Framing the Geithner Bank Plan

What are your expectations for the impending Geithner Bank Plan?  Listening carefully to the messaging from the top, you are probably hoping for an increase in bank lending.  In fact, over the past few weeks, Congressional leaders (e.g., at the Senate Budget Committee hearing last week) and the President (e.g., see the penultimate paragraph of last week’s TV address) have repeatedly insisted that, going forward, banks that receive government support should increase their lending.

And you’ve probably seen matching statements from the banks recently, either (a) explaining why the fall in lending was not their fault, or (b) celebrating the fact that, against all odds, they did manage to increase loans in the last quarter.

So the perception has been created that the new Bank Plan will succeed if it raises bank lending, and that it can be judged by this metric.

But this is the wrong framing of the problem.  Or, perhaps it was the right framing for last October, when credit supply was severely disrupted, but it is an out-of-date and perhaps dangerous way to think about what is now needed.

If many creditworthy consumers and firms currently want to borrow less (i.e. increase their savings/strengthen their balance sheets), the amount of outstanding credit in the economy should fall.

Banks have definitely tightened lending standards (subscription link, but the point is in the free part) – there might be some overreaction here, but everyone agrees that overly loose standards were a major cause of the crisis, so what else would you want them to do?  Certainly there are some creditworthy borrowers who cannot currently get loans at the prevailing interest rate, but how many?

If you think there was overlending in the boom (and who doesn’t?), then you should expect a contraction in total credit now – this is the simple and compelling idea behind the fancy term “deleveraging”.

The task is not so much to force lending to increase now, but rather to clean up the banking system so that, when the recovery begins in earnest, credit will be available on reasonable terms and subject to sensible lending standards.

This difference matters because the real danger is that either the executive or legislative branch will see the need to mandate that lending must increase – or that loans must be made to particular categories of borrowers, such as small business or housing.  This would be a recipe for more bad loans and further damage to the banking system (and more costs for you, the taxpayer.)  It would also lead to corruption, scandal, and reform fatigue.

The Geithner plan may work – let’s see the details before we take a more definite view on that.  But if the wrong expectations are set, it could even work well and still be judged a failure.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.