Of Banks, Stimulus, and the Future--Part I

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.

The failure of conventional monetary policy (that is, of pushing down the overnight rate to reduce the price of reserves) to stimulate the desired amount of bank lending provoked a variety of governmental responses--monetary (the Fed's buying of private debt, both short term and long term, and long-term government debt), fiscal (Treasury loans to banks and subsidies to private investors to buy overvalued, mortgage-related assets from banks), and regulatory (the "stress tests" recently completed). The monetary measures are designed in part to bypass banks by providing cash to other lenders who may be less prone to hoard rather than lend it than the banks are. Both the subsidies to buyers of mortgage-related assets (the misnamed "toxic assets") and the stress tests are measures designed to assist banks to raise private capital by providing assurance that the banks are sound, or by making them sound, or both.

Because the mortgage-related assets are difficult to value, it has been argued that until they are removed from the banks' balance sheets the banks will find it difficult to obtain further capital from the private sector. I am skeptical. Most corporations' balance sheets contain some difficult-to-value assets, yet this does not prevent their obtaining access to the capital markets. The real significance of the effort to get these assets off the banks' balance sheets, I have come to believe, is that it is considered a superior alternative to the government's either buying them directly or lending against them.

The government's buying them directly is objectionable because unless it overpays for them it is doing nothing for the banks, but if it does overpay them it is transferring wealth from the taxpayer to the shareholders of "Wall Street" corporations that the public abhors. The government's lending the banks money against the mortgage-related loans as collateral is also objectionable, however, because there is no satisfactory form that the loan might take.

If instead of making a loan as such, the government bought common stock in the banks, becoming in all likelihood (because of the banks' depressed market capitalization) their controlling shareholder, the banking business, controlled by government, would become politicized, and probably incompetently managed to boot. Alternatively, if, as it has done in the past, the government made the loan in the form of a purchase of preferred stock, this would increase the debt-equity ratio of the bank (because preferred stock, despite the name, is really a form of debt, not equity--in effect a bond without a maturity date). Management prefers the preferred route because issuing additional common stock would dilute the ownership interest of the existing shareholders, who include management. But by buying preferred rather than common stock, the government increases the bank's incentive to engage in risky lending that might bring the bank down. For the higher a bank's debt-equity ratio (the greater, in other words, the bank's "leverage"), the more profitable a successful transaction would be to the bank; and while there would be equal and opposite downside risk, the owners if desperate might discount it because, given limited liability, losses to the owners of a corporation are truncated at zero. (The incentive of a firm at risk of insolvency to roll the dice is called "gambling for resurrection.") That is why the government is considering requiring banks that may lack a sufficient equity cushion to survive a further downturn in the economy to convert preferred stock to common stock or to issue preferred stock convertible to common.

Because government involvement, by either the equity or preferred-stock route, in a bank is objectionable, the alternative of in effect paying private investors to buy the overvalued assets from the banks at a high price that will therefore enhance the banks' solvency is attractive, though the transaction costs may be so high as to foil the attempt.



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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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