Trapped
by David on January 26th, 2009
Why aren’t banks making more loans? Hasn’t the Federal Reserve lowered the cost of overnight, unsecured loans between banks virtually to nothing? Since banks can borrow no-cost money, they should surely make low-interest rate loans to borrowers. In fact, and contrary to the daily headlines, banks are lending. Consumer loans at US banks increased 8% to more than $860 billion in 2008. Banks would like to lend more. That’s what they’re in business for. One reason they aren’t, is that the United States is in a liquidity trap.
“A liquidity trap occurs when a country’s nominal interest rate has been lowered nearly or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy. In these situations, borrowers prefer to keep assets in short-term cash bank accounts rather than making long-term investments. This makes a recession even more severe.”
From: Wikipedia: The Free Encyclopedia
When the economy stumbles, the Fed lowers interest rates in order to stimulate spending. Very low rates of interest make borrowing cheap. They also make savings unrewarding. Normally, the combination is enough to kick start the economy. But 2009 isn’t normally.
Question: Who in their right mind would put $1,000 in the bank just to earn $5 a year? Answer: Someone who put $2,000 in the stock market a year ago and now has $1,000 left.
A liquidity trap is born when enough people decide to protect principal, no matter how little it earns. Once the trap is sprung, low interest rates lose their power to revitalize the economy. Fear of the future trumps the willingness to take risk.
In our economy, the trap has an added barb. Over the last few decades, the demand for consumer credit expanded exponentially. Banks had nowhere near enough money to meet the need. The result was the invention of loan securitization, which is the sale, aggregation, and re-division of loans into bonds that are sold to all sorts of investors all around the world. Unfortunately, these investors no longer have the risk appetite to buy pools of securitized loans, except those guaranteed by the Federal government. They too have fallen into the liquidity trap.
It takes a long time to build a liquidity trap. It will take a long to climb out. But, with “imagination joined to common purpose and necessity to courage,” we will get out.
Tags: community development, economic predictors, financial crisis, green banking, ShoreBank, triple bottom line
