Would Cleansing Banks' Balance Sheets Kick-start the US Economy?

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US Treasury
Unveils Plan to Buy Banks’ Troubled Assets

Last Monday
the US Treasury presented a plan that is aimed at cleaning toxic
assets from banks’ balance sheets. The Treasury is to take over
up to $1 trillion in bad assets (such as mortgage securities) with
the help of private investors.

According to
the plan, for every $100 of bad mortgages being purchased from banks,
the private sector would put up $7 that would then be matched by
$7 from the government. The remaining $86 would be covered by a
government loan.

It is believed
that banks fund economic activity by means of credit expansion.
Toxic assets, however, cause banks to curtail the expansion of credit
and thereby plunge the economy into a severe economic slump. So
it is not surprising that for most experts and President Obama the
success of the Treasury plan (i.e., the removal of toxic assets
from banks’ balance sheets) is a key for economic recovery.

The goal, said
President Obama,

is to get
banks lending again, so families can get basic consumer loans,
auto loans, student loans, (and so on) that small businesses are
able to finance themselves, and we can start getting this economy
moving again. (MSNBC.com March 23, 2009)

Some commentators,
such as Nobel laureate Paul Krugman, are of the view that what is
needed to get the economy going is to nationalize banks. By doing
so, the government could force the banks to expand credit. The increase
in lending would then provide support to various economic activities
and this in turn would set the foundation for general economic expansion.

If what keeps
the economy depressed is too many toxic assets on banks’ balance
sheets, then it makes sense to do whatever is necessary to remove
those assets from banks’ balance sheets. Equally, it also makes
sense to nationalize banks and force them to lend.

We suggest,
however, that what matters when it comes to economic recovery is
the state of real savings. Contrary to popular thinking, it is real
savings that fund economic activity and not bank lending.

Real Savings
and Lending

Consider John
the baker who has produced ten loaves of bread and has consumed
two loaves. The real savings here is eight loaves of bread.

Let us say
that John decided to lend his real savings (eight loaves of bread)
to a shoemaker Bill for a pair of shoes in one month’s time.

Through lending,
John supplies Bill the shoemaker with the means of sustenance (eight
loaves of bread) while Bill is busy making shoes. Also note that
what made the lending possible here is the saved loaves of bread.
Hence, what limits the size of lending is the amount of loaves saved.
If John could produce twelve loaves and consume two loaves, then
he would be able to increase his lending from eight loaves to ten.

Now let us
introduce an intermediary and let’s called it a bank. Instead of
lending eight loaves directly, John transfers his saved bread to
the bank. The bank in turn lends it to Bill the shoemaker or to
other individuals.

Bank lending
here is dictated by real savings – eight loaves of bread –
and it is real savings that sets the size of lending here.

Now let us
assume that John’s real savings declines – his production of
bread has fallen to eight loaves while his consumption is still
two loaves. In this case, the bank would be forced to curtail it’s
lending to six loaves.

Would it make
sense to blame the bank for curtailing lending?


The essence
of our analysis does not change with the introduction of money.
Now John the baker can exchange his saved loaves for money. When
deemed necessary, John can use the money to secure various goods
and services. John can also decide to lend the money to another

The borrower
can now use the money and secure consumer goods that will support
him while he is engaged in the production of other goods (say, tools
and machinery).

Again, note
that what makes the lending possible here is not money but the saved
consumer goods. Money just serves here as a facilitator. Or we can
say that the act of lending here is about the transfer of final
consumer goods from lender to a borrower with the help of money.

The essence
of credit will not be altered by the introduction of banks. Instead
of lending money directly, John could now engage in lending through
the intermediary. (John transfers his money to the bank. The bank
lends the money to a borrower.)

Real savings
determines the size of credit. What people really want is real stuff,
i.e., real savings and not money as such. Hence, as long as banks
facilitate credit that is fully backed by real savings, they should
be seen as the agents in the transmission of wealth.

In the modern
monetary system, which is presided over by the central bank, banks
can embark on lending that is not fully backed by real savings –
credit created "out of thin air."

In the case
of fully backed credit, the borrower secures goods that were produced
and saved for him. This, however, is not the case with unbacked
credit. No goods were produced and saved here.

As a result
of the unbacked credit, an additional demand for various goods emerges.
This leads to an attempt at expanding the infrastructure of the
economy. This attempt is bound to fail since the flow of real savings
is not large enough to support the expansion of the infrastructure.

The attempt
to expand the infrastructure leads to the diversion of real savings
from various activities that make the present flow of real savings

the flow of real savings comes under pressure and the rate of real
economic growth follows suit. (Remember that real savings fund economic
activity – not money.)

Credit or money
created out of thin air can’t replace the non-existent real savings.
(In our previous example, we saw that without the saved loaves of
bread no lending is possible.)

Can the cleansing
of banks’ balance sheets lead to an increase in fully backed lending?
Without the expansion of the pool of real savings, the increase
in lending is mission impossible.

The Obama administration
is currently introducing plans that are likely to further undermine
the flow of real savings and hence hamper banks’ abilities to engage
in productive (fully backed) lending.



$19  $14


By forcing
banks to expand lending while the pool of real savings might be
in trouble, policy makers are only encouraging an increase in credit
created out of thin air. Such credit only further dilutes real savings
and retards prospects for a meaningful economic recovery.

It is extraordinary
that various commentators who are currently blaming the banks for
refusing to increase the pace of lending and thus delaying economic
recovery, were the first to accuse the banks for causing the present
economic crisis by not practicing prudent lending.

Currently banks
are happy to lend to quality borrowers – those who are likely
to repay the borrowed money. A stagnant or a falling pool of real
savings implies that the economy’s ability to produce real wealth
is currently impaired. Obviously, in this case the percentage of
wealth generators and good-quality borrowers is likely to be under

The issue of
the good quality of borrowers cannot be fixed by an artificial cleansing
of banks’ balance sheets or by nationalizing the banks. What is
required is the expansion of the pool of real savings. Monetary
pumping and credit created out of thin air cannot fix this.

Since the heart
of credit is real savings, it is obvious that no government schemes,
such as cleansing banks’ balance sheets, can increase fully backed
credit. These government plans can only redistribute a given pool
of real savings.

Instead, wealth
generators must be allowed to move forward as soon as possible.
Only wealth generators can lay the foundation for the expansion
of the pool of real savings and hence lending. Wealth generators,
however, cannot work efficiently in an environment of government
controls, and money and credit created out of thin air.

This article
first appeared on Mises.org.

2, 2009

Shostak [send him
] is an adjunct scholar of the Mises Institute and a frequent
contributor to Mises.org. He is chief
economist of M.F. Global.

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