Why Do Banks Lend More?

Why has household debt grown so much? One rather convincing argument, prominently developed by Elizaeth Warren, is that income growth has not kept pace with the cost of basic consumption. To maintain consumption, many families ultimately relied more and more on consumer debt. This argument, though, only explains why the demand for credit has increased.

For the supply side of the market, the opposite should have been true. The same income trends that translated into more demand for credit should have resulted in less supply. Greater income inequality and slower income growth meant less collateral for banks. Also, slower income growth and rising inequality occurred at a time of financial deregulation, which has a priori an ambiguous effect on the supply of credit. There may be more banks entering the market, which could raise the credit supply, but there is also more consolidation in the industry, which could reduce the credit supply, at least for low-income and moderate-income borrowers.

A New Regulatory Tool for Financial Stability

Economists tend to be pretty good at pointing out what is currently going wrong with the economy. But we tend to be rather hamstrung at offering solutions. In the current crisis, public policy needs to achieve three things: 1) help troubled homeowners and declining communities, 2) maintain liquidity and stability in the credit market, and 3) prevent another financial crisis of this magnitude from happening again. Lawyers, community activists, consumer advocates, sociologists, among others, have offered a wide array of proposals to address the first two problems. Little has been suggested in ways of addressing the chance of a repeat crisis in the future. Economists in particular are reluctant to go beyond simple proposals that call for more market transparency. A changed regulatory, environment, though, may help to reduce the chance of future financial crises. Specifically, a few economists have proposed a new regulatory tool called asset-based reserve requirements for more than three decades. This tool would allow the regulatory agency, often assumed to be the Fed, to force financial institutions to bear the cost of their investment decisions and not to unload them onto society.

The Fed Cannot Do it All

Many wait for Ben Bernanke and his colleagues at the Fed to save the economy from further turmoil. The reality, though, is that monetary policy is limited in addressing the crisis. In particular, the economy is slowing because the housing boom is over, which was caused and fuelled by deteriorating mortgage quality that resulted from people no longer paying their mortgages. The rise in foreclosures followed higher interest rates on resetting adjustable  rate mortgages, lower incomes in a weakening labor market, and declining home prices that put many mortgages “under water”. Monetary policy can only directly impact interest rates and even there its reach is limited.

Sliding into the Great Deflation

We are headed for the Great Deflation – a period spanning a decade or more of very slow growth, rising unemployment, flat or falling real wages, fewer employer-provided benefits and increasing pressures on government finances.

Do the Math on Recession and Foreclosures

Thanks to CreditSlips for inviting me to be a guest blogger and to share my views on credit and the economy.

By now, it's obvious that the housing crisis is dragging down the economy. For the past eight quarters, the declining activity in the housing market dampened growth on average by 0.9 percentage points below where it otherwise would have been. This is the largest housing induced subtraction from economic growth since 1975.

Some observers argue that this is just a natural correction of the market and that policy makers should let market forces play themselves out. The logic is that a nice, quick recession will get rid of the debt overhang by forcing people to default. Once banks’ balance sheets are free of the excess loans, the economy will get a clean slate to start over again as a rejuvenated banking sector will once again pave the way for innovation and production and not for speculation and Wall Street greed. The way it is portrayed, it almost sounds like a day at the spa for the US economy.

The situation, though, is far more serious. A recession that would get rid of the debt overhang would have to be very deep, especially since the mortgage foreclosure rate would have to jump to unimaginably high rates.