ECON545 Project 1 Microeconomic Analysis

AN INSIDE LOOK AT POLICY Increased Lending Boosts Money Supply Growth

FISCAL TIMES

Bank Lending Signals a Strengthening Economy

The financial crisis of 2008 rocked the foundation of the U.S. banking sector. The shock left banks short of capital and hesitant to lend, even as the recession cut deeply into loan demand. The Federal Reserve has pumped in an ocean of lendable funds, trying to prime the process of bringing banks and borrowers together. But many still wonder when, if ever, bank lending will return to normal.

We’re not there yet, but recent signs have been encouraging. Despite the sluggish economy, loan growth is finally beginning to pick up in key areas, reflecting both greater willingness to lend and increased desire to borrow. Loan volume of U.S. commercial banks rose at a one percent annual rate in June as expansion in business loans and non-mortgage consumer lending more than offset the ongoing contraction in real estate financing. It was the third consecutive monthly increase after steady declines for more than two years....

a Lending to businesses is leading the credit upswing. The volume of commercial and industrial (C&I) loans in the second quarter rose at a 9.6 percent annual rate, the largest increase in 2½ years. Banks have progressively eased lending standards for C&I loans to large and medium-sized companies for the past six quarters. Small companies have seen easier terms and conditions in each of the past four quarters. Economists expect to see signs that this loosening in standards is continuing when the Fed issues it third-quarter report from bank senior loan officers in mid-August.

More credit is starting to flow to small businesses, as well. That’s important, because small firms account for about half of U.S. job creation, and depend greatly on banks for credit, unlike large corporations that have the option to raise funds in the capital markets by issuing bonds. In the second quarter, the balance of banks reporting stronger vs. weaker demand for commercial and industrial (C&I) loans by small businesses was positive for the first time in five years, according to the latest Fed survey. Another positive sign is the gradual rise in C&I loans made by small banks, whose customers tend to be small local companies. Small-bank C&I loan volume has been rising gradually in 2011 after hitting bottom late last year.

Despite increased attention by policymakers over the past year to the dearth of small business lending, the problem has been not so much banks’ unwillingness to lend but simply a lack of loan demand, reflecting weak sales. Although the percentage of small companies saying credit is harder to get is still somewhat higher than before the recession, it has fallen steadily over the past two years, from a peak of 16 percent, to 9 percent in June, according to the National Federation of Independent Business.

b Banks are also warming to consumer loans. Despite sluggish job markets, households have made great progress in getting their financial obligations under control, allowing qualified borrowers to take on more debt. So far this year, monthly financial obligations of households have fallen to only 16.4 percent of household income, the lowest since 1994. In the second quarter, the percentage of banks reporting increased demand for auto loans was the highest since 2003.

Banks began easing lending standards for auto loans, credit cards, and other borrowing this time last year. In the 2011 second quarter the percentage of loan officers saying they were more willing to make consumer loans rose to the highest level in 17 years....

c The ebb and flow of bank lending during recessions and recoveries exerts a powerful force on any business cycle. Aside from this cycle’s problems in mortgage lending, banks are finally beginning to behave as they usually do in a recovery. Barring some new shock, especially from the debt troubles in Washington or Europe, evidence that loan growth is beginning to expand in response to easier lending standards and stronger loan demand is a key sign that the recovery has staying power.

Source: “Bank Lending Signals a Strengthening Economy” by James C. Cooper, from Fiscal Times website, August 1st, 2011. Copyright © 2011 by The Fiscal Times. Reprinted with permission.

Key Points in the Article

The financial crisis of 2007–2009 resulted in decreases in both the supply of funds available to lend and in the demand for those funds. Despite the Federal Reserve’s infusion of large amounts of funds into the economy, bank lending continued to decline for more than two years. In April 2011, loan volumes finally began to increase. The largest increase occurred in business lending, with the volume of commercial and industrial (C&I) loans rising at an annual rate of 9.6 percent for the second quarter of 2011, which was the largest increase in over two years. The increase in small business lending was particularly encouraging, with banks in the second quarter reporting increased demand for small business loans for the first time in five years. The market for consumer loans was improving as well. As consumer debt as a percentage of income fell to its lowest level since 1994, banks became more willing to make consumer loans. The expansion of loan growth was a positive sign for the economy during what had been a sluggish recovery from the recession.

Analyzing the News

a As we saw in Chapter 9, banks help channel funds from savers to borrowers by making loans to individuals and businesses. Rising defaults on home loans after the housing bubble burst led to the collapse of a number of financial intermediaries in 2008, and loan volume declined for more than two years. Growth in the market for loans reemerged in the second quarter of 2011, with business loans leading the up-swing. Commercial and industrial loans rose at an annual rate of 9.6 percent as banks continued to loosen lending requirements for small, medium, and large companies. As Figure 1 below shows, the percentage change in commercial and industrial bank loans turned positive toward the end of 2010, and it accelerated for much of the second quarter of 2011.

b Loans to consumers began to increase in mid-2011. Following the collapse of financial markets in 2008, banks were much less willing to make consumer loans, increasing their lending standards as households’ financial obligations grew. The decrease in the supply of funds available to households was met with a decrease in the demand for these funds as households worked to reduce their debts. As household debts became more manageable, banks became increasingly willing to make consumer loans, as shown in Figure 2 below.

c As you read in this chapter, banks create money by loaning out excess reserves. Because of the money multiplier process, a given amount of new reserves results in a multiple increase in bank deposits. In an attempt to bring lenders and borrowers together following the financial crisis of 2008, the Federal Reserve made a large amount of new funds available to financial markets. These extra funds had the potential to affect the economy as banks, responding to an increase in demand, finally began to see an increase in loans in 2011. The increases in excess reserves, bank deposits, and loan volume are indications that the economy was in the expansion phase of the business cycle and were positive signs for continued economic recovery.

Thinking Critically About Policy

1. During the financial crisis of 2007–2009, the Fed attempted to stimulate the economy by taking actions to increase the money supply. How effective would these actions be if banks remained reluctant to make consumer loans while households remained reluctant to obtain loans? Briefly explain.

2. The quantity theory of money predicts that a large increase in the money supply will result in inflation. Why, then, even though the money supply increased rapidly was inflation relatively low during the recession of 2007–2009 and its immediate aftermath?

(Glenn 856-857)

Glenn, R., Anthony Patrick. Economics, 4th Edition. Pearson Learning Solutions, 1/2012. VitalBook file.