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Should banks Lend? Loan Supply vs. Loan Demand

While many are deriding the Treasury for its reluctance to force banks to lend capital allocated under the TARP program, it is not at all clear that bank lending is the proper way out of the crisis right now.

The reason is that, without knowing the distribution of potentially high job losses and continued economic decline it would be foolish for consumers and businesses to borrow. But it would also be foolish in those circumstances for banks to lend. Hence, the economy is faced with the classic dilemma of whether current difficulties are due to loan supply or loan demand.

The relative emphasis of loan supply versus loan demand has been debated since the Great Depression, and there remains little agreement on the primary cause of business cycle persistence in during that period even today. In fact, the contributions of loan supply and loan demand to the Great Depression are still one of the great unknowns from that era.

The uncertainty about the relative effects of loan supply and loan demand puzzled economists even during the Great Depression. Classic studies, like that of Charles Hardy and Jacob Viner (Report on the Availability of Bank Credit in the Seventh Federal Reserve District. Washington, DC: US Government Printing Office, 1935) and that of Lewis Kimmel (The Availability of Bank Credit, 1933-1938. New York: National Industrial Conference Board, 1939) sought through surveys of banks and borrowers to add some understanding to the problem. Ultimately, however, while it was clear that banks were reluctant to lend, it was also clear that borrowers were reluctant to invest in new capital during such a time of great uncertainty.

Hence, today, it is not at all clear that we really want people to borrow to buy new cars when they could lose their jobs next month. Given memories of failed credit programs like Mitsubishi’s famous zero-zero-zero program, wherein they offered zero money down, zero payments for six months, and zero interest – and ultimately received zero money when the cars were repossessed, it is also not clear that such consumer borrowing would really help companies weather the crisis. We need to think hard about this classically unresolved conundrum before rushing headlong into $350 billion more in capital outlays.

In defense of Treasury on this one narrow point, it is not at all clear that we want Treasury or Congress directing this or other capital injections into the financial sector. Directed credit failures like that of Japan’s MITI or South Korean investment programs should be enough to dissuade policymakers from such exercises. Instead, what policymakers should have extracted in return for recapitalizations is a full, accurate, and complete disclosure of bank losses so those can be written off once and for all. Only after the losses are ascertained will prudent businesses and consumers alike move on and begin to invest and consume once again.

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