-sponsored institutions that directed credit to mortgages, farm loans, and various other enterprises. The Small Business Administration began in 1953. There are now countless other programs and subsidies provided directly by government. The central bank creation in 1913 brought a heavy influence on overall credit creation, but the allocation was largely left to individual banks. In the last 30 years, that independence was compromised by various government acts and regulations that encouraged mortgage loans, community loans, and substandard loans. Recounting all these would fill several books. Now the allocation of credit by individual banks is being directly attacked and eroded by TARP. Further measures and regulation are likely.

These subsidies and controls are a one-way street. There is no case that can be made on economic grounds in support of what the government is doing, none whatever. Those many elements of the American public that are supporting what the government has and is doing to our credit system, our capital markets, and our economy, are undermining their own welfare and bringing about their own economic calamity. We are in the midst of such a downfall now. The same poisonous policies that produced this downfall cannot now remedy it. They can only continue the fall of the American economy and bring about a lower standard of living.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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