When Will Lending Return to Normal Activity?

Due to my dedication to the mortgage industry for the past two decades I often get questions like “When will lending return to normal?” or “How long will it be until rates go up?”  While I do not have a crystal ball I can only theorize based on my knowledge of macroeconomics and experience in the lending world.  First I will address that what we had for the first part of the last decade was not a normal lending activity in the sense that “free money for all” was an extreme event.  What we’re experiencing today – a credit freeze – is the other extreme.  The problem is however on how the equilibrium can be re-established and when.  To have a prosperous economy a nation must have a healthy – not excessive and not rigged – lending sector.  But alas, our political leaders and Central Bank are still trying to figure it out.

To get you an idea of where lending may be heading I have to bring in the topic of inflation and deflation as they are very much connected.  The “Inflation or Deflation?” is one of the most debated daily topics amongst economists and central bankers.  Recently it’s been one of the most debated topics I’ve had with friends and colleagues that I highly respect so I decided to analyze the subject based on purely Austrian fundamental principles.  Of course there are other factors that could throw off my theory and change the outcome of what I believe to be runaway price inflation.  For example, we could be involved in another major war, possibly WWIII, where unemployment would decrease (based on the idea that many unemployed people would be needed to go and fight the war) and the U.S. production would increase dramatically due to the need for military devices.  That would not be a natural recovery and I don’t endorse it due to tragedy and loss of lives that it involves.

So, what’s it going to be?  Inflation or Deflation?  To determine the potential outcome one should understand how the money supply is one of the biggest pieces of the puzzle.  The monetary base represents roughly a small percentage (15% or so) of the true money supply TMS.  The U.S. Central Bank directly controls only this portion of the money supply.  I should emphasize the word directly because indirectly there are a lot of things that the Federal Reserve can and does control, yet that’s another topic of its own on which I won’t elaborate at this time.  Many experts argue that the monetary base has remained relatively flat.  But in looking at the chart below I see a steady increase from 1980 until 2008.  Then in 2008 from $850B the base shot up to $2.8T (as of July 14, 2011) in response to the first few rounds of “Quantitative Easing.”

The monetary base comprises physical currency and bank reserves.  When the Fed purchases securities through its open-market operations, the monetary base increases by a corresponding amount, but it is ultimately the banks and their customers who determine the amount of circulation credit built on top of the monetary base.  Indeed the Fed cannot force banks to make loans to individuals and businesses but by continuing to buy securities from banks it helps them increase their reserves, and do remember that bank reserves are part of the monetary base.  This monetary base increase to infinity should and will eventually react in a less than desirable form.

OK, so now we understand that Mr. Bernanke is not really “printing” all the money that many believe he does, and again he only directly affects about 15% of the total money supply but indirectly he does rely on banks to expand the remainder through the fractional reserve banking system.  Mr. Bernanke feels confident that at least for a while banks will not make loans due to factors such as newly taken risk (in form of new loans at low rates) at a time when the banks are still trying to heal their balance sheets.

It is known that these reserves are sitting quietly at the Fed generating a yield to the banks of 25 basis points (.25%).  This gives me a hint that inflation could be the possible threat but not until banks start lending at their full potential.  Back in March 2011 the amount of reserves posted by St. Louis Federal Reserve Bank was $1.2T.  My recent search showed it spiked to $1.6T in just four months (see chart below.)  But eventually the banks balance sheets will heal and they will be ready to lend again.  And this is the concern for those that believe inflation would be the cause of another economic crises.  In simple terms the reserves that were idle for a while would start circulating in the global economy and would lead to more money chasing the same amount of goods raising their prices and known as inflation.

So, where does that leave us?  Will lending or can lending be frozen forever to avoid a potential massive inflation?  For a while it may work considering the banks are still not ready due to lack of sufficient qualified borrowers.   Eventually, down the road banks and borrowers will be ready but that event could trigger the massive inflation that most of us are not prepared for.   To avoid it the Fed would have to use the strategy of banks reserves reversal.  But it;s easier said than could be done because the Fed cannot simply take them away from the banks.  From a banker’s standpoint this would be analogous to stealing.  The option left would be for banks to buy back securities – that include toxic assets – and return some of these excess reserves back to the Fed while the Fed would remove them from their balance sheet.  But again if banks buy back the assets they sold to the Fed – in exchange for the reserves they currently hold – their balance sheets would be no better than in 2008.  This would lead to sky rocketing interest rates and a banking system failure worse than back in 2008.  Either way a soft landing gets harder and harder to achieve.

Following is a brief reminder of how all of this had started during the early 2000 through the housing boom (that not coincidentally extinguished the potential harm caused by the dot.com bust.)   The Fed’s expanded credit via banks – multiplied through the fractional reserve banking system – during the “roaring” 2000′s went primarily into hard assets and primarily into real estate.  Through this credit expansion phenomenon the rates were kept at artificially low levels (when the money rate should have been allowed to rise in a free market scenario) and it distorted the value of assets by inflating them artificially.  Then the defaults started to gain traction and what once used to be a good asset (for the bank and the borrower) it ended up being a toxic asset.  Along with this the banks stopped making loans, the real estate activity suddenly dropped and the glut of foreclosed homes brought down the values of the rest of the homes.

To end with a more defined answer I will recap the options that appear to exist.  One would be a moral one for the Federal Reserve and our leaders by allowing freedom of the markets to take its course.  This would be expressed in form of very high interest rates, lack of lending capacity associated with a credit contraction, bankruptcy of many Wall Street institutions, and a deflationary depression that would be required for a fresh start.   With this option the risk of Hyperinflation is considerably minimized.  The other option, that appears more of where we’re heading is the one with government intervention in the markets.  The Fed continues to expand the monetary base, keeps interest rates at the bottom, and when banks are ready to start lending at their full potential it may trigger  a massive inflation or hyperinflation along with the destruction of the dollar.


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