I want to consider three important intertwined questions concerning the depression. The first is why the government places so much emphasis on the banking industry and how effective its banking-related measures have been; the second is whether the stimulus program ($787 billion in government deficit spending to jump-start the economy) is, as some conservative economists claim, utterly futile; and, connected to both issues, what the long-run effects of the present economic crisis are likely to be. This first of two entries discusses the first question, and the second entry will discuss the other two.
The bursting of the housing bubble, and resulting decline in the value of home mortgages, in which the banking industry was heavily invested, brought the major banks to the brink of insolvency last September, and as a result froze lending. Not that banks are the only source of loans. But they are a major source and the credit system would be gravely impaired by their disappearance. True, their remaining assets would be taken over by other lenders; but the credit system would still be disrupted. The willingness to make loans to particular customers depends on the lender's knowledge of a customer's creditworthiness, and that knowledge is lost when the lender is dissolved and its staff scattered; it is difficult for a borrower to create forthwith a relationship with a new bank if his old bank fails. A further disruption occurred last fall because the failure of certain nonbank lenders activated stand-by credit commitments by the banks, leaving the banks with less money to lend to other borrowers.
The banks never stopped lending altogether. But their lending declined and so interest rates rose to ration the limited supply of loanable funds. High interest rates reduce economic activity, and so the decline in bank lending reinforced the "contractionary" (reductive) effect of the fall in household wealth occasioned by the sharp decline in housing and common stock values. The decline in economic activity further reduced bank lending, and thus kept interest rates high, because lending is more risky in an economic downturn, as there are more defaults; and the demand for loans falls because there is less economic activity to finance. And the fall in house prices reduced the collateral that borrowers could offer to secure loans to them.
So it became national policy last fall to try to reduce interest rates in order to stimulate economic activity. The usual way in which the Federal Reserve reduces interest rates is by (in effect) buying short-term Treasury bonds. The cash that the sellers receive goes into bank accounts and thus is available for lending, and the more lending there is the lower interest rates are. The target interest rate at which the Fed aims is the "overnight" (also called the "federal funds") rate, which is the rate at which banks borrow reserves (i.e., cash) from each other. The Fed has pushed that rate down to essentially zero, which means that banks can borrow all they want from each other at no cost. Ordinarily that would stimulate loans, and at low rates because the cost of the money lent (the money obtained from another bank) would be zero to the bank making the loan.
No doubt the Fed's action had some effect in limiting the decline in bank loans. But not a great effect. The banks were and are swimming in cash. As of April 1 of this year, they were sitting on $824 billion in what are called "excess reserves," which means cash that banks are not required by the bank regulators to retain as a cushion against losses. In other words, the banks were hoarding cash. In addition, they were using cash to pay generous dividends to shareholders, to buy other banks, and to buy low-risk bonds. They were doing little lending, and that at high interest rates.
Payment of dividends was a hedge against bankruptcy; shareholders (including bank managers, who are shareholders as well as employees) would be wiped out in bankruptcy, but would not be forced to return their dividends. The purchase of banks and if safe assets reflected a judgment that these were less risky or more profitable transactions than lending into a depression.