You can lead a horse to water but you can’t make it drink. Keep that in mind when reading how much the Fed has driven down interest rates. In finance, you can increase the amount of money available for lending, but you cannot force banks to make loans. That limits the broader effects of plentiful money on the economy as a whole.
Interest rates are not the only indicator of credit availability. At any given interest rate and for any type of loan, lenders can vary the amount of money they lend. That does not jibe with introductory economics, but it is true and important.
We teach freshmen that interest rates are determined by supply and demand — with the important qualification that a central bank can alter the supply of money nearly instantaneously.
An increase in the money supply therefore pushes down interest rates and should increase the amount lent to households and businesses. In turn, this should increase household spending on consumption and business spending on new plants and equipment. Both should boost overall economic output and employment.
At least that is the Keynesian theory economists have taught to introductory econ students for a half-century. But John Maynard Keynes himself recognized the limitations of a greater money supply in times of fear and uncertainty.
In such times, when potential borrowers worry about what the future holds, they are reluctant to take on new debt.
Lenders may lower interest rates as the central bank increases liquidity. But they can tighten their lending standards, requiring higher income and net worth for a given loan. They can require more collateral, shorten the maturities of loans and reduce the limits on credit lines. Lenders can increase the spread between the interest they pay depositors and what they charge borrowers and tighten the covenants that restrict borrowers’ financial autonomy until the loan is repaid.
According to the Federal Reserve’s April survey, senior loan officers report doing all of these things in recent months. They also report that “demand for bank loans from both businesses and households reportedly weakened further.”
This is not necessarily bad. We are coming off of a long period when it was far too easy to get loans. Rising default rates on home mortgages and other debts demonstrate that too much money went to borrowers with questionable ability to repay. So increased caution by lenders reflects, in part, a return to healthy prudence.
From a macroeconomic point of view, however, tighter lending standards offset some of the stimulus to the overall economy that is a primary objective of lower rates.
A central bank making money more available can stimulate consumer spending and business investment, two important components of Gross Domestic Product. That in turn can bolster employment.
However, when potential borrowers shun new debt and bankers ratchet up their lending conditions, any stimulus quickly runs dry. That is what is happening right now.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.