24 July 2011

Why banks do not lend at near-zero interest rates
The Fed is surprised. For more than two years it has held the Fed Funds Rate at near zero levels. Yet bank lending has remained anaemic during the whole of that period.

That meagre bank lending is due to, not in spite of, low interest rates is an idea that has never occurred to the Fed.

The logic behind keeping interest rates low seems to be as follows, to use an analogy. If the price of wheat is kept low, even the poor can afford it and demand will be high. Then, if the government supplies wheat at low prices to grocers, they will add a small mark-up and supply it to consumers.

The analogy seems apt, if you replace grocers by banks and the low price of wheat by the low supply cost of money. But in practice the analogy does not seem to have worked. Why?

To begin with, money is not wheat. When a grocer sells a kilogram of wheat to a customer he collects the price for it and that is the end of the transaction. When a banker lends money that is just the first leg of the transaction. He needs to get the money back and make sure that the value of the money he gets back is not only more than the value of the money he lent out but also meets all his costs and yields a profit besides.

During a period of near-zero interest rates the chances of this are bleak. The reason is inflation. If inflation is 0% when the bank lends at, say, an interest rate of 5% and is 5% at the end of a year when the load is repaid, the bank will have clearly sustained a large loss, if lending costs and provisions for bad loans are taken into account. And high inflation is not just a remote possibility. It is a certainty considering that it is the Fed's avowed aim to raise inflation. And given the Fed's record before and after the Great Recession, what guarantee is there that inflation will be just 5%? In such an uncertain situation why blame banks for not lending? Their chances of losing money are smaller if they don't lend than if they lend.

The other reason that banks don't lend when the cost of money is low is just plain common sense. But in an era of complex mathematical economics, common sense has been a prime casualty, so that I need to invoke an economist who has for long been held in considerable contempt: Alfred Marshall.

This is what he said in Principles of Economics (edition of 1920):

"If a person has a thing which he can put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility in all. For if it had a greater marginal utility in one use than another, he would gain by taking away some of it from the second use and applying it to the first."

Now, loans are not the only use that money can be put to. Banks can also use money in trading, which has the singular advantage of not tying up money for long periods and so does away with the uncertainty connected with those long periods. If banks can earn profits through trading, they would naturally not risk making loans. The return of huge bank bonuses just a year after the financial crash is proof that this was what happened.

Why has such a commonsensical idea not occurred to the Fed or to most economists? I think the reason is that Keynesianism has held economics in thrall for more than half a century so that economists are unable to see past the demand side of an equation.

To illustrate the point he makes in the above quotation Marshall considers a housewife with a limited number of hanks of yarn who must make a decision about how to divide the yarn between making socks and making vests.

In the footnote he says:

"Our illustration belongs indeed properly to domestic production rather than to domestic consumption. But that was almost inevitable; for there are very few things ready for immediate consumption which are available for many different uses. And the doctrine of the distribution of means between different uses has less important and less interesting applications in the science of demand than in that of supply."

It almost sounds like an admonition to Keynesians from beyond the grave.

I hope readers will be interested in the following graph which plots a) Commercial and Industrial Loans at All Commercial Banks against b) the Effective Federal Funds Rate from January 2001 to June 2011 [The data are from (where else?) the web site of the Federal Bank of St Louis.]

Especially interesting is the period from around the beginning of 2001 when the Fed began to reduce interest rates to get out of a recession and kept reducing rates until the middle of 2004. All through that period, commercial and industrial loans shrank. From the middle of 2004 the Fed started raising rates to curb the housing bubble and immediately commercial and industrial loans began to rise.

Only an amazing coincidence, I'm sure.

Category: Economics

Philip George
Debunker of Keynesian, monetarist and Austrian economics

Buy my new ebook
Contact Me
December 2016
October 2016
August 2016
July 2016
April 2016
March 2016
January 2016
December 2015
November 2015
October 2015
September 2015
August 2015
June 2015
May 2015
February 2015
November 2014
October 2014
August 2014
May 2014
April 2014
December 2013
October 2013
July 2013
May 2013
January 2013
November 2012
October 2012
August 2012
July 2012
June 2012
May 2012
March 2012
February 2012
January 2012
December 2011
November 2011
August 2011
July 2011
June 2011
May 2011
April 2011
March 2011
August 2010
October 2009
May 2009
June 2008
March 2008
February 2008
January 2008
December 2007
August 2007
June 2007
May 2007