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

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?

Introducing Money

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 producer.

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 possible.

Consequently 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.

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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 pressure.

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.

April 2, 2009